Thursday, December 18, 2008

Getting off Square One on America’s Long-Term Fiscal Deficit

As the United States Government seeks to dig the economy out of a recession through a massive fiscal stimulus package, many voices continue to remind us that the larger challenge to be faced is the large and growing long-term fiscal debt. For example, the Center on Budget and Policy Priorities (CPBB) has just issued budgetary forecasts through 2050 ( These highlight that under current policies and with historically reasonable assumptions, the federal debt will reach 279 percent of GDP in 2050. “The average amount of program reductions or revenue increases that would be needed over the next four decades to stabilize the debt at its 2009 level…equals 4.2 percent of projected GDP”, “the equivalent of an immediate and permanent 24 percent increase in tax revenues.” These warnings are not new. They follow similar alerts from the Congressional Budget Office, academics, and journalists over the last several years. The Peter G Peterson Foundation is also ramping up for a major initiative to raise the alarm, starting with the airing of its film on the long-term fiscal crisis, I.O.U.S.A (see, early next year.

Perhaps the more challenging question is why there has been so little traction on this issue, particularly given that these facts are undisputed among America’s political leaders as well as by most economic analysts. There are two simple answers. The first is the most obvious. Addressing the long-term fiscal deficit will be politically painful, requiring significant increases in taxes or cuts in expenditure programs, and the political system does not do pain very well. The second is the difficulty of coming to grips with how to tame the major elephant in the room, that is the largest source of the looming fiscal gap—the rising costs of medical care.

What has been missing in this litany of fiscal warnings, and which perhaps best explains why there has been so little political groundswell for action (including in the recent Presidential campaign), is any significant discussion of how this fiscal mess will be resolved, and who will bear the burden of its resolution. And here the CBPP’s note does highlight one important observation, which was first made in a joint op-ed by former Treasury Secretary Robert Rubin, incoming OMB head Peter Orszag, and economist Allen Sinai. Long before we get to 2050, it is likely that the edifice will crumble—that the capacity of the US government to continue to run large fiscal deficits and to service its growing debt will implode. Interest rates will begin to rise, further aggravating the debt service burden, and foreign buyers of US debt obligations will begin to be wary of too large a portfolio exposure to the US government.

In effect, markets will force action sometime in the next decade or so—this might occur through tax increases, draconian cutbacks in government programs, or by cutbacks in coverage or benefit eligibility. It also might occur through inflation, if the government were to erode the real value of its debt by printing money (though it is doubtful that in today’s globalized financial markets that this can be a successful strategy for very long). But action will take place because there will be little alternative. This will be painful and will have real consequences. The need for action, when pushed by markets, will not occur at a time of our choosing; indeed, one could imagine scenarios where the timing is simply awful in terms of the global economy or national security interests.

The current financial crisis is illuminating in this regard. We have just experienced (during a Republican Administration no less) an enormous unexpected and untargeted wealth “tax” of roughly 20 percent, borne largely by homeowners and by those with portfolio wealth (that has sunk in value). Unlike a tax increase, where at least the government would receive the associated revenues, few (and certainly not the government) have benefited from this current loss of wealth. Others are feeling or will feel the ripple effects of this loss in the form of lost wage earnings, lower benefits at the State level, higher taxes and fees, and lower interest incomes. A year ago, few would have imagined the starkness of the crisis that we now face.

Who will bear the financial burden of how this larger long-term fiscal debt problem will be resolved remains to be determined. One can imagine a number of equally plausible scenarios. The most desirable would be one that arose from a well-thought out strategy entailing many “politically difficult” measures sequenced over time: with some increases in tax rates and revisions in the tax code (e.g., reducing some present tax subsidies), significant efforts at rationalizing how and what medical services are provided, adjustments in coverage and eligibility for medical benefits, cutbacks in inefficient or less meritorious government programs, adjustments in the social security system in the form of higher payroll taxes or delayed ages for benefit eligibility (see Eugene Steuerle’s recent blog for some obvious candidates for reform ttp:// Another scenario might entail a far more comprehensive revision of the way in which medical care is delivered and financed, coupled with some less dramatic revisions to taxes and expenditures. Still another might reflect a far less strategic approach, involving ad hoc tax increases, brutal expenditure cuts, and ad hoc adjustments in the Medicaid or Medicare system. And finally, of course, using inflation to reduce the real value of a government’s debt is an approach many governments have used in the past, with large and long-term harm, both to individual households and to the government’s financial credibility. Regrettably, these latter solutions have been the outcome too often in the past.

How individual American households—of different income groups, from different generations, and from different sectors—would be affected by these very different ways in which the problem might be resolved would need to be analyzed carefully. A major part of these effects would be reflected in higher taxes, lower benefit incomes, a higher cost of public services, and a need to defray some costs that had been previously been financed by the government. But another important part of the effect would be reflected, say, in diminished access to real and useful government services or reduced availability of some medical care that had heretofore been provided by the government. Some groups in society might be affected far more than others—for example, if there were a major restructuring of the medical care system. Equally, some approaches—such as an increase in inflation--would certainly affect creditors and, as we have long known, would disproportionately affect those with a more limited ability to adjust their assets to an inflationary environment. What is important to acknowledge and clarify is that different approaches would affect different households in different ways, but the effects would be real and substantial.

Perhaps the best way to motivate political action would be to explore a few alternative scenarios and to illustrate specifically and transparently who would bear what part of the burden. Let the American public come to grips with the stark reality of the possible consequences of a well-thought-out strategy as opposed to an ad hoc, unplanned approach or recourse to inflation. The chips will fall, but they do not have to fall in an unintended way. Equally, some policy solutions will involve far less harm to America’s long-run interests. Others will not only be costly, but inefficient and damaging to America’s security and long-term interests.

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