By Simon Johnson and James Kwak
During this hot summer of fitful economic growth, high unemployment and an oil slick visible from space, Washington is obsessed with…deficits. The resurgence of this periodic fascination is not entirely surprising, given our historically large current deficits. According to the Congressional Budget Office, the 2010 deficit will come in at $1.3 trillion, almost 10 percent of our gross domestic product and, along with the deficit of 2009, the highest level since World War II.
Imminent fiscal collapse has even become a theme for literary novelists – in Gary Shteyngart’s “Super Sad True Love Story,” American fiscal policy has become a bad joke and the Chinese threaten to stop buying our government debt. And the overextension of government is again a big theme; sales of Ayn Rand’s “Atlas Shrugged” are up sharply, although the book was first published more than 50 years ago (it is in and out of the Top 100 list on Amazon).
Deficit fears do have a real foundation. But it is not, as some assume, simply that government spending is out of control. Our current deficits result from the recent financial crisis and recession, and they will recede as the economy recovers. But the federal government also faces a long-term, structural gap between its revenues and its spending commitments – a gap due to policies established decades ago.
To see where our current deficits come from, we need only look at the budget office’s baseline projections. In January 2008, the budget office projected that total government debt in private hands – the best measure of what the government owes – would fall to $5.1 trillion by 2018 (23 percent of GDP). As of January 2010, the budget office now projects that debt will rise to $13.7 trillion (more than 65 percent of GDP) – a difference of $8.6 trillion. Of this change, 57 percent is due to decreased tax revenues resulting from the financial crisis and recession; 17 percent from increases in discretionary spending, much of it the stimulus package necessitated by the financial crisis; and another 14 percent to increased interest payments on the debt – because we now have more debt.
The lessons are obvious. First, we need to restore the economy to healthy growth. Here the latest news is mildly encouraging – the world economy is growing, although not as fast as we would like. But the financial crisis will leave a scar on our economy. Long-term unemployment will permanently reduce the skills of too many workers, cutting productivity and increasing spending on the social safety net.
Second, we need to protect our economy from the next financial crisis. The Dodd-Frank financial reform act is a modest step in that direction, but it is unlikely to solve the problem of systemic risk. As long as massive financial institutions continue to take on huge amounts of risk, there remains a strong possibility that governments will once again face unexpected liabilities and collapsing tax revenues in a financial crisis – pushing up debt by another 40 percent or so of GDP. Yet discussion of this risk was largely absent from the recent Senate debate on financial regulation.
Financial crisis and recession are only half the story. The other half is long-term entitlements. Under the Congressional Budget Office’s “alternative fiscal scenario,” which includes policy changes that are politically likely, government debt in private hands will grow to 185 percent of GDP by 2035 as Social Security, Medicare, Medicaid and other health care programs grow to consume almost all tax revenues.
This should not be a surprise. In 2000, the budget office had already projected that these programs would grow to more than 16 percent of GDP by 2040 – a figure virtually identical to current estimates. This was predictable because it rested on two simple trends: changing demographics and, more importantly, high health-care cost inflation.
For many commentators, the only possible response is immediate austerity – the course being taken in Britain and parts of the euro zone. Already the national debt is being used as a hammer to beat down any proposed government spending, no matter what its merits. If we continue to spend, the argument goes, markets will lose faith in our ability to repay our debts, interest rates will skyrocket, the dollar will collapse and our way of life will be at an end.
While this argument is plausible in the abstract, there is no reason for panic. For starters, the Treasury Department can currently borrow money at historically low interest rates. This is no surprise. Investors around the world like saving in a safe currency, the dollar has traditionally been seen as the safest of currencies and recent developments in Europe and the rest of the world have done nothing to change that.
It is true that markets can suddenly lose confidence in a country, with severe economic repercussions. But there is no magical threshold that suddenly makes a country a poor credit risk; Japan’s net government debt relative to its economy is roughly at Greek levels, yet Japan can still borrow money cheaply. A country’s ability to borrow is determined by its economic fundamentals, its position in the international economy and the credibility of its political system relative to other systems.
So while an extra dollar of spending today is an extra dollar (plus interest) of debt later, what really matters are policies that affect taxes or spending year after year. In contrast, $34 billion for extended unemployment benefits – a temporary program that will become smaller as unemployment falls – has no appreciable impact on our structural deficit.
What do matter are taxes and entitlements. Therefore, the coming battle over the Bush tax cuts is of real importance. According to the Congressional Budget Office, extending the Bush tax cuts would add $2.3 trillion to the total 2018 debt. The single biggest step our government could take this year to address the structural deficit would be to let the tax cuts expire. And a credible commitment to long-term fiscal sustainability should reduce interest rates today, helping to stimulate the economy.
Critics say that this amounts to increasing taxes at a time of high unemployment, and that instead the tax cuts should be extended as a stimulus measure. This overlooks the fact that tax cuts are an inefficient form of stimulus, because many people choose to save their additional income instead of spending it.
If the goal is to boost growth and employment immediately, it would be better to let the tax cuts expire and dedicate some of the increased revenue to real stimulus programs. Alternatively, if some tax cuts are extended – as it seems likely that at least those for the middle class will be – there should be provisions to eliminate them automatically when unemployment falls to a preset level.
This post appeared today on the NYT.com’s Economix blog; it is used here with permission. If you would like to reproduce the entire piece, please contact the New York Times.