I happened to spot a USA Today in the coffee shop where I was working today (think of it as practice for my upcoming furlough days) and noticed a headline in the “Money” section entitled “How do we dig out from under $12 trillion in debt?” It reminds readers of the very salient fact that our national debt-to-GDP ratio (now at 70.4 percent of GDP) is the highest it has been since the post WWII period. Importantly, this figure substantially under-states the sad state of the U.S. fiscal position because it ignores the massive unfunded obligations facing our “big three” entitlement programs – Medicare, Medicaid and Social Security.
While this is not good news, I was pleased to see one of the nation’s widely read newspapers addressing the issue. And I thought it was worth a brief post about why deficits matter.
There is some public confusion around this issue, not least because neither party seems to do much about it. Whatever you like or dislike about the Bush Administration (disclosure: I worked for President Bush in 2001-02, participated in the Social Security reform tour with him and 2005, and received a Presidential appointment to the Social Security Advisory Board in 2006), it is near impossible to make a credible case that his Administration took deficit or debt reduction seriously.
Thus far, the Obama Administration has an even worse record of fiscal discipline. Yes, yes, I know – the midst of a deep recession is not the best time to cut federal spending (or increase taxes) in an attempt to close the fiscal gap. But despite the significant lip service that the Obama Administration gives to deficit reduction, there is so far scant little evidence that they are serious about reducing it even after the economy improves. Most of their calls for increasing taxes are accompanied by new ideas for growing the size of government, such as paying for health care reform.
Leaving politics aside, do deficits matter? V.P. Cheney famously quipped that they do not. But most economists agree that they do. The standard textbook analysis is that deficits reduce national saving and drive up long-term interest rates, thus reducing private investment and thus sacrificing long-term economic growth.
There is plenty of empirical evidence to support this. Indeed, President Obama’s own budget director Peter Orszag, a distinguished economist and fiscal policy expert (another disclosure: Peter is a good friend and co-author of mine, despite our policy disagreements) has an influential paper on this topic. The full paper (with Bill Gale) appeared in the Brookings Papers on Economic Activity, but a more reader-friendly summary is available from their piece in the Economist’s Voice.
Keep in mind that this article was written in 2004, back when annual deficits were projected to run 3.5 percent of GDP. In contrast, current deficits are running about double that (although, admittedly, no one expects the current level of deficit spending to persist once the economy improves and we stop spending like drunken sailors in an attempt to stem the decline).
Here is what Gale and Orszag said then:
“Under reasonable projections, the unified budget deficits over the next decade will average 3.5 percent of GDP. Compared to a balanced budget, the unified budget deficits will reduce annual national income a decade hence by 1 to 2 percent (or roughly $1,500 to $3,000 per household per year, on average), and raise average long-term interest rates over the next decade by 80 to 120 basis points. Looking out beyond the next decade, the budget outlook grows steadily worse. Over the next 75 years, if the tax cuts are made permanent, this nation’s fiscal gap amounts to about 7 percent of GDP. The main drivers of this long-term fiscal gap are, in order, the spending growth associated with Medicare and Medicaid, the revenue losses from the 2001 and 2003 tax cuts, and increases in Social Security costs. The nation has never before experienced such large long-term fiscal imbalances. They will gradually impair economic performance and living standards, and carry with them the risk of a severe fiscal crisis.”
I am heartened that OMB Director Orszag understands the serious long-term consequences of our nation’s fiscal imbalance. Of course, Peter and I will likely disagree on how to fix the problem (he will want to rely primarily on taxes, whereas I would prefer to first go after spending). But future generations had better hope that our elected officials find a way to compromise, do some of both, and get this nation back on a sustainable fiscal path.