President Obama has two choices to avoid a major fiscal debt crisis for the U.S.: Fix it or ignore it. Unfortunately, he has so far chosen the latter.
Now it’s official. The budget President Obama released today does virtually nothing to address the growth of entitlement spending that’s by far the biggest factor driving our gargantuan deficits and debt. As for the administration’s claims that it’s making big cuts in areas such as defense and discretionary spending, it’s instructive to read the most important item in the entire 1343 page document, the “Total Outlays” line on page 151. You may want to read it twice.
After dipping 2% in fiscal 2012, federal spending increases at a compound rate of 5.2% for the next eight years, from 2013 to 2020. Bottom line: The administration’s claims that it’s tackling the budget deficit depend entirely on projected tax increases that probably won’t happen, notably the return of the Bush tax cuts for high-earners after 2014.
The congressional Republicans are practically certain to block those tax hikes. At the same time, the GOP is still dodging all specifics about curbing entitlements.
So what will America’s budgets over the next decade really look like? The way we’re heading now, it won’t be a pretty picture.
Let’s start with the Congressional Budget Office’s recent paper, “Budget and Economic Outlook: Fiscal Years 2011 Through 2021.” To get the real picture of future deficits, we’ll need to expand on the CBO’s official numbers. That’s because the CBO is required to make its projections based on current law, even when changes to those laws are fully predictable––in fact, they happen every year. It would also need to forecast the crucial reaction of the bond buyers, foreign and domestic, to our fiscal policies, another factor the CBO doesn’t consider.
So let’s take our own deep-dive into the budget, and adjust the numbers to produce the most likely scenarios. The U.S. is pretty much restricted to one of two broad fiscal paths. We’ll call the those possible outcomes “The Standoff Scenario,” and “The Solution Scenario.” In the former, a deadlock over deficit reduction unleashes a disastrous cycle where interest rates jump, growth slows, and the increase in debt swamps even today’s direst predictions. In the latter, the U.S. tackles the entitlement issue quickly and decisively, creating a climate for low borrowing costs, strong expansion, falling joblessness––and a receding burden from borrowing.
“We’re operating on a knife-edge between the two possible outcomes,” says J.D. Foster, a former George W. Bush budget official who’s now an economist at the conservative Heritage Foundation.
Amazingly, the real danger is that by not choosing at all, the U.S. will by default make the worst possible choice.
The cost of doing nothing
First, let’s examine the Standoff Scenario by adjusting the CBO’s projections for the changes that all budget experts know will happen. The agency spells out these routine annual fixes in a table called “Budgetary Effects of Selected Policy Alternatives Not Included in CBO’s Baseline.” These items all increase the future deficits, either by reducing revenues or increasing outlays. For example, forecasting that the Alternative Minimum Tax will be adjusted each year for inflation, and that the Bush tax cuts will be renewed, lowers revenue. Projecting that Medicare will raise, not radically lower, payment to physicians and that discretionary spending will grow in tandem with the economy increases future spending.
The adjusted budget––Heritage ran the numbers, which aren’t in dispute––shows deficits falling from $1.5 trillion in fiscal 2011 to $1 trillion in 2013, then swelling again to $1.9 trillion. Debt would grow to $25 trillion, or 104% of GDP. At those levels, our borrowings would reach the red zone of a Greece or Ireland.
Those figures, however, don’t incorporate a critical, potentially decisive force. It’s the effect of mammoth, historic borrowings on interest rates. The CBO reckons that rates will rise from 3.7% today on 10-year Treasuries to just 5.4% 10 years from now, a modest number that’s around average for the past two decades.
It’s highly improbable that borrowing costs will stay at normal levels in a period of extraordinary borrowing and mountainous debt. The reason is that the Treasury issuing bonds in such huge quantities that it will need to pay extra-high rates to sell them. Borrowers will fear that the flood will keep coming and even growing, year after year, driving down future prices. That will push Asian and other usually loyal investors to demand higher rates now.
“The supply and demand equation means higher rates,” says David Walker, former chief of the Government Accountability Office (GAO). “The Fed is buying debt now to hold down rates in the short-term, but you can’t control market forces indefinitely.”
We’ll further adjust the CBO’s projections for higher rates. Under the Standoff Scenario, they’re virtually inevitable. Let’s say the U.S. is obligated to pay 6% on its borrowings, or 4 points over inflation, a reasonable estimate. Say that jump in rates begins only in fiscal 2014. Over the eight years through 2021, U.S. debt would jump by an additional $2.9 trillion or 12% to almost $28 trillion or 117% of GDP. Interest payments of $1.68 billion would absorb 29% of all spending, versus 6.1% today.
The Standoff Scenario suffers from two crippling features. First, the U.S. does nothing to address spending on Social Security, Medicare and Medicaid. That’s why rates would rise steeply, since investors would see no end to the parade of gigantic bond sales needed to fund those programs.
Second, the rise in rates on government bonds would spread to every part of the economy, making mortgages and corporate loans more costly, and hence dampening growth. The slower growth rates would leave joblessness at high levels. The CBO is projecting that the economy will expand at just 2.9% over the next decade, well below its historic average. Higher rates could push that number even lower. And it’s highly questionable if GDP rising in the mid-2% range will do much more freeze the unemployment rate where it is now at around 9%.
The best possible outcome
Now, let’s examine the Solution Scenario. In most recoveries, starting with a high jobless rate, the economy far exceeds its normal pace of growth. That’s because companies perceive that labor is now relatively cheap, wages will rise slowly, and rates will remain subdued because of idle capacity for cars, steel or computers. Hence, they’ll start pursuing new markets and products because low costs make future returns more attractive. The U.S. can reasonably count on labor force growth of 0.5% a year, and annual productivity increases of around 2%. That’s a formula for 2.5% growth in most years. But coming out of a recession, says Foster, that rate should be around 3.5%. And at 3.5%, the U.S. would drive down the unemployment rate to between 5% and 6% by 2020.
That course isn’t possible with high interest rates. But if the U.S. convinces bond buyers that our future borrowing needs will fall rather than explode, it’s not only possible, but likely. If the economy grows at 3.5% from 2014 to 2021 and borrowing cost stay in the 4.5% range, the U.S. would add far less debt than under the Standoff Scenario. The reason is two-fold. First, the higher growth rates would mean higher incomes and bigger tax receipts. Second, the lower rates would mean that annual interest payments would stay far lower, and the debt would accumulate at a much slower rate.
The rub is that we can’t achieve the virtuous combination of better growth and low rates unless we radically lower deficits, through some combination of reductions in excessive spending––by far the main culprit–– or tax increases. So how much do deficits need to come down? In the low-rate, good growth case, they need to shrink by an average of $750 billon a year. That’s about 15% of all spending, assuming cuts are the main source of closing the gap. Achieving reductions of those proportions is only possible by lowering entitlement spending.
Of course, if America follows the Standoff Scenario, it’s impossible to say if we’ll ever reach that ratio of over 100% of debt to GDP. Before 2021, we may face a full-blown crisis where investors simply refuse to refinance our debt, except at ruinously high rates. If that happens, the U.S. will be forced to move fast to stave off a default. The crisis could conceivably prove healthy if it forces deep entitlement cuts, or disastrous if it brings a European-style VAT on top of our current income tax that’s destined to just keep growing.
Why take the risk of charting our future in a crisis? The time to decide between the two scenarios is now. The splendid package of low rates, good growth and spreading jobs are within our grasp. But only if we make the wrenching fiscal choices that in turn, can make all those good things possible.