The Brookings Institution just released an updated paper by their own Bill Gale and Alan Auerbach (of UC Berkeley) on “The Economic Crisis and the Fiscal Crisis: 2009 and Beyond” (here is the pdf of the complete paper). Watch Bill’s nice interview above, in which he summarizes what he sees as the biggest take-away points from their analysis.
I like to dig into the economic nuts and bolts of this sort of paper, while also carrying my own big-picture policy biases of course, so here are my own favorite points in the paper…
First, there’s the gradual and yet sudden way in which we have gotten to such a bad fiscal place:
“How did you go bankrupt?” Bill asked.
“Two ways,” Mike said. “Gradually and then suddenly.”
–Ernest Hemingway, The Sun Also Rises…
The collapse of the budget happened both gradually and suddenly. The gradual, but sizable, decline that occurred from 2001 to 2008 was primarily the result of policy – tax cuts and spending increases. The sudden, sharp decline that occurred from 2008 to 2009 was primarily the result of the economic downturn and the financial interventions.
Second, it used to be we could talk about the “longer run” being the “unsustainable” part of our fiscal future. But now that “unsustainability” is evident within the ten-year budget window (”the future is now”):
Under the Administration’s budget, the figures are not quite as bad as under continuation of Bush Administration policies, but are troubling nonetheless. The ten-year deficit is projected to $9.1 trillion. The deficit declines to 4.0 percent of GDP by 2012. By 2019, although the economy is projected to have been at full employment for several years, the deficit rises to 5.5 percent of GDP (a structural deficit about equal to the 2009 figure); spending rises to 24.5 percent of GDP (the highest since World War II, except for the current downturn), the debt-to-GDP ratio rises to 82 percent (the highest since 1948), and net interest payments rise to 3.8 percent of GDP (the highest share ever and larger than defense or non-defense discretionary spending). All of these figures are poised to rise further after 2019, implying that the situation is unsustainable.
Third, the longer-term outlook has gotten worse, and hence the fiscal gap more challenging to close:
We estimate a long-term fiscal gap – the immediate and permanent increase in taxes or reduction in spending that would keep the long-term debt-to-GDP ratio at its current level – to be about 4-6 percent of GDP under the assumptions in the CBO baseline and about 7-9 percent of GDP under the assumptions in the adjusted baseline or the Administration budget. The debt-to-GDP ratio would pass its 1946 high of 108.6 percent by 2037 under the CBO baseline, but much sooner – in 2025 and 2026, respectively – under the adjusted baseline or the Administration budget. Under all three scenarios, however, the debt-to-GDP ratio would then continue to rise rapidly, contrary to its sharp decline in the years immediately after 1946.
And one might be surprised that closing the gap won’t be easy even with low (even zero percent) interest rates:
Low interest rates will slow the accumulation of national debt, but do not necessarily help in addressing the fiscal gap. The fiscal gap arises from two sources: the debt already in place and to be accumulated in the near term, and the implicit liabilities that loom in the more distant future. Lower interest rates reduce the cost of servicing the debt, but raise the adjustment needed to offset large future imbalances. Calculated over the infinite horizon, the long-term gap is actually higher if one assumes that the government will face a zero interest rate for the next 20 years.
(You can think of this as the iceberg ahead isn’t growing as fast, but on the other hand, it’s suddenly a lot closer, and we have a lot less time to reverse our crash course. A zero percent interest rate means those future liabilities aren’t “discounted” anymore–it’s as if those future liabilities are right here, right now, and we have to give up much more today to fill in those “back-to-the-future” fiscal holes.)
And the long-term fiscal crisis can’t even be solved by pursuing health care reform, even one that turns out to be hugely successful in controlling costs:
Under the projections using the Administration’s baseline, cutting the annual growth rate of health spending by 1.5 percentage points for 10 years would reduce the long-term fiscal gap by 1.5 percent of GDP; the same reduction for 30 years would reduce the gap by almost 4 percent of GDP. To eliminate the long-term gap through reductions in health spending growth alone, the growth rate of spending on Medicare and Medicaid would have to fall by 3 percentage points annually over the next 75 years. That is, [health] expenditures currently projected to grow at a rate nearly 2.5 percent faster than GDP during the next ten years would instead have to begin falling immediately as a share of GDP.
Bottom line is that the Bush tax cuts–and now extension of the Bush tax cuts as proposed by the Obama Administration–have nearly doubled the fiscal gap:
Even if rising health care costs are an important component of the long-term problem, they are not necessarily “the” cause of the fiscal gap. The gap has been increased by more than 5 percentage points of GDP just by continuation of the policies that have been enacted during the Bush Administration.
(So how is it that the Obama Administration chooses to work so hard on controlling health care costs–a very tall order–while pretty much “rolling over” on the Bush tax cuts?…)
And the Obama Administration’s call for a new statutory PAYGO rule which would exempt the extended Bush tax cuts is something Bill Gale can’t help but remind his former colleague Peter Orszag that he shouldn’t (and doesn’t really) like:
The Administration’s willingness to adopt a baseline that extends the Bush tax cuts is no minor matter and it colors several issues…
In every year since 2001, the Administration has requested that the tax cuts be made permanent and in every year Congress has refused to do so – even when Congress was in Republican hands and even when the budget projections suggested future surpluses. Now that even the CBO baseline projection is for large deficits throughout the ten-year budget period, it does not seem obvious that the tax cuts should be extended. It is certainly is not obvious that the extension should be incorporated into the Administration’s baseline…
[A]llowing PAYGO not to apply to extension of the Bush tax cuts is simply an enormous budget gimmick. When the Bush Administration proposed such a change, Gale and Orszag (2004b, p. 9) wrote that in the light of the (in retrospect relatively benign) fiscal imbalances that existed at that time: “…the temptation to turn to budget gimmicks may prove overwhelming. Policymakers and the public should be especially aware of at least five tricks …[including] policies that allow politicians to ignore budget issues – such as not reinstating budget rules that require spending and tax changes to be self-financing, or even worse, the [Bush] Administration’s proposal in last year’s budget to allow the tax cuts to be made permanent without showing any change in the budget baseline.”
Alan and Bill conclude:
Recent developments…have caused a change in circumstances. Huge short-term deficits have accelerated the arrival of the future that policy makers have been choosing to ignore. And capital market disruptions have reduced the likelihood that growing U.S. fiscal imbalances will be tolerated. Thus, the United States will soon enter a new phase of fiscal policy decision-making. Although huge deficits are not desirable in the short term, they are nonetheless understandable. Once – or as – the economy recovers, though, the need to impose fiscal discipline will be a short-term and urgent problem that will require difficult choices that policy makers have so far refused to make. Worse still, if the economy recovers only very slowly or not at all, those decisions will still need to be faced, but in the context of a weaker economic situation.
Suddenly, the not-so-happy fiscal future is now. Rather than blame the past leadership for how we got here, what will the current leadership do to make the best of it going forward?