The Current Federal Debt and Deficit Debate in the US - CIPFA
The Current Federal Debt and Deficit Debate in the U.S. Gilbert Yochum College of Business and Public Administration Old Dominion University Norfolk, Virginia 23529
Journal of Finance and Management in Public Services. Volume 10 Number 2
1
The Current Federal Debt and Deficit Debate in the U.S.
Gilbert Yochum
Abstract
A decade of foreign wars and the 2008 financial crisis have conspired to push U.S. debt and deficits to historic highs. These highs along with the generalized fear of debt, its potential default and other issues associated with the current sovereign debt problems of Euro Zone countries have served to help create a fear of debt and resulted in a general paralysis with respect to near term U.S. fiscal policy. As if this weren’t bad enough, the U.S., like its European and Japanese counter parts, faces serious long term fiscal issues that center on an aging, retired population that under current U.S. law is entitled to lay claim to significant future production. These extant claims, which are estimated to lead to roughly a doubling of the proportion of federal spending to gross output, are not likely to be met with increased taxes, but rather with rising deficits and debt. This scenario may not be sustainable because the debt required to support it may negatively affect the country’s future productivity and level of inflation. Serious future inflation raises the odds of de facto default on federal debt. Unfortunately, there appears to be little hope that the near term paralysis can be overcome. The long term issue of the proper size of government and its debt will serve as a focus for the 2012 presidential election.
Introduction
In late November 2011 the U.S. congressional “super committee”was dissolved after it failed to agree on how to meet its intended minimum target of $1.2 trillion in prospective deficit reduction in the U.S. government budget over the next decade. This event continued the public display of failed fiscal leadership on the part of both the executive and legislative branches of government that began in earnest in the summer of 2011 with the inability of federal leaders to come to grips with raising the national debt limit. Given this failure, “automatic” spending reductions, half defense spending and half other discretionary programs, will now be in force but don’t begin to take effect until January 2013, a convenient date given the intervening presidential election. At its core the debate over how to reduce projected future budget deficits by adjusting taxes and/or spending centers on the proper size of the federal government and so in the end it was probably too much to ask even a select group of congressional representatives to come up with a minimum solution. Thus the stage is now set for public debate at the highest level, leading up to the November 2012 presidential election, over the proper size of the nation’s federal government and what the spending and tax footprint of that government should be. Much of the public confusion and complexity generated by the recent debates over U.S. federal budget deficits and national debt is rooted in the multiple time dimensions that often lie behind and form the context for public positions by professionals and politicians on the issue. In particular, over the near term, or the current business cycle, counter cyclical deficits are an inevitable by-product of pre-existing U.S. law as well as deliberate fiscal policy initiatives such as the “Stimulus” program. However, current circumstances appear to have called into question the efficacy of increased deficit spending. Alternatively, the summer 2011 congressional debate over raising the national debt ceiling, although ostensibly over raising the debt limit in order to insure government operations today, ultimately centered on the longer term issue of how to fund rapidly growing spending for entitlement programs over the next decade and beyond. This debate can be more constructively thought of as focused on the issue of the proper sizing of the federal government. The size issue is made especially contentious given the changing demographics of the U.S. population and existing federal obligations built into future budget commitments especially with respect to health care. The very real threat to America’s future output and well-being originates from the possibility that too large a government will act as a drag on productivity and the resulting subsequent economic growth. This paper attempts to give a brief historical context to some of the above issues which swirl around the U.S. government debt as well as to decompose federal budget deficits into near term efforts to offset business cycles and longer term issues over the size of government and economic growth.
Journal of Finance and Management in Public Services. Volume 10 Number 2
2
The Current Federal Debt and Deficit Debate in the U.S.
Gilbert Yochum
Some Historical Context: The U.S. National Debt and its Scale over Time
According to Federal Reserve data, as of the second quarter of 2011 the U.S. national debt amounted to$14.3 trillion dollars and the FY 2011 budget deficit was $1.3 trillion. The debt is held in the form of U.S. Treasury bills, bonds and notes. Budget deficits account for the year-to-year change in the national debt1. One way to view how much debt a nation should have is to compare its value to that of national output, as presented in Figure 12. Several things stand out about this figure, some rather obviously. Over the past 73 years the highest value of this ratio was reached in 1946 when the ratio of gross debt to GDP stood at 122 percent. The lowest value over the period occurred in 1981, the year Ronald Reagan was inaugurated as president. The estimated 95.6 percent gross debt to GDP ratio in 2011 is the highest this measure has been Figure 1 since 1947, a statistic that plays an important role in the current budget debates in light of the recent highly influentialU.S. Gross and Net (Publically Held) Federal Debt as a Proportion of GDP 1941‐2011 work of Reinhart and Rogoff (2010) which identifies a 90 percent threshold; a gross debt to output ratio larger than 90 percent is seen as a drag on economic growth.
Source: Federal Reserve Bank. Net (or Publically Held) debt data available beginning in 1970. Figure 1: U.S. Gross and Net (Publically Held) Federal Debt as a Proportion of GDP 1941 - 2011.
Some other characteristics of Figure 1 aren’t as apparent but can add useful context to understanding U.S. debt and deficits. Although the annual debt to GDP ratio declined consistently and by more than two thirds from 1947 through 1981 the size of the debt more than tripled over this period from $257.1 billion to $994.8 billion. The reason for this seeming inconsistency is that although debt and deficits were growing nominal GDP was growing at a much faster rate. Notably over the period price adjusted or real GDP grew by a factor of 3.4 while the debt grew by a factor of 3.9 implying that the decline in the debt to GDP ratio from 1947 to 1981 was due totally to inflation, a sometimes suggested, though not widely accepted, solution to reducing the debt ratio 1. All data displayed in this paper are Federal Reserve Data or the author’s calculations based on U.S. Federal Reserve Data unless otherwise noted. 2. See for example Robert Eisner’s () exposition on the reasoning for comparing national debt to income (p.95). The definitions of gross and net public debt in this paper generally follow those laid out by the IMF in () (p.4); gross public debt refers to gross financial liabilities of the federal government. Net public debt is gross financial liabilities less gross financial assets of the federal government. Following the IMF, net public debt is the more important concept for long-run national debt sustainability, while gross debt is the key indicator from the perspective of the securities market. 3. Germany has experienced the consequences of strategic price inflation and debt. There is an eerie similarity between strategically inflating the Euro to reduce the externally held real obligations of Euro Zone sovereign bond issuers and Germany’s inflation during the 1920’s intended to reduce its real war debt obligations under the Versailles Treaty.
Journal of Finance and Management in Public Services. Volume 10 Number 2
3
The Current Federal Debt and Deficit Debate in the U.S.
Gilbert Yochum
in many countries today. One might argue that this is the point of contention between France and Germany with respect to ECB purchases of sovereign securities; that is, potentially inflating one’s way out of current real obligations3. Over the period from 1947 to 1981 nominal gross debt grew through every presidential administration whether the president was a declared balanced budget conservative or whether democrat or republican. It grew least in value during the Eisenhower administration and most in value during Nixon’s tenure. Despite being thought of by many as fiscally conservative republicans, over the twelve year consecutive tenure of the Reagan and George H.W. Bush administrations the national debt more than quadrupled rising from $909 billion in 1980 to $4 trillion in 1992 the last year of Bush’s presidency. In addition, over the same period the debt to GDP ratio also grew rapidly almost doubling from 33.6 percent to 63.1 percent over the period and in terms of the rhetoric used in today’s budgetary debates added significantly to the scale of debt. Measured in proportional terms with respect to national output the nation’s debt grew faster than in any twelve year period in post war American history. The cost of defeating communism could be measured in these terms. Despite several years of surplus budgets during the Clinton administration, the first budget surpluses the nation had seen since the 1950’s, from 1992 to 2000 the national debt grew by $1.6 trillion. However, the debt to GDP ratio declined from 63.1 percent to 56.6 percent over the period but, as during 1947 to 1981, this decline can be attributed to inflation. During the George W. Bush presidency, the debt to GDP ratio resumed its increase; an increase that has continued and accelerated through Obama’s time in office. The Obama administration has experienced the most rapid annual growth in the ratio since World War II. Several things can be noted from this brief political tour of America’s ability, measured in the ratio of debt to output, to carry debt. First, although currently at a 64 year high the nation’s ratio of debt to income is still below that of 1946. It is worth recounting that although the ratio was at a historical high in 1946 it was followed by one of the strongest growth periods in the modern American economy; a period which lasted through the late 1960’s. Second, fiscal conservatism, defined as budget balance, has not been associated with any particular political party. Somewhat ironically given the party’s historical rhetoric, between 1946 and 2008 republican administrations were much more likely than their democratic counterparts to accelerate the growth rate of the ratio; an observation that may help explain some of the current partisan confusion over the debt. That is, with respect to party lines, evoking the specter of larger debt and deficits by either party may be more a political ploy aimed at voter’s visceral reactions deployed in the extant interest of the party, than an expression of an earnest goal to control debt. The real “pea under the pod” is likely the size of government. Third, to the extent that the debt to output ratio has been lowered, that lowering has come not from real output growth but from inflation.
More Context: Keynes Institutionalized Into the American Budget Process
Following directly on the work of Keynes’ and his theory that identified the lack of aggregate demand as the culprit in economic cycles, Gunnar Myrdal, a Swedish Nobel winner, in a 1939 article in the American Economic Review (1939) laid out the policy prescription that, as a practical matter, has served as the object of modern American fiscal policy. That is, the optimal fiscal policy will aim for budget deficits during cyclical economic downturns and budget surpluses to absorb too much demand, and its subsequent inflation, in boom years. This fiscal policy ideal is matched by its closest expression in the U.S. during the Clinton administration. There have been many new theories introduced into modern macroeconomics and into American graduate schools from the New Classical Economics to the Austrians to Real Business Cycle Theory that seriously challenge, and many would argue have relegated to obscurity in those schools, the Keynes/Myrdal fiscal policy prescription. There has also been a serious challenge to structural macroeconomic Keynesian models that finds its source in the Lucas Critique. However, as a practical matter and from a fiscal policy perspective, until this day none have unseated the Myrdal guidelines for reactive fiscal policy. Despite what many view as advances in macroeconomic theory, in terms of post-war U.S. economic policy, when it comes to fiscal policy, two signature events have driven America’s general fiscal reaction to recession:
Journal of Finance and Management in Public Services. Volume 10 Number 2
4
The Current Federal Debt and Deficit Debate in the U.S.
Gilbert Yochum
John F. Kennedy’s 1962 Yale speech and the Employment Act of 1946. Although many might have it that the first deliberate practical application of Keynes’ recommendation for the counter cyclical use of deficit financing occurred during the Roosevelt administration, it would appear to be more historically accurate to identify Kennedy, a student of J.K. Galbraith who himself was a student of Keynes and Keynes protégé Alvin Hansen, as the moving force behind the muting of what had been the moral imperative to annually balance the federal budget. In order to build political support for deficits Kennedy explicitly acknowledged that budget deficits could be a source of expansion and strength. In addition he openly questioned the efficacy of setting national budget balance as a goal when the budget (NIPA) technique itself, “…neglects changes in assets and inventories. It cannot tell a loan from a straight expenditure--and worst of all cannot distinguish between operating expenditures and long term investments.”(Kennedy 1962). By effectively removing the moral imperative from public debate over a balanced budget, “there is no single, simple slogan in this field we can trust,”(Kennedy 1962) and replacing it with a more functional perspective, Kennedy laid the intellectual ground work for what resulted in successive decades of both aggressive countercyclical policy and in some periods politically expedient deficits. Over the past fifty years, the effective dampening of this moral constraint has been repeatedly criticized, often for its political utility, but the constraint has not been restored. For example, Buchanan and Wagner (1977) made the case that once the moral constraint imposed by the budget balance requirement is taken away politicians may pay lip service to the idea but acting in their self-interest, defined as the desire for re-election, have little incentive to cut expenditures or raise taxes, or alternatively, to aim for a budget surplus in non-recessionary periods. Alternatively, from Buchanan and Wagner’s perspective Myrdal’s policy prescription might be nice in theory but not possible to achieve in reality. As a practical matter, the Employment Act of 1946 and the Humphrey Hawkins Act of 1978 (HHA), a more aggressive version of the Employment Act, requires the federal government to use its budget to achieve fullemployment and codifies the use of expanding deficits to achieve that end. Thus, during recessions successive administrations have been obliged to submit budget plans to counter downward cycles in GDP. Countercyclical “automatic stabilizers,” such as a progressive tax structure, unemployment compensation and welfare “safety net,” draw at least part of their credibility from this legislation. Some might argue that this legislation and its resulting fiscal policy reaction is at least partly responsible, along with monetary policy, for the relatively continuous post war reduction in the amplitude and length of U.S. business cycles, a phenomena that until the 2007 recession was labeled the “great moderation.”
Near Term Cycles: Build-Up to the Great Recession
The recovery that followed the 2001 recession was characterized by a slow rate of employment growth. It was not until 2005, four years after the beginning of the recession that U.S. employment began to exceed its pre-recession level. True to the HHA full employment mandate and in reaction to the recession, significant tax cuts were included in the Economic Growth and Tax Reconciliation Act of 2001. As seen in Figure 1, the combination of tax cuts and rising defense expenditures in support of a supplemental budget for war in Iraq and Afghanistan, and the subsequent relatively large annual budget deficits they helped create, swung the 2001 debt GDP ratio from annually decreasing to increasing. Relatively slow employment growth, and the possibility of a deflation following 2001, led not only to active fiscal efforts in the form of annually rising budget deficits to support output growth but also to accommodative Federal Reserve actions evidenced by an aggressive and sustained reduction in short-term interest rates. The three month T-Bill rate fell from near six percent in late 2000 to around one percent by mid-2004. Sequential short term rate reductions, combined with rapidly rising residential property prices, significantly lowered underwriting and margin standards for mortgages, as well as a highly liquid market for short-term adjustable rate mortgages (ARM’s) and the advent of sophisticated new mortgage derivatives such as collateralized debt obligations (that caused a classic market failure in the financial sector because of their obtuseness) created a veritable witches brew that led to a collapse in the banking system’s total asset value, particularly in the $10 trillion dollar U.S. mortgage market, and to the subsequent financial crisis.
Journal of Finance and Management in Public Services. Volume 10 Number 2
5
The Current Federal Debt and Deficit Debate in the U.S.
Gilbert Yochum
Given that personal consumption accounts for more than seventy percent of GDP, arguably the most insidious component of this brew and key to the resulting historical federal deficits, was the more than doubling of residential property prices between 2000 and 2007 (Case-Shiller 20 City Index). As property values grew so did the ability of U.S. households to refinance their homes at lower rates and extract equity from their home appreciation that was used for current expenditures. Figure (2) shows the extent of this equity withdrawal relative to disposable income. From 2004 Figure 2 to 2007, the height of the house price bubble, households extracted an average of more than $850 million per year from their appreciated home values, in effect using their homes Tapped‐Out Consumer Credit: Mortgage Equity Withdrawal as veritable piggy banks to support increased household spending. This broad based subsidy in the ability of households to spend essentially collapsed with the fall in housing prices which began in earnest in 2007.
Annual percentage change in house value (blue)
Percent of disposable income (red)
10
8
6
4
2
0
-2 1992 1993 1994 1995 1996 1997 1998 1999 2000 2001 2002 2003 2004 2005 2006 2007 2008 2009e Net Equity Extraction
Source: Federal Reserve Bank, Kennedy‐Greenspan Data Updated as of January 2010; the Old Dominion University Economic Forecasting Project and the Federal Housing Finance Agency.
Figure 2: Tapped-Out Consumer Credit: Mortgage Equity Withdrawal.
Collapsing along with house prices and consumer spending were asset values of U.S. banks and capital investment. Bank assets declined by roughly ten percent from the first quarter of 2007 through the last quarter of 2008 when liquidity in the banking system literally froze. Growth in total bank credit has been at a virtual stand-still since that time and through the third quarter of 2011. In addition, gross investment declined by more than a third from the fourth quarter of 2007 to third quarter of 2009. It continues to remain far below its prerecession level despite the fact that firms are flush with cash (liquidity). Corporate retained earnings reached $2 trillion, a historical high, in the second quarter of 2011 the most recent data available4. Both of which explain why the private sector has failed to spur economic growth and why the relatively low level of U.S. output and growth rate continue to linger; the U.S. could be described as experiencing a “liquidity trap” for the first time since 1937-38. That is, at current interest rates banks and firms prefer to hold cash as opposed to lending or investing it.
Near Term Cycles: Budget Deficits and Economy Wide Demand
Figure 3 displays the central difficulty of the current U.S. economic situation characterized most importantly by consumer balance sheet problems, bank failure to lend, firms reluctant to reinvest their record profits, an overvalued currency and fear of the future. Potential GDP, that is the potential output of the nation based on the full employment of its stock of land, labor and capital, continues to grow (ironically the U.S. potential continues to strengthen not weaken as some would have it) as U.S. productivity and the labor force continues to grow. 4. U.S. Department of Commerce, Bureau of Economic Analysis
Journal of Finance and Management in Public Services. Volume 10 Number 2
6
The Current Federal Debt and Deficit Debate in the U.S.
Gilbert Yochum
Figure 3 However, economy wide demand has not been at a level that enables taking advantage of this enhanced U.S. Real GDP and Real Potential GDP (in 2005 dollars) potential, a circumstance that Nobel laureate Paul Samuelson (Greenhouse 1993) throughout his career aptly described as “poverty amidst plenty.” That is a nation’s economy, in this case that of the U.S., is capable of producing considerably more than it is; a description of wasted ability and inefficiency.
Billions of Dollars
15,000 14,000
Real Gross Domestic Product Real Potential Gross …
13,000 12,000 11,000
Source: US Department of Commerce, Congressional Budget Office and Federal Reserve Bank Figure 3: U.S. Real GDP and Real Potential GDP (in 2005 dollars).
In reaction to the precipitous decline in output in the fourth quarter of 2008 and true to past practice congress passed a “Stimulus,” or the American Recovery and Reinvestment Act of 2009 (ARRA). Designed to be spread over a number of years, it was a $787 billion attempt to, over several years, close the gap between actual and potential output by increasing aggregate demand and subsequently actual output, and true to the HHA, force the economy toward full employment. According to CBO estimates, the ARRA deficit impact,spread over a number of years,added or will add annually in billions $200, $404, $135 and $56 from 2009 to 2012 respectively to each intervening year’s deficit; the effect continuously diminishing from its 2010 peak5. The result of this historically large government deficit financed effort to stimulate the economy has been mixed. Most empirical studies6 have found that the effect of the ARRA has been to keep the 2007 to 2009 recession from being much worse. For example, Wilson (2011) found that roughly 3.4 million jobs had been saved or created by the ARRA close to the jobs number found by Blinder and Zandi (2010). Further, the consensus of these studies is that GDP was one to three percent larger in 2009 than it would have been in the absence of the stimulus. In terms of its length, the recent recession was the worst in the post war period but at 18 months not much different from those of the mid 70’s and early 80’s, both of which lasted for 16 months. However, as seen in Figure 4, it has taken fifteen quarters for GDP to attain its pre-recession level, three times the average for post war recessions and more than double that for the previously worst recessions in 1973 and 1981. The real problem, as seen in Figure 3, is that the ARRA and follow-on deficit financed spending intended to spur growth has not been successful in pushing the economy to its potential output; GDP has persistently remained about 6 to 7 percent below its potential.
5. http://www.cbo.gov/ftpdocs/108xx/doc10871/AppendixA.shtml. 6. See for example: The Congressional Budget Office (2011), Blinder and Zandi (2010) and Wilson (2011).
Journal of Finance and Management in Public Services. Volume 10 Number 2
7
The Current Federal Debt and Deficit Debate in the U.S.
Gilbert Yochum
Figure 4
U.S. GDP: Percentage Change from Pre‐Recession Peak Quarters Subsequent to the Peak
1973
1981
2007
Quarter Since Peak
Source: Federal Reserve Bank and author’s calculations. Figure 4: U.S. GDP: Percentage Change from Pre-Recession Peak Quarers Subsequent to the Peak.
Near Term Policy Paralysis:
In the Keynes/Myrdal tradition near-term fiscal policy action to counter recession and lead the economy to fullemployment, as required by U.S. law, has been to increase the budget deficit by increasing spending, reducing taxes or some combination of the two; the exact mix and composition depending on the politics extant. When there has been congressional debate on such policy it was likely to center on the size of the deficit required to prod the economy toward full employment rather than whether or not to initiate the action. The “Stimulus,” which for many was shockingly larger than any previous fiscal action to counter recession, was promoted in the minds of some with the idea that it was a cure-all that would push the economy to full-employment. Although the empirical evidence suggests that the ARRA despite its flaws appears to have prevented a much more serious U.S. economic downturn in 2009 and 2010, as shown in Figure 3 there remains a $1 trillion dollar difference between actual output and that of fully employed factor resources. This has prompted some to conclude that the ARRA has ended in failure. The residual gap, to date unclosed after what was viewed by many as a figurative fiscal “maximum effort” has opened up a new chapter in the creation of American post-war fiscal policy. Consumer balance sheet retrenchment, an over-valued dollar and uncertainty about the future on the part of both banks and non-financial businesses that manifests itself in a modern day liquidity trap imply that in the near term, demand in the private sector is unlikely to be a source for closing the gap. Given the lack of prospective near term demand from the private sector, why can’t government fill the demand gap? Public fear of any fiscal action associated with increased debt has percolated up through the American political structure from individual households many of whom on a personal level have found their budgets burdened with disconcerting debt legacies; the result of the decline in U.S. home values in combination with low margin home purchase or equity extraction. At the national level debt fear takes on a more palpable focus from two current events: sovereign default fear that has spread from the current Euro Zone crisis and the previously mentioned 90 percent gross debt to GDP threshold established in the recent and much cited empirical work of Reinhart and Rogoff.
Journal of Finance and Management in Public Services. Volume 10 Number 2
8
The Current Federal Debt and Deficit Debate in the U.S.
Gilbert Yochum
Considerable confusion over federal debt and deficits has resulted in both the American media and in political debate because of the European sovereign debt crisis. Many tend to lump together analysis of U.S. debt with that of fiscally failing European nations who have no control over the creation and destruction of their currency. These nation’s, analogously like American states or countries utilizing currency boards such as Argentina and many others have in the past, have ceded their sovereign ability to manage their debt in coordination with their currency and have seriously reduced their degrees of freedom in dealing with their debt. One might argue that one benefit of a break-up of the Euro Zone would be to restore to the zone’s individual countries the freedom of action shared by sovereigns who print their own currency. Reinhart and Rogoff (2010) sought to answer the difficult question of how much sovereign debt is too much. Their work covers over 200 years and many countries and is unique in that it is the only empirical work of its kind and that specifically answers the question of how much debt is too much debt. Previous efforts to answer this question were theoretical and inconclusive. For example, Lerner (1943) argued that a country could finance unlimited debt as long as it managed its currency properly. Ball and Mankiw (1995) were more circumspect. They identified investor confidence as the key to how much fiscal debt a country could manage but could “only guess what level of debt will trigger a shift in investor confidence.” Reinhart and Rogoff were on the other hand, definitive about that confidence: at a gross debt to GDP ratio of greater than 90 percent, an increased debt would serve to reduce GDP rather than increase it. The current U.S. gross debt ratio is greater than 95 percent. Thus a perfect storm consisting of the confluence of fear of a rising national debt, the rising debt ratio to output and fear of potential debt default have conspired to insure that the Keynes/Myrdal policy reaction can no longer gain virtually assured support. Academic counter theories, long in vogue in American graduate schools but usually confined to debate over longer term policy, have gained real world policy traction from the perceived failure of the ARRA and have been put to work in defense of various political agendas. All have combined to create political paralysis that has resulted in the federal government’s inability to in the near term aggressively attack and close the potential/actual output gap.
The Longer-Run: Into the Future
The late Senator Daniel Patrick Moynihan(1977)had observed that, “[T]here is simply nothing so important to a people and its government as how many of them there are, whether their number is growing or declining, how they are distributed as between different ages, sexes…and different social classes and racial and ethnic groups...” With Moynihan’s observation in mind, it is important to recognize that although the U.S. has a growing population it will over the coming decades experience a sea change in age distribution. Those 65 years and older, made up 12.9 percent of the U.S. population in 2010 and are projected to account for 20.2 percent by 2050 while those in prime working ages, 18 to 64 years will fall from 62.8 percent of the population to 56.7 percent over the same period7. The practical fiscal effect of this prospective change in the distribution of the population on future federal government obligations and debt cannot be understated. Payments to support the elderly, which are concentrated in social security, Medicaid and Medicare benefits, and sometimes referred to as entitlements, will over the foreseeable future drive-up both the level of federal spending and its proportion with respect to output. CBO estimates, which factor in expected future GDP growth, project that under current policy, entitlement payments alone are likely to rise from roughly ten percent of GDP in 2011 to near twenty percent by 2050 and, when debt interest payments are factored-in, would roughly double total federal spending as a proportion of GDP from its current post war average of nearly twenty percent to about forty percent in 2050. As seen in Figure 5, even during World War II government spending only reached thirty-two percent of GDP.
7. Population data are U.S. Census data derived from: http://www.census.gov/population/www/projections/summarytables.html
Journal of Finance and Management in Public Services. Volume 10 Number 2
9
The Current Federal Debt and Deficit Debate in the U.S.
Gilbert Yochum
Proportion of GDP
Figure 5 Federal Government Spending, Revenue and Deficit as a Proportion of GDP 1941‐2040 (CBO Alternative Scenario)
Source: Federal Reserve Bank and Congressional Budget Office.
Figure 5: Federal Goverment Spending, Revenue and Deficit as a Proportion of GDP 1941-2040 Figure 6 (CBO Alternative Scenario)
U.S. Net Debt as a Percent of GDP
Source: The National Commission on Fiscal Responsibility and Reform, The White House, Washington D.C., December 2010, p.11.
Figure 6: U.S. Net Debt as a Percent of GDP
Journal of Finance and Management in Public Services. Volume 10 Number 2
10
The Current Federal Debt and Deficit Debate in the U.S.
Gilbert Yochum
The projected effect on publically held debt of potential future spending obligations can be seen in the accompanying chart (Figure 6) developed by the Congressional Budget Office and the Simpson-Bowles (SB) commission. The Alternative Fiscal Scenario is viewed by the commission as the most likely to occur8. Most importantly the alternative scenario assumes that the income tax rate reductions of the Economic Reconciliation and Growth Act (ERGA) of 2001, set to automatically expire in December of 2012, will be renewed for all income levels below $250,000 and that discretionary (non-entitlement) spending grows at the same rate as GDP. The simulated result of this scenario is an unacceptable tripling of federal debt over the next twenty-five years. The extended baseline scenario simulation, which results in no increase in the debt to GDP ratio for more than ten years, assumes congress does nothing and lets the ERGA and the current temporary attempts to spur the economy, for example the payroll tax reduction and extended unemployment benefits, expire. Ironically, this donothing scenario is projected to result in the accumulation of less debt through 2020 than the recommendations of the SB debt reduction committee. Should the commission’s proposal be adopted, prospective debt would be reduced by an estimated $3.885 trillion between 2012 and 2020, seventy-five percent of which would come from recommended spending reductions and twenty-five percent from tax increases. Federal spending would be reduced from its current (2010) 25.6 percent to 21.8 percent of GDP by 2020. On the other hand, if congress does nothing and the extended base line scenario becomes reality debt would be reduced by more than $4 trillion by 2020. The alternative and extended scenarios are key to understanding this summer’s debt ceiling conflict, the rationale for creating the “super committee,” and why there appears to be so little publically expressed concern over the November failure of the super committee to resolve the inter party impasse. This summer’s fiscal debate, ostensibly over raising the federal debt ceiling, was in reality a different and emotionally laden way of packaging the on-going struggle over the prospective size of the federal government, or whether or not the tax cuts of the ERGA, sometimes referred to in the media as the “Bush tax cuts,” would be temporary (expiring in December 2012) or permanent. Authorization for raising the debt ceiling, the lack of which raised the specter of a voluntary debt default, was unfortunately held hostage to the politics (should prospective debt reduction come from spending or taxes) of this debate. Specifically, if the ERGA tax cuts became permanent there would need to be a significant reduction in government spending in order to keep the publically held debt to GDP ratio from ballooning. On the other hand, if the ERGA simply expires, tax rates increase and the debt ratio is expected to remain stable. The latter was not, and currently is not, a likely outcome given the written commitment of many republican legislators to not raise taxes. The super committee turned out to be an efficient and face saving way of allowing for an increase in the debt ceiling, thus defusing the pressure of this summer’s debate. The impasse over the prospective size of government still exists but has defaulted to being a center piece for debate and resolution in the upcoming (2012) presidential election.
Long Term Debt Default
The stakes of the presidential election are high; muddling through over the desired size and role of government is a less than optimal option. In the absence of acceptance of the Simpson-Bowles tax and spending recommendations on debt reduction, or some other substitute such as President Obama’s $3 trillion reduction plan submitted to the congressional super committee or even expiration of the ERGA, the prospect of such a high proportion of the nation’s output being dedicated to federal spending, an increasing portion of which would be funded by deficits and debt, raises serious concerns for future economic growth. In particular, government spending may “crowd-out” private sector capital investment, leading to a reduction in potential productivity and economic growth. For example, during World War II, when government spending accounted for thirty-two percent of GDP, net investment through the period in the country’s capital stock was negative.
8. Simpson-Bowles’ (2010, p.11) scenario definitions are: “The Extended-Baseline Scenario generally assumes continuation of current law. The Alternative Fiscal Scenario incorporates several changes to current law considered likely to happen, including the renewal of the 2001/2003 tax cuts on income below $250,000 per year, continued Alternative Minimum Tax (AMT) patches, the continuation of the estate tax at 2009 levels, and continued Medicare “Doc Fixes.” The Alternative Fiscal Scenario also assumes discretionary spending grows with Gross Domestic Product (GDP) rather than to inflation over the next decade, that revenue does not increase as a percent of GDP after 2020, and that certain cost-reducing measures in the health reform legislation are unsuccessful in slowing cost growth after 2020.”
Journal of Finance and Management in Public Services. Volume 10 Number 2
11
The Current Federal Debt and Deficit Debate in the U.S.
Gilbert Yochum
Under potential future conditions where the economy’s production factors are fully employed crowding-out is likely to occur because, as governments issue debt to fund their increased spending, interest rates are much more likely to rise making it more expensive and difficult for the private sector to fund capital projects. To the extent that capital is not accumulated at a rate that it would have been in the absence of debt, productivity declines. If a central bank intervenes to accommodate the increased debt, as might be the case when the bank issues its own sovereign’s currency as in the U.S. or U.K., attempting to temper rising interest rates, the increased liquidity in the economy can result in inflation. This is also the mechanism Germany fears if the ECB were to intervene in the current Euro Zone crisis by purchasing the securities of countries such as Italy and Spain in an effort to protect liquidity and lower rates in those national bond markets. In such a world inflation could result from either declining productivity, the result of lowered private sector capital spending, or enhanced liquidity. In either case the resulting inflation can reduce the purchasing power of government securities, as previously seen in the U.S. debt market during the 1947 to 1981 period. For example, holding real interest rates constant, if an individual purchased a 20 year U.S Treasury Bond in 1955 and held it to maturity in 1975, a period of rapidly rising prices, the purchasing power of that security would have fallen to half of its face value. Although under such circumstances there is no de jure default9 one could argue that there is a de facto default of the federal government that resulted from the decrease in the security’s real purchasing power; a decrease caused by inflation.
Summary
The size and scale of the U.S. national debt and federal budget deficits are rapidly reducing the degrees of freedom with respect to the political and fiscal options available to the U.S. Congress and the Obama administration. Economic historians may eventually view the current near term persistent negative deviation of U.S. actual output from its potential as the result not only of the lingering effects of the 2008 financial collapse but also of policy failure and inability of the government to aggressively deficit finance to remove this gap, sooner as opposed to later, as it has through most of U.S. post World War II history. That inability, or paralysis, is a least partly due to confusion in the political debate between the country’s near term debt and long term obligations. U.S. federal long term obligations will increase significantly over the next few decades, driven by an aging population with its associated social security and health care entitlements. If left unchanged, these obligations are likely to increase government spending as a proportion of output to a level that will seriously bias capital accumulation, factor productivity and future economic growth leaving the country vulnerable to a de facto default, induced by inflation, on its outstanding debt. The 2012 presidential election is expected to focus squarely on the long term issue of the proper sustainable size of the federal government with respect to its spending, revenue and debt. For the near term, however, it appears that the debt and deficit debate has rendered the country near helpless in its ability to approach full employment of factor resources.
9. For countries that print their own currency, for example the U.S., U.K. and Japan, a legal default on that country’s outstanding securities is possible only if the securities are issued and denominated in another country’s currency (e.g. Argentina, a serial defaulter in national debt issued in U.S. dollars) and the debt can’t be met, the nation’s central bank is totally independent and refuses to accommodate debt, or, as in the U.S. in the summer of 2011, a country chooses to raise the issue of voluntarily default on its debt. The latter situation is so bizarre and caused so much confusion about what was actually happening during the debt limit debates that it prompted what would have been a meaningless downgrade of U.S. securities by the S&P. De facto default is dealt with later in the paper.
Journal of Finance and Management in Public Services. Volume 10 Number 2
12
The Current Federal Debt and Deficit Debate in the U.S.
Gilbert Yochum
References:
Blinder, A., & Zandi, M. (2010). How the Great Recession Was Brought to an End. Princeton University, Moody’s Analytics. Retrieved from http://www.economy.com/mark-zandi/documents/End-of-GreatRecession.pdf Ball, L., & Mankiw, Gregory N. (1995). What Do Budget Deficits Do? Working Paper 5263. Cambridge: National Bureau of Economic Research. Buchanan, J., & Wagner, R. (1977). Democracy in Deficit. New York: Academic Press. Congressional Budget Office. (May 2011). Estimated Impact of the American Recovery and Reinvestment Act on Employment and Economic Output from January 2011 Through March 2011. Washington, D.C: Congressional Budget Office. Eisner, R. (1994). The Misunderstood Economy. Boston: Harvard Business School Press. Greenhouse, S. (1993, October 31). Conversations/Paul A. Samuelson; The Man Who Wrote the Book Suggests Econ 101 for Presidents. New York Times. Retrieved from http://www.nytimes. com/1993/10/31/weekinreview/conversations-paul-samuelson-man-who-wrote-book-suggests-econ101-for-presidents.html?pagewanted=all&src=pm International Monetary Fund. (November 2011). Japan Sustainability Report. Washington D.C.: International Monetary Fund. Kennedy, John F. (Speaker). (1962, June 11). Yale University Commencement Speech. Retrieved from http://www.jfklibrary.org Lerner, A. (1943). Functional Finance and the Federal Debt. Social Research, 10, 38-51 Moynihan, Daniel P. (1977). The Most Important Decision-Making Process. Policy Review, 1, 89-93. Myrdal, G. (1939). Fiscal Policy in the Business Cycle. American Economic Review, Papers and Proceedings of the Fifty-first Annual Meeting of the American Economic Association, 29(1), 183-193. Reinhart, Carmen M., & Rogoff, Kenneth S. (2010, January 7). Growth in a Time of Debt. American Economic Review Papers and Proceedings. Rogoff, Kenneth S., & Reinhart, Carmen M. (2009). This Time is Different. Princeton: Princeton University Press. Simpson Bowles Commission. (December 2010). The National Commission on Fiscal Responsibility and Reform. Washington D.C: The White House. Wilson, Daniel J. (2011). Fiscal Spending Job Multipliers: Evidence form the 2009 American Recovery and Reinvestment Act. Working Paper 2010-17. San Francisco: Federal Reserve Bank of San Francisco. Wilson, Daniel J. (October 2011). Fiscal Spending and Jobs Multipliers: Evidence from the 2009 American Recovery and Reinvestment Act. Federal Reserve Bank of San Francisco Working Paper Series.
Journal of Finance and Management in Public Services. Volume 10 Number 2
13
Journal of Finance and Management in Public Services. Volume 10 Number 2
1
The Current Federal Debt and Deficit Debate in the U.S.
Gilbert Yochum
Abstract
A decade of foreign wars and the 2008 financial crisis have conspired to push U.S. debt and deficits to historic highs. These highs along with the generalized fear of debt, its potential default and other issues associated with the current sovereign debt problems of Euro Zone countries have served to help create a fear of debt and resulted in a general paralysis with respect to near term U.S. fiscal policy. As if this weren’t bad enough, the U.S., like its European and Japanese counter parts, faces serious long term fiscal issues that center on an aging, retired population that under current U.S. law is entitled to lay claim to significant future production. These extant claims, which are estimated to lead to roughly a doubling of the proportion of federal spending to gross output, are not likely to be met with increased taxes, but rather with rising deficits and debt. This scenario may not be sustainable because the debt required to support it may negatively affect the country’s future productivity and level of inflation. Serious future inflation raises the odds of de facto default on federal debt. Unfortunately, there appears to be little hope that the near term paralysis can be overcome. The long term issue of the proper size of government and its debt will serve as a focus for the 2012 presidential election.
Introduction
In late November 2011 the U.S. congressional “super committee”was dissolved after it failed to agree on how to meet its intended minimum target of $1.2 trillion in prospective deficit reduction in the U.S. government budget over the next decade. This event continued the public display of failed fiscal leadership on the part of both the executive and legislative branches of government that began in earnest in the summer of 2011 with the inability of federal leaders to come to grips with raising the national debt limit. Given this failure, “automatic” spending reductions, half defense spending and half other discretionary programs, will now be in force but don’t begin to take effect until January 2013, a convenient date given the intervening presidential election. At its core the debate over how to reduce projected future budget deficits by adjusting taxes and/or spending centers on the proper size of the federal government and so in the end it was probably too much to ask even a select group of congressional representatives to come up with a minimum solution. Thus the stage is now set for public debate at the highest level, leading up to the November 2012 presidential election, over the proper size of the nation’s federal government and what the spending and tax footprint of that government should be. Much of the public confusion and complexity generated by the recent debates over U.S. federal budget deficits and national debt is rooted in the multiple time dimensions that often lie behind and form the context for public positions by professionals and politicians on the issue. In particular, over the near term, or the current business cycle, counter cyclical deficits are an inevitable by-product of pre-existing U.S. law as well as deliberate fiscal policy initiatives such as the “Stimulus” program. However, current circumstances appear to have called into question the efficacy of increased deficit spending. Alternatively, the summer 2011 congressional debate over raising the national debt ceiling, although ostensibly over raising the debt limit in order to insure government operations today, ultimately centered on the longer term issue of how to fund rapidly growing spending for entitlement programs over the next decade and beyond. This debate can be more constructively thought of as focused on the issue of the proper sizing of the federal government. The size issue is made especially contentious given the changing demographics of the U.S. population and existing federal obligations built into future budget commitments especially with respect to health care. The very real threat to America’s future output and well-being originates from the possibility that too large a government will act as a drag on productivity and the resulting subsequent economic growth. This paper attempts to give a brief historical context to some of the above issues which swirl around the U.S. government debt as well as to decompose federal budget deficits into near term efforts to offset business cycles and longer term issues over the size of government and economic growth.
Journal of Finance and Management in Public Services. Volume 10 Number 2
2
The Current Federal Debt and Deficit Debate in the U.S.
Gilbert Yochum
Some Historical Context: The U.S. National Debt and its Scale over Time
According to Federal Reserve data, as of the second quarter of 2011 the U.S. national debt amounted to$14.3 trillion dollars and the FY 2011 budget deficit was $1.3 trillion. The debt is held in the form of U.S. Treasury bills, bonds and notes. Budget deficits account for the year-to-year change in the national debt1. One way to view how much debt a nation should have is to compare its value to that of national output, as presented in Figure 12. Several things stand out about this figure, some rather obviously. Over the past 73 years the highest value of this ratio was reached in 1946 when the ratio of gross debt to GDP stood at 122 percent. The lowest value over the period occurred in 1981, the year Ronald Reagan was inaugurated as president. The estimated 95.6 percent gross debt to GDP ratio in 2011 is the highest this measure has been Figure 1 since 1947, a statistic that plays an important role in the current budget debates in light of the recent highly influentialU.S. Gross and Net (Publically Held) Federal Debt as a Proportion of GDP 1941‐2011 work of Reinhart and Rogoff (2010) which identifies a 90 percent threshold; a gross debt to output ratio larger than 90 percent is seen as a drag on economic growth.
Source: Federal Reserve Bank. Net (or Publically Held) debt data available beginning in 1970. Figure 1: U.S. Gross and Net (Publically Held) Federal Debt as a Proportion of GDP 1941 - 2011.
Some other characteristics of Figure 1 aren’t as apparent but can add useful context to understanding U.S. debt and deficits. Although the annual debt to GDP ratio declined consistently and by more than two thirds from 1947 through 1981 the size of the debt more than tripled over this period from $257.1 billion to $994.8 billion. The reason for this seeming inconsistency is that although debt and deficits were growing nominal GDP was growing at a much faster rate. Notably over the period price adjusted or real GDP grew by a factor of 3.4 while the debt grew by a factor of 3.9 implying that the decline in the debt to GDP ratio from 1947 to 1981 was due totally to inflation, a sometimes suggested, though not widely accepted, solution to reducing the debt ratio 1. All data displayed in this paper are Federal Reserve Data or the author’s calculations based on U.S. Federal Reserve Data unless otherwise noted. 2. See for example Robert Eisner’s () exposition on the reasoning for comparing national debt to income (p.95). The definitions of gross and net public debt in this paper generally follow those laid out by the IMF in () (p.4); gross public debt refers to gross financial liabilities of the federal government. Net public debt is gross financial liabilities less gross financial assets of the federal government. Following the IMF, net public debt is the more important concept for long-run national debt sustainability, while gross debt is the key indicator from the perspective of the securities market. 3. Germany has experienced the consequences of strategic price inflation and debt. There is an eerie similarity between strategically inflating the Euro to reduce the externally held real obligations of Euro Zone sovereign bond issuers and Germany’s inflation during the 1920’s intended to reduce its real war debt obligations under the Versailles Treaty.
Journal of Finance and Management in Public Services. Volume 10 Number 2
3
The Current Federal Debt and Deficit Debate in the U.S.
Gilbert Yochum
in many countries today. One might argue that this is the point of contention between France and Germany with respect to ECB purchases of sovereign securities; that is, potentially inflating one’s way out of current real obligations3. Over the period from 1947 to 1981 nominal gross debt grew through every presidential administration whether the president was a declared balanced budget conservative or whether democrat or republican. It grew least in value during the Eisenhower administration and most in value during Nixon’s tenure. Despite being thought of by many as fiscally conservative republicans, over the twelve year consecutive tenure of the Reagan and George H.W. Bush administrations the national debt more than quadrupled rising from $909 billion in 1980 to $4 trillion in 1992 the last year of Bush’s presidency. In addition, over the same period the debt to GDP ratio also grew rapidly almost doubling from 33.6 percent to 63.1 percent over the period and in terms of the rhetoric used in today’s budgetary debates added significantly to the scale of debt. Measured in proportional terms with respect to national output the nation’s debt grew faster than in any twelve year period in post war American history. The cost of defeating communism could be measured in these terms. Despite several years of surplus budgets during the Clinton administration, the first budget surpluses the nation had seen since the 1950’s, from 1992 to 2000 the national debt grew by $1.6 trillion. However, the debt to GDP ratio declined from 63.1 percent to 56.6 percent over the period but, as during 1947 to 1981, this decline can be attributed to inflation. During the George W. Bush presidency, the debt to GDP ratio resumed its increase; an increase that has continued and accelerated through Obama’s time in office. The Obama administration has experienced the most rapid annual growth in the ratio since World War II. Several things can be noted from this brief political tour of America’s ability, measured in the ratio of debt to output, to carry debt. First, although currently at a 64 year high the nation’s ratio of debt to income is still below that of 1946. It is worth recounting that although the ratio was at a historical high in 1946 it was followed by one of the strongest growth periods in the modern American economy; a period which lasted through the late 1960’s. Second, fiscal conservatism, defined as budget balance, has not been associated with any particular political party. Somewhat ironically given the party’s historical rhetoric, between 1946 and 2008 republican administrations were much more likely than their democratic counterparts to accelerate the growth rate of the ratio; an observation that may help explain some of the current partisan confusion over the debt. That is, with respect to party lines, evoking the specter of larger debt and deficits by either party may be more a political ploy aimed at voter’s visceral reactions deployed in the extant interest of the party, than an expression of an earnest goal to control debt. The real “pea under the pod” is likely the size of government. Third, to the extent that the debt to output ratio has been lowered, that lowering has come not from real output growth but from inflation.
More Context: Keynes Institutionalized Into the American Budget Process
Following directly on the work of Keynes’ and his theory that identified the lack of aggregate demand as the culprit in economic cycles, Gunnar Myrdal, a Swedish Nobel winner, in a 1939 article in the American Economic Review (1939) laid out the policy prescription that, as a practical matter, has served as the object of modern American fiscal policy. That is, the optimal fiscal policy will aim for budget deficits during cyclical economic downturns and budget surpluses to absorb too much demand, and its subsequent inflation, in boom years. This fiscal policy ideal is matched by its closest expression in the U.S. during the Clinton administration. There have been many new theories introduced into modern macroeconomics and into American graduate schools from the New Classical Economics to the Austrians to Real Business Cycle Theory that seriously challenge, and many would argue have relegated to obscurity in those schools, the Keynes/Myrdal fiscal policy prescription. There has also been a serious challenge to structural macroeconomic Keynesian models that finds its source in the Lucas Critique. However, as a practical matter and from a fiscal policy perspective, until this day none have unseated the Myrdal guidelines for reactive fiscal policy. Despite what many view as advances in macroeconomic theory, in terms of post-war U.S. economic policy, when it comes to fiscal policy, two signature events have driven America’s general fiscal reaction to recession:
Journal of Finance and Management in Public Services. Volume 10 Number 2
4
The Current Federal Debt and Deficit Debate in the U.S.
Gilbert Yochum
John F. Kennedy’s 1962 Yale speech and the Employment Act of 1946. Although many might have it that the first deliberate practical application of Keynes’ recommendation for the counter cyclical use of deficit financing occurred during the Roosevelt administration, it would appear to be more historically accurate to identify Kennedy, a student of J.K. Galbraith who himself was a student of Keynes and Keynes protégé Alvin Hansen, as the moving force behind the muting of what had been the moral imperative to annually balance the federal budget. In order to build political support for deficits Kennedy explicitly acknowledged that budget deficits could be a source of expansion and strength. In addition he openly questioned the efficacy of setting national budget balance as a goal when the budget (NIPA) technique itself, “…neglects changes in assets and inventories. It cannot tell a loan from a straight expenditure--and worst of all cannot distinguish between operating expenditures and long term investments.”(Kennedy 1962). By effectively removing the moral imperative from public debate over a balanced budget, “there is no single, simple slogan in this field we can trust,”(Kennedy 1962) and replacing it with a more functional perspective, Kennedy laid the intellectual ground work for what resulted in successive decades of both aggressive countercyclical policy and in some periods politically expedient deficits. Over the past fifty years, the effective dampening of this moral constraint has been repeatedly criticized, often for its political utility, but the constraint has not been restored. For example, Buchanan and Wagner (1977) made the case that once the moral constraint imposed by the budget balance requirement is taken away politicians may pay lip service to the idea but acting in their self-interest, defined as the desire for re-election, have little incentive to cut expenditures or raise taxes, or alternatively, to aim for a budget surplus in non-recessionary periods. Alternatively, from Buchanan and Wagner’s perspective Myrdal’s policy prescription might be nice in theory but not possible to achieve in reality. As a practical matter, the Employment Act of 1946 and the Humphrey Hawkins Act of 1978 (HHA), a more aggressive version of the Employment Act, requires the federal government to use its budget to achieve fullemployment and codifies the use of expanding deficits to achieve that end. Thus, during recessions successive administrations have been obliged to submit budget plans to counter downward cycles in GDP. Countercyclical “automatic stabilizers,” such as a progressive tax structure, unemployment compensation and welfare “safety net,” draw at least part of their credibility from this legislation. Some might argue that this legislation and its resulting fiscal policy reaction is at least partly responsible, along with monetary policy, for the relatively continuous post war reduction in the amplitude and length of U.S. business cycles, a phenomena that until the 2007 recession was labeled the “great moderation.”
Near Term Cycles: Build-Up to the Great Recession
The recovery that followed the 2001 recession was characterized by a slow rate of employment growth. It was not until 2005, four years after the beginning of the recession that U.S. employment began to exceed its pre-recession level. True to the HHA full employment mandate and in reaction to the recession, significant tax cuts were included in the Economic Growth and Tax Reconciliation Act of 2001. As seen in Figure 1, the combination of tax cuts and rising defense expenditures in support of a supplemental budget for war in Iraq and Afghanistan, and the subsequent relatively large annual budget deficits they helped create, swung the 2001 debt GDP ratio from annually decreasing to increasing. Relatively slow employment growth, and the possibility of a deflation following 2001, led not only to active fiscal efforts in the form of annually rising budget deficits to support output growth but also to accommodative Federal Reserve actions evidenced by an aggressive and sustained reduction in short-term interest rates. The three month T-Bill rate fell from near six percent in late 2000 to around one percent by mid-2004. Sequential short term rate reductions, combined with rapidly rising residential property prices, significantly lowered underwriting and margin standards for mortgages, as well as a highly liquid market for short-term adjustable rate mortgages (ARM’s) and the advent of sophisticated new mortgage derivatives such as collateralized debt obligations (that caused a classic market failure in the financial sector because of their obtuseness) created a veritable witches brew that led to a collapse in the banking system’s total asset value, particularly in the $10 trillion dollar U.S. mortgage market, and to the subsequent financial crisis.
Journal of Finance and Management in Public Services. Volume 10 Number 2
5
The Current Federal Debt and Deficit Debate in the U.S.
Gilbert Yochum
Given that personal consumption accounts for more than seventy percent of GDP, arguably the most insidious component of this brew and key to the resulting historical federal deficits, was the more than doubling of residential property prices between 2000 and 2007 (Case-Shiller 20 City Index). As property values grew so did the ability of U.S. households to refinance their homes at lower rates and extract equity from their home appreciation that was used for current expenditures. Figure (2) shows the extent of this equity withdrawal relative to disposable income. From 2004 Figure 2 to 2007, the height of the house price bubble, households extracted an average of more than $850 million per year from their appreciated home values, in effect using their homes Tapped‐Out Consumer Credit: Mortgage Equity Withdrawal as veritable piggy banks to support increased household spending. This broad based subsidy in the ability of households to spend essentially collapsed with the fall in housing prices which began in earnest in 2007.
Annual percentage change in house value (blue)
Percent of disposable income (red)
10
8
6
4
2
0
-2 1992 1993 1994 1995 1996 1997 1998 1999 2000 2001 2002 2003 2004 2005 2006 2007 2008 2009e Net Equity Extraction
Source: Federal Reserve Bank, Kennedy‐Greenspan Data Updated as of January 2010; the Old Dominion University Economic Forecasting Project and the Federal Housing Finance Agency.
Figure 2: Tapped-Out Consumer Credit: Mortgage Equity Withdrawal.
Collapsing along with house prices and consumer spending were asset values of U.S. banks and capital investment. Bank assets declined by roughly ten percent from the first quarter of 2007 through the last quarter of 2008 when liquidity in the banking system literally froze. Growth in total bank credit has been at a virtual stand-still since that time and through the third quarter of 2011. In addition, gross investment declined by more than a third from the fourth quarter of 2007 to third quarter of 2009. It continues to remain far below its prerecession level despite the fact that firms are flush with cash (liquidity). Corporate retained earnings reached $2 trillion, a historical high, in the second quarter of 2011 the most recent data available4. Both of which explain why the private sector has failed to spur economic growth and why the relatively low level of U.S. output and growth rate continue to linger; the U.S. could be described as experiencing a “liquidity trap” for the first time since 1937-38. That is, at current interest rates banks and firms prefer to hold cash as opposed to lending or investing it.
Near Term Cycles: Budget Deficits and Economy Wide Demand
Figure 3 displays the central difficulty of the current U.S. economic situation characterized most importantly by consumer balance sheet problems, bank failure to lend, firms reluctant to reinvest their record profits, an overvalued currency and fear of the future. Potential GDP, that is the potential output of the nation based on the full employment of its stock of land, labor and capital, continues to grow (ironically the U.S. potential continues to strengthen not weaken as some would have it) as U.S. productivity and the labor force continues to grow. 4. U.S. Department of Commerce, Bureau of Economic Analysis
Journal of Finance and Management in Public Services. Volume 10 Number 2
6
The Current Federal Debt and Deficit Debate in the U.S.
Gilbert Yochum
Figure 3 However, economy wide demand has not been at a level that enables taking advantage of this enhanced U.S. Real GDP and Real Potential GDP (in 2005 dollars) potential, a circumstance that Nobel laureate Paul Samuelson (Greenhouse 1993) throughout his career aptly described as “poverty amidst plenty.” That is a nation’s economy, in this case that of the U.S., is capable of producing considerably more than it is; a description of wasted ability and inefficiency.
Billions of Dollars
15,000 14,000
Real Gross Domestic Product Real Potential Gross …
13,000 12,000 11,000
Source: US Department of Commerce, Congressional Budget Office and Federal Reserve Bank Figure 3: U.S. Real GDP and Real Potential GDP (in 2005 dollars).
In reaction to the precipitous decline in output in the fourth quarter of 2008 and true to past practice congress passed a “Stimulus,” or the American Recovery and Reinvestment Act of 2009 (ARRA). Designed to be spread over a number of years, it was a $787 billion attempt to, over several years, close the gap between actual and potential output by increasing aggregate demand and subsequently actual output, and true to the HHA, force the economy toward full employment. According to CBO estimates, the ARRA deficit impact,spread over a number of years,added or will add annually in billions $200, $404, $135 and $56 from 2009 to 2012 respectively to each intervening year’s deficit; the effect continuously diminishing from its 2010 peak5. The result of this historically large government deficit financed effort to stimulate the economy has been mixed. Most empirical studies6 have found that the effect of the ARRA has been to keep the 2007 to 2009 recession from being much worse. For example, Wilson (2011) found that roughly 3.4 million jobs had been saved or created by the ARRA close to the jobs number found by Blinder and Zandi (2010). Further, the consensus of these studies is that GDP was one to three percent larger in 2009 than it would have been in the absence of the stimulus. In terms of its length, the recent recession was the worst in the post war period but at 18 months not much different from those of the mid 70’s and early 80’s, both of which lasted for 16 months. However, as seen in Figure 4, it has taken fifteen quarters for GDP to attain its pre-recession level, three times the average for post war recessions and more than double that for the previously worst recessions in 1973 and 1981. The real problem, as seen in Figure 3, is that the ARRA and follow-on deficit financed spending intended to spur growth has not been successful in pushing the economy to its potential output; GDP has persistently remained about 6 to 7 percent below its potential.
5. http://www.cbo.gov/ftpdocs/108xx/doc10871/AppendixA.shtml. 6. See for example: The Congressional Budget Office (2011), Blinder and Zandi (2010) and Wilson (2011).
Journal of Finance and Management in Public Services. Volume 10 Number 2
7
The Current Federal Debt and Deficit Debate in the U.S.
Gilbert Yochum
Figure 4
U.S. GDP: Percentage Change from Pre‐Recession Peak Quarters Subsequent to the Peak
1973
1981
2007
Quarter Since Peak
Source: Federal Reserve Bank and author’s calculations. Figure 4: U.S. GDP: Percentage Change from Pre-Recession Peak Quarers Subsequent to the Peak.
Near Term Policy Paralysis:
In the Keynes/Myrdal tradition near-term fiscal policy action to counter recession and lead the economy to fullemployment, as required by U.S. law, has been to increase the budget deficit by increasing spending, reducing taxes or some combination of the two; the exact mix and composition depending on the politics extant. When there has been congressional debate on such policy it was likely to center on the size of the deficit required to prod the economy toward full employment rather than whether or not to initiate the action. The “Stimulus,” which for many was shockingly larger than any previous fiscal action to counter recession, was promoted in the minds of some with the idea that it was a cure-all that would push the economy to full-employment. Although the empirical evidence suggests that the ARRA despite its flaws appears to have prevented a much more serious U.S. economic downturn in 2009 and 2010, as shown in Figure 3 there remains a $1 trillion dollar difference between actual output and that of fully employed factor resources. This has prompted some to conclude that the ARRA has ended in failure. The residual gap, to date unclosed after what was viewed by many as a figurative fiscal “maximum effort” has opened up a new chapter in the creation of American post-war fiscal policy. Consumer balance sheet retrenchment, an over-valued dollar and uncertainty about the future on the part of both banks and non-financial businesses that manifests itself in a modern day liquidity trap imply that in the near term, demand in the private sector is unlikely to be a source for closing the gap. Given the lack of prospective near term demand from the private sector, why can’t government fill the demand gap? Public fear of any fiscal action associated with increased debt has percolated up through the American political structure from individual households many of whom on a personal level have found their budgets burdened with disconcerting debt legacies; the result of the decline in U.S. home values in combination with low margin home purchase or equity extraction. At the national level debt fear takes on a more palpable focus from two current events: sovereign default fear that has spread from the current Euro Zone crisis and the previously mentioned 90 percent gross debt to GDP threshold established in the recent and much cited empirical work of Reinhart and Rogoff.
Journal of Finance and Management in Public Services. Volume 10 Number 2
8
The Current Federal Debt and Deficit Debate in the U.S.
Gilbert Yochum
Considerable confusion over federal debt and deficits has resulted in both the American media and in political debate because of the European sovereign debt crisis. Many tend to lump together analysis of U.S. debt with that of fiscally failing European nations who have no control over the creation and destruction of their currency. These nation’s, analogously like American states or countries utilizing currency boards such as Argentina and many others have in the past, have ceded their sovereign ability to manage their debt in coordination with their currency and have seriously reduced their degrees of freedom in dealing with their debt. One might argue that one benefit of a break-up of the Euro Zone would be to restore to the zone’s individual countries the freedom of action shared by sovereigns who print their own currency. Reinhart and Rogoff (2010) sought to answer the difficult question of how much sovereign debt is too much. Their work covers over 200 years and many countries and is unique in that it is the only empirical work of its kind and that specifically answers the question of how much debt is too much debt. Previous efforts to answer this question were theoretical and inconclusive. For example, Lerner (1943) argued that a country could finance unlimited debt as long as it managed its currency properly. Ball and Mankiw (1995) were more circumspect. They identified investor confidence as the key to how much fiscal debt a country could manage but could “only guess what level of debt will trigger a shift in investor confidence.” Reinhart and Rogoff were on the other hand, definitive about that confidence: at a gross debt to GDP ratio of greater than 90 percent, an increased debt would serve to reduce GDP rather than increase it. The current U.S. gross debt ratio is greater than 95 percent. Thus a perfect storm consisting of the confluence of fear of a rising national debt, the rising debt ratio to output and fear of potential debt default have conspired to insure that the Keynes/Myrdal policy reaction can no longer gain virtually assured support. Academic counter theories, long in vogue in American graduate schools but usually confined to debate over longer term policy, have gained real world policy traction from the perceived failure of the ARRA and have been put to work in defense of various political agendas. All have combined to create political paralysis that has resulted in the federal government’s inability to in the near term aggressively attack and close the potential/actual output gap.
The Longer-Run: Into the Future
The late Senator Daniel Patrick Moynihan(1977)had observed that, “[T]here is simply nothing so important to a people and its government as how many of them there are, whether their number is growing or declining, how they are distributed as between different ages, sexes…and different social classes and racial and ethnic groups...” With Moynihan’s observation in mind, it is important to recognize that although the U.S. has a growing population it will over the coming decades experience a sea change in age distribution. Those 65 years and older, made up 12.9 percent of the U.S. population in 2010 and are projected to account for 20.2 percent by 2050 while those in prime working ages, 18 to 64 years will fall from 62.8 percent of the population to 56.7 percent over the same period7. The practical fiscal effect of this prospective change in the distribution of the population on future federal government obligations and debt cannot be understated. Payments to support the elderly, which are concentrated in social security, Medicaid and Medicare benefits, and sometimes referred to as entitlements, will over the foreseeable future drive-up both the level of federal spending and its proportion with respect to output. CBO estimates, which factor in expected future GDP growth, project that under current policy, entitlement payments alone are likely to rise from roughly ten percent of GDP in 2011 to near twenty percent by 2050 and, when debt interest payments are factored-in, would roughly double total federal spending as a proportion of GDP from its current post war average of nearly twenty percent to about forty percent in 2050. As seen in Figure 5, even during World War II government spending only reached thirty-two percent of GDP.
7. Population data are U.S. Census data derived from: http://www.census.gov/population/www/projections/summarytables.html
Journal of Finance and Management in Public Services. Volume 10 Number 2
9
The Current Federal Debt and Deficit Debate in the U.S.
Gilbert Yochum
Proportion of GDP
Figure 5 Federal Government Spending, Revenue and Deficit as a Proportion of GDP 1941‐2040 (CBO Alternative Scenario)
Source: Federal Reserve Bank and Congressional Budget Office.
Figure 5: Federal Goverment Spending, Revenue and Deficit as a Proportion of GDP 1941-2040 Figure 6 (CBO Alternative Scenario)
U.S. Net Debt as a Percent of GDP
Source: The National Commission on Fiscal Responsibility and Reform, The White House, Washington D.C., December 2010, p.11.
Figure 6: U.S. Net Debt as a Percent of GDP
Journal of Finance and Management in Public Services. Volume 10 Number 2
10
The Current Federal Debt and Deficit Debate in the U.S.
Gilbert Yochum
The projected effect on publically held debt of potential future spending obligations can be seen in the accompanying chart (Figure 6) developed by the Congressional Budget Office and the Simpson-Bowles (SB) commission. The Alternative Fiscal Scenario is viewed by the commission as the most likely to occur8. Most importantly the alternative scenario assumes that the income tax rate reductions of the Economic Reconciliation and Growth Act (ERGA) of 2001, set to automatically expire in December of 2012, will be renewed for all income levels below $250,000 and that discretionary (non-entitlement) spending grows at the same rate as GDP. The simulated result of this scenario is an unacceptable tripling of federal debt over the next twenty-five years. The extended baseline scenario simulation, which results in no increase in the debt to GDP ratio for more than ten years, assumes congress does nothing and lets the ERGA and the current temporary attempts to spur the economy, for example the payroll tax reduction and extended unemployment benefits, expire. Ironically, this donothing scenario is projected to result in the accumulation of less debt through 2020 than the recommendations of the SB debt reduction committee. Should the commission’s proposal be adopted, prospective debt would be reduced by an estimated $3.885 trillion between 2012 and 2020, seventy-five percent of which would come from recommended spending reductions and twenty-five percent from tax increases. Federal spending would be reduced from its current (2010) 25.6 percent to 21.8 percent of GDP by 2020. On the other hand, if congress does nothing and the extended base line scenario becomes reality debt would be reduced by more than $4 trillion by 2020. The alternative and extended scenarios are key to understanding this summer’s debt ceiling conflict, the rationale for creating the “super committee,” and why there appears to be so little publically expressed concern over the November failure of the super committee to resolve the inter party impasse. This summer’s fiscal debate, ostensibly over raising the federal debt ceiling, was in reality a different and emotionally laden way of packaging the on-going struggle over the prospective size of the federal government, or whether or not the tax cuts of the ERGA, sometimes referred to in the media as the “Bush tax cuts,” would be temporary (expiring in December 2012) or permanent. Authorization for raising the debt ceiling, the lack of which raised the specter of a voluntary debt default, was unfortunately held hostage to the politics (should prospective debt reduction come from spending or taxes) of this debate. Specifically, if the ERGA tax cuts became permanent there would need to be a significant reduction in government spending in order to keep the publically held debt to GDP ratio from ballooning. On the other hand, if the ERGA simply expires, tax rates increase and the debt ratio is expected to remain stable. The latter was not, and currently is not, a likely outcome given the written commitment of many republican legislators to not raise taxes. The super committee turned out to be an efficient and face saving way of allowing for an increase in the debt ceiling, thus defusing the pressure of this summer’s debate. The impasse over the prospective size of government still exists but has defaulted to being a center piece for debate and resolution in the upcoming (2012) presidential election.
Long Term Debt Default
The stakes of the presidential election are high; muddling through over the desired size and role of government is a less than optimal option. In the absence of acceptance of the Simpson-Bowles tax and spending recommendations on debt reduction, or some other substitute such as President Obama’s $3 trillion reduction plan submitted to the congressional super committee or even expiration of the ERGA, the prospect of such a high proportion of the nation’s output being dedicated to federal spending, an increasing portion of which would be funded by deficits and debt, raises serious concerns for future economic growth. In particular, government spending may “crowd-out” private sector capital investment, leading to a reduction in potential productivity and economic growth. For example, during World War II, when government spending accounted for thirty-two percent of GDP, net investment through the period in the country’s capital stock was negative.
8. Simpson-Bowles’ (2010, p.11) scenario definitions are: “The Extended-Baseline Scenario generally assumes continuation of current law. The Alternative Fiscal Scenario incorporates several changes to current law considered likely to happen, including the renewal of the 2001/2003 tax cuts on income below $250,000 per year, continued Alternative Minimum Tax (AMT) patches, the continuation of the estate tax at 2009 levels, and continued Medicare “Doc Fixes.” The Alternative Fiscal Scenario also assumes discretionary spending grows with Gross Domestic Product (GDP) rather than to inflation over the next decade, that revenue does not increase as a percent of GDP after 2020, and that certain cost-reducing measures in the health reform legislation are unsuccessful in slowing cost growth after 2020.”
Journal of Finance and Management in Public Services. Volume 10 Number 2
11
The Current Federal Debt and Deficit Debate in the U.S.
Gilbert Yochum
Under potential future conditions where the economy’s production factors are fully employed crowding-out is likely to occur because, as governments issue debt to fund their increased spending, interest rates are much more likely to rise making it more expensive and difficult for the private sector to fund capital projects. To the extent that capital is not accumulated at a rate that it would have been in the absence of debt, productivity declines. If a central bank intervenes to accommodate the increased debt, as might be the case when the bank issues its own sovereign’s currency as in the U.S. or U.K., attempting to temper rising interest rates, the increased liquidity in the economy can result in inflation. This is also the mechanism Germany fears if the ECB were to intervene in the current Euro Zone crisis by purchasing the securities of countries such as Italy and Spain in an effort to protect liquidity and lower rates in those national bond markets. In such a world inflation could result from either declining productivity, the result of lowered private sector capital spending, or enhanced liquidity. In either case the resulting inflation can reduce the purchasing power of government securities, as previously seen in the U.S. debt market during the 1947 to 1981 period. For example, holding real interest rates constant, if an individual purchased a 20 year U.S Treasury Bond in 1955 and held it to maturity in 1975, a period of rapidly rising prices, the purchasing power of that security would have fallen to half of its face value. Although under such circumstances there is no de jure default9 one could argue that there is a de facto default of the federal government that resulted from the decrease in the security’s real purchasing power; a decrease caused by inflation.
Summary
The size and scale of the U.S. national debt and federal budget deficits are rapidly reducing the degrees of freedom with respect to the political and fiscal options available to the U.S. Congress and the Obama administration. Economic historians may eventually view the current near term persistent negative deviation of U.S. actual output from its potential as the result not only of the lingering effects of the 2008 financial collapse but also of policy failure and inability of the government to aggressively deficit finance to remove this gap, sooner as opposed to later, as it has through most of U.S. post World War II history. That inability, or paralysis, is a least partly due to confusion in the political debate between the country’s near term debt and long term obligations. U.S. federal long term obligations will increase significantly over the next few decades, driven by an aging population with its associated social security and health care entitlements. If left unchanged, these obligations are likely to increase government spending as a proportion of output to a level that will seriously bias capital accumulation, factor productivity and future economic growth leaving the country vulnerable to a de facto default, induced by inflation, on its outstanding debt. The 2012 presidential election is expected to focus squarely on the long term issue of the proper sustainable size of the federal government with respect to its spending, revenue and debt. For the near term, however, it appears that the debt and deficit debate has rendered the country near helpless in its ability to approach full employment of factor resources.
9. For countries that print their own currency, for example the U.S., U.K. and Japan, a legal default on that country’s outstanding securities is possible only if the securities are issued and denominated in another country’s currency (e.g. Argentina, a serial defaulter in national debt issued in U.S. dollars) and the debt can’t be met, the nation’s central bank is totally independent and refuses to accommodate debt, or, as in the U.S. in the summer of 2011, a country chooses to raise the issue of voluntarily default on its debt. The latter situation is so bizarre and caused so much confusion about what was actually happening during the debt limit debates that it prompted what would have been a meaningless downgrade of U.S. securities by the S&P. De facto default is dealt with later in the paper.
Journal of Finance and Management in Public Services. Volume 10 Number 2
12
The Current Federal Debt and Deficit Debate in the U.S.
Gilbert Yochum
References:
Blinder, A., & Zandi, M. (2010). How the Great Recession Was Brought to an End. Princeton University, Moody’s Analytics. Retrieved from http://www.economy.com/mark-zandi/documents/End-of-GreatRecession.pdf Ball, L., & Mankiw, Gregory N. (1995). What Do Budget Deficits Do? Working Paper 5263. Cambridge: National Bureau of Economic Research. Buchanan, J., & Wagner, R. (1977). Democracy in Deficit. New York: Academic Press. Congressional Budget Office. (May 2011). Estimated Impact of the American Recovery and Reinvestment Act on Employment and Economic Output from January 2011 Through March 2011. Washington, D.C: Congressional Budget Office. Eisner, R. (1994). The Misunderstood Economy. Boston: Harvard Business School Press. Greenhouse, S. (1993, October 31). Conversations/Paul A. Samuelson; The Man Who Wrote the Book Suggests Econ 101 for Presidents. New York Times. Retrieved from http://www.nytimes. com/1993/10/31/weekinreview/conversations-paul-samuelson-man-who-wrote-book-suggests-econ101-for-presidents.html?pagewanted=all&src=pm International Monetary Fund. (November 2011). Japan Sustainability Report. Washington D.C.: International Monetary Fund. Kennedy, John F. (Speaker). (1962, June 11). Yale University Commencement Speech. Retrieved from http://www.jfklibrary.org Lerner, A. (1943). Functional Finance and the Federal Debt. Social Research, 10, 38-51 Moynihan, Daniel P. (1977). The Most Important Decision-Making Process. Policy Review, 1, 89-93. Myrdal, G. (1939). Fiscal Policy in the Business Cycle. American Economic Review, Papers and Proceedings of the Fifty-first Annual Meeting of the American Economic Association, 29(1), 183-193. Reinhart, Carmen M., & Rogoff, Kenneth S. (2010, January 7). Growth in a Time of Debt. American Economic Review Papers and Proceedings. Rogoff, Kenneth S., & Reinhart, Carmen M. (2009). This Time is Different. Princeton: Princeton University Press. Simpson Bowles Commission. (December 2010). The National Commission on Fiscal Responsibility and Reform. Washington D.C: The White House. Wilson, Daniel J. (2011). Fiscal Spending Job Multipliers: Evidence form the 2009 American Recovery and Reinvestment Act. Working Paper 2010-17. San Francisco: Federal Reserve Bank of San Francisco. Wilson, Daniel J. (October 2011). Fiscal Spending and Jobs Multipliers: Evidence from the 2009 American Recovery and Reinvestment Act. Federal Reserve Bank of San Francisco Working Paper Series.
Journal of Finance and Management in Public Services. Volume 10 Number 2
13
