(Original Post)
The National Journal
November 7, 2009
The Debt Problem Is Worse Than You Think
by John Maggs
It is hard to imagine, but not long from now the epic fight over health care reform and the looming battles over climate change and banking regulation could seem like footnotes to the Obama presidency. The jury is still out on whether the economic stimulus bill and corporate bailouts helped pull the United States out of the worst recession since the Depression, but these too will fade in importance once the true challenge faced by the U.S. government comes into focus.
Sometime in the next few years -- possibly before the 2012 presidential election and probably by 2016 -- it is likely that two huge challenges will come to dominate government and politics. Either of them alone would be daunting enough to overwhelm the unreliable machinery for making hard decisions in Washington. Together, they will demand a degree of consensus, acumen, and political bravery that hasn't been seen here for a long, long time.
The first task is to confront the reality that the budget process is out of control and that deficits and government debt are headed much higher than anyone can remember. The tripling of the deficit in 2009 has been much noted in Washington, but the implications of the longer-term path of the budget are not fully appreciated by many policy makers. Simply put, even alarmists may be underestimating the size of the problem, how quickly it will become unbearable, and how poorly prepared our political system is to deal with it.
There is a sense in Washington that the budget problem is merely one of several challenges that Obama would face in a two-term presidency, just a nettlesome complication for him as he pursues climate change, entitlement reform, and other priorities. Yet dealing with the budget and the debt is likely to dominate, one way or another, most of Obama's domestic policy agenda, whatever his hopes and intentions. Republicans tend to portray the budget woes as the product of the nine-month-old Obama presidency and the $787 billion stimulus plan. Democrats blame the Bush tax cuts and reckless spending on the wrong war. Such posturing obscures the consensus that underlies the fiscal expansion, over many years, that has brought us to this perilous moment.
The second challenge is monetary policy, as set by the Federal Reserve Board. The Fed uses interest rates and other tools to influence inflation, employment, and economic growth. In the same way that fiscal policy will need to make a sharp U-turn from expansion to contraction, monetary policy must do so as well. The switch isn't on the radar screen of nearly as many decision makers as the budget, but it is probably just as important and daunting a task.
In normal times, this monetary about-face is a delicate operation, but these are not normal times. Ordinarily, the Fed gradually raises interest rates during an economic recovery to tamp down inflation but not so much as to throttle growth. During this recession, it cut rates to zero to combat the near collapse of the banking system, and raising them will risk reigniting that crisis.
Just as the economy begins to strengthen, the Fed will have the added job of selling off upward of $2 trillion in assets from its efforts to rescue banks. It will need to do so because, as with the banks it saved, the Fed has become over-leveraged. As Fed Chairman Ben Bernanke has noted, the Fed has acted in ways and on a scale that it never has before. To reduce its holdings, the Fed will need to engage in many kinds of transactions that it has done only on a limited basis -- this time on an unprecedented scale. Part of Bernanke's job is to project an easy confidence about this enormous task, but Fed experts know that he is in uncharted waters.
Mishandled, these efforts to rein in the money supply could revive the financial crisis, kill off a recovery, or unleash ruinous inflation that would wreak havoc with the economy for years, as it did in the 1970s. As much as the budget or any other issue, the tightening of monetary policy is likely to shape history's view of the Obama era.
What unites these two challenges is that they are ultimately about how government will manage its debts. The financial crisis that began in 2007 was driven by the excessive debt of businesses and consumers. Government stepped in to effectively assume some of those private debts, saving many companies and families from bankruptcy. But now the U.S. government is starting to have debt problems of its own.
Unusual among developed countries, the United States has always escaped the temptation to pile up too much debt, even while fighting wars and building a welfare state. Part of the reason is the unique blessing of cheap resources and a productive free-enterprise system that allowed the country to grow its way out debt, as it did after World War II when government debt was greater than 100 percent of the country's yearly output. Since 1950, it has fallen to an average of 40 percent.
But that legacy of thrift is under siege as never before. Economists Kenneth Rogoff and Carmen Reinhart have written a dense analysis of financial crises through 800 years of world history, full of scatter charts and equations with Greek symbols. Their book,This Time Is Different,is a surprise best-seller, outpacing cookbooks and celebrity memoirs. Rogoff and Reinhart document every financial predicament back to 1300 to show the great consistency with which these crises come about and what happens afterward. The book doesn't deal with the recent U.S. crisis, but it is an implicit critique of American exceptionalism in economics -- the idea that we can avoid the fate of other nations.
The influx of foreign capital, the bubbles in housing and stocks, and the run-up in borrowing and commodity prices that preceded the meltdown that began in mid-2007 were typical signals of an impending crash. Financial crises tend to yield weak recoveries, the authors found. Both poor and rich countries spend hugely on bailouts and stimulus and fail to rein in spending, leading to crushing debt problems. Even more than the cost of bailouts, however, weak revenues from sluggish recoveries strangle governments as they maintain spending levels to soften the downturn.
In one comparison of 14 major financial crises involving a mix of developed and developing countries, Rogoff and Reinhart find that within three years of the onset of the problem, debt rose by an average of 86 percent. In the best of circumstances, the United States will blow through this number. According to an estimate by the Office of Management and Budget (which excludes many likely developments, such as an extension of the Bush tax cuts), the net federal debt will nearly double from $5 trillion at the end of 2007 to $9.9 trillion at the end of 2010. (This is the number that matters to investors. Gross debt, including federal trust funds, is now close to $12 trillion.)
A debt default -- a form of bankruptcy -- seems unthinkable for the United States, but Rogoff reminds us that it happened in 1933, when President Franklin Roosevelt revalued the dollar by seizing gold supplies. A default would wipe out wealth and retirement savings and do long-term damage to the economy. No one knows how much debt America would have to incur to risk a default, but one thing is certain: Without a drastic fiscal U-turn soon, debt is going to reach the point where some kind of default is likely.
The Thermostat
As the charts on pp. 21-24 show, spending and taxes collected by the federal government have been remarkably steady until recently, despite popular belief. Since 1969, federal spending has stayed within a narrow band, running between 19 and 22 percent of gross domestic product, with only brief periods when it was higher or lower. During the 1980s, spending was mostly above 20 percent, and from 1995 to 2007, it was mostly below 20 percent. The average over 40 years is 20.6 percent.
Revenue is even more stable. Despite tax cuts, recessions, and major tax increases, the amount of tax revenue from 1969 through 2008 was amazingly constant, varying by just a couple of percentage points. The average for revenue was 18.3 percent, yielding a long-term average deficit of about 2.4 percent.
Looking more closely at spending and revenue together, it seems that the largest swings in one direction are almost immediately followed by a move back toward the average.
The metaphor of a thermostat nicely describes how Washington responds to changes in the political climate. This idea of a set point for spending and taxes is consistent with what economists think of as "dynamic equilibrium." Whenever policy moves taxes or spending very far from the set point, other forces -- some economic, some political -- emerge to move it back toward the average.
For example, when taxes get too high and government does not lower them, slower economic activity comes along to reduce revenues. When tax revenue drops, often reflecting a tax cut, the economy responds with higher growth that boosts revenue, reversing the trend.
Likewise, when spending gets too high, government eventually acts to rein it in. In the popular view of history, Ronald Reagan cut taxes sharply and backed a defense buildup that boosted overall spending. The truth is that spending, as a share of the economy, peaked in 1983 and fell gradually for the rest of Reagan's presidency. By 1982, in the face of rapidly rising deficits, Reagan endorsed a series of tax increases after it became clear that "business tax cuts had gone way too far," recalled Bob McIntyre, director of Citizens for Tax Justice, which has targeted the decline in corporate taxes. After tax cuts and a deep recession drove down revenues in the Reagan administration's early years, tax increases and a recovering economy brought revenue back to the set point, almost exactly.
Repairs Are Needed
Based on recent events and future plans, however, this thermostat seems to be on the fritz. According to the Obama budget's baseline, if current policies stand, spending that jumped to a postwar peak of 26 percent of GDP in 2009 will settle in at a new set point of 24 percent for the next 10 years. But revenues -- with or without Obama's proposed tax increase on high-income earners -- will continue to average about 18 percent of GDP, which is right around their 40-year norm.
In other words, spending will bump up to a new, higher set point, but taxes will not. The resulting gap would produce deficits in the range of 5 to 6 percent over the next 10 years -- more than twice as large as the 40-year norm.
Even this is probably too optimistic. Obama's budget, by all measures, undercounts some likely expenses, such as the continued cost of the Afghanistan war, and leaves out the extension of some likely tax breaks. The budget hawks at the nonpartisan Concord Coalition propose their own scenario to account for these likelihoods, dubbed the "plausible baseline." It finds a new 10-year set point of 24.6 percent for spending and 16.3 percent for revenue, an average deficit of 8.3 percent.
What are the sources of this long-term shift? Despite the sense that Washington has never been more divided ideologically, in practice there is a surprising amount of agreement about taxes and spending. Unlike the 1980s, when Republicans were associated with the idea of smaller government, and the 1990s, when a Democratic president and a Republican Congress achieved the biggest reduction in the relative size of government since the 1940s, neither party is much identified now with the idea of limited government -- nor with fiscal prudence. Republicans may be fighting tooth and nail over the Obama
health care proposal, but they aren't willing to challenge popular spending programs such as Medicare, as they once did. Democrats, meanwhile, have embraced tax cuts as a political bonanza.
As an example, Obama recently proposed a $250 per person payment to Social Security recipients because recent deflation means that they won't be getting the customary bump in their monthly checks to account for inflation. Economists condemned the rebate as political pandering to seniors, who as a group don't need the money as much as others and are less likely to spend it. But there was hardly a peep from Democrats or Republicans in Congress.
The new tolerance for high deficits comes at a time when government badly needs to address the long-term cost of entitlements. As a presidential candidate, Obama complained that Bush had squandered his opportunity to deal with the looming funding shortfall for Social Security and Medicare. But now Obama proposes to jettison what truly does appear to be the last chance to "bend the curve" of runaway costs. According to a comparable "plausible" scenario from the Congressional Budget Office, entitlement costs will start to rise steeply near the end of the 10-year budget cycle in 2019. Government spending is projected to ascend even more sharply -- past 30 percent of GDP around 2030, and 40 percent around 2050. Unless Obama does something to rein in spending in the next few years, solving this problem seems much more improbable than it did even a year ago.
The effect would be a frightening accumulation of debt much sooner than Obama's economic team is acknowledging. According to the White House's baseline projections, federal debt is expected to rise from 40 percent of GDP in 2008 to 53 percent in 2009 and top out at 65.9 percent in 2013, and then come down slightly until 2019. But the more realistic alternative scenario from CBO sees debt rising steadily through that period to 87 percent of GDP in 2020. Thereafter, it takes off like a rocket, jumping to 181 percent by 2035 and 321 percent by 2050. In today's dollars, this would be enough money to fight three wars the size of World War II.
Too Much Money
The threat of accumulating public debt is also a problem for the Federal Reserve in managing the dollar and interest rates. Even in calmer times, knowing when to cut rates and when to raise them is tricky. Increase rates too soon after a recession, and you can squelch the recovery. Hike them too late, and you can unleash inflation. Since it was created in 1913, the Fed has mishandled the timing of interest-rate changes many times, according to John Taylor, a former Bush Treasury official and one of the foremost experts on the Fed.
This time, the job for the Fed is going to be much more complicated, according to Rogoff, a Harvard economist. In addition to interest-rate cuts, the Fed has effectively lent $1.5 trillion to banks, with about $500 billion more in loans planned by early next year. This doesn't count guarantees to banks and other financial institutions that could potentially add trillions more to the money supply if some aspect of the financial crisis returns.
Sometime in the next year or two, the Fed must start selling off its assets. Like any bank, it will need to do this to bolster confidence that it has the means to deal with future problems -- akin to the "stress tests" that the Treasury Department is using to determine whether private banks are healthy. Put another way, the Fed will have to sell assets to soak up the extra trillions in the money supply. In times of normal growth, when banks are more willing to lend their own money, this extra money could fuel inflation.
Meanwhile, the Fed will do its customary about-face on interest rates, but this too will be more complicated than usual. For starters, the Fed will be raising short-term rates after effectively cutting them to zero last December (the actual rate is between zero and 0.25 percent, which is more or less a transaction fee). It will do this in a financial system that has depended on virtually free money to maintain its lending to businesses and consumers.
Both actions are a way for the Fed to reduce the money supply, which has grown more and faster than at any time in its history. The risk is that even modest economic growth could trigger inflation that will be hard to control. Bernanke projects great confidence in the Fed's capacity to manage this complex switch on debt and interest rates, but again "we are in new territory," Rogoff said.
The damage could be deep and lasting: If rates are raised too soon or too steeply, a recession would return, threatening companies and consumers already weakened by the Great Recession. That's what happened in 1937, when the Fed boosted rates too soon and extended the Great Depression by a year. On the other hand, if the Fed waits too long to raise rates and moves too slowly to sell off its assets, inflation would ensue, a problem that could take years -- and perhaps another recession -- to correct.
The Fed Is Part Of The Government
Because of the Fed's unique independence, it is tempting to view these crucial decisions by the board as fundamentally different from the budget and debt problems outlined earlier. Unlike the very public process by which Congress writes a budget and votes to raise the federal debt limit, the Fed makes its decisions privately and then announces them in press releases. But that doesn't mean that the Fed is not accountable for its actions, as Bernanke is learning in hearing after hearing about his handling of the bank bailouts. Even routine decisions on interest rates are the subject of intense scrutiny in Washington and on Wall Street, and politics has always influenced Fed chairmen.
Consider Arthur Burns, a close political adviser of President Nixon's who was rewarded with the Fed chairmanship in 1970. According to former Nixon aide William Safire, Burns was pressured to lower interest rates before the 1972 presidential election, through Nixonian leaks to the media about Burns's possible replacement. The Fed chairman relented, unleashing nearly a decade of ruinous inflation and one of the worst eras of economic turmoil in the 20th century.
Bernanke has already been renominated, but Fed chairmen still face pressures. Alan Greenspan, generally considered to have been above such suasion, has been at pains to explain how he came to unequivocally support the Bush tax cuts, something that he now says he never intended to do. Paul Volcker was vilified at the time for engineering the 1981-82 recession to help throttle inflation, and only years later received the credit he deserved.
Like the president and congressional leaders, who will face intense pressure and agonizing choices about the budget, Bernanke will encounter the same forces in his complicated series of decisions on reducing the money supply. And like those leaders, he must find consensus among the Fed's other board members and the sometimes very independent presidents of the Fed's regional banks. In the same way that Volcker's recession helped shape the view of Reagan's presidency, Bernanke and the Fed will influence whether Obama's stimulus and bailouts are seen as a success.
A large part of the Fed's lending involves short-term debt, or gaining control of assets that will be relatively easy to dispose of, Rogoff says, but that doesn't include mortgage-backed securities. By next spring, the Fed will have purchased $1.3 trillion of these bonds -- $1.3 trillion more than it owned before the crisis, when its total assets were $860 billion. Rogoff is among those who think that it is going to be tricky to unload these securities without destabilizing the credit markets. After the Fed's unusually close coordination with the executive branch of late, its image as an independent agency would probably be helped if ownership of those mortgage securities were transferred to the Treasury Department, Rogoff says (as originally envisioned under the Troubled Asset Relief Program). But he acknowledged that Congress is unlikely to embrace the optics of boosting the debt limit by another trillion dollars, even though it makes no difference to the true size of the public debt.
Borrowing by the Fed may not show up in the budget as an expenditure by taxpayers, but as Rogoff points out, the economic effect is the same: Until the Fed is able to successfully unwind its trillions of dollars in commitments, the board is adding to a growing Everest of debt.
Banana Republic
Debt is rising so fast that it seems reasonable to wonder why long-term interest rates remain so low, suggesting that Wall Street isn't worried. Consider the conditions that led to public debt harming the economy the last time. This was 1990 to '92, when economists concluded that growing deficits and debt were keeping long-term interest rates higher than they otherwise might be. Deficits had risen from about 3.8 percent of GDP in the late 1980s to 5.5 percent in 1992, which in turn helped drive up debt from its long-term average of 40 percent of GDP to 48 percent that year.
There is little doubt that the picture is much worse now, as outlined earlier -- debt has already risen more and faster, and deficits and debt are on a path to continue rising far higher. Economist Simon Johnson, among others, has warned that the United States is headed for the kind of debt crisis that has often plagued developing countries. In such cases, nations see interest rates climb, currency values plunge, and inflation soar out of control. Investment flees, confidence in the economy suffers, and long-term damage is done to the country's finances. That has been the experience of Japan, which once appeared to have eclipsed the United States in productivity and living standards but since 1990 has been mired in slow growth. Depressed about the three-year slump in home prices? In Japan, home prices fell for 17 straight years.
Still, Washington seems far from grappling with the financial crisis. William Gale of the Brookings Institution has been trying for years to interest policy makers in budget problems that looked scary before the crisis. "If you had told me two years ago that the housing market was going to collapse by 50 percent, that there was going to be a credit crisis that put the economy in free fall, that the world economy would collapse, that the deficit would be 10 percent of GDP, and that Congress would do nothing about the budget, I would have said you were crazy."
During the last budget crisis in Washington, an important factor moving the political system to action was the perception on Wall Street that the process was out of control. This was reflected in high long-term interest rates, slow growth, and, by some accounts, a heightened volatility in stock and bond markets. The financial situation helped Robert Rubin, as director of the newly created National Economic Council, to persuade President Clinton in 1993 to focus his efforts on deficit reduction.
Don Marron, a former top CBO official, is one economist who wonders why the markets haven't registered more concern recently. One possibility, he said, is that investors believe that the budget crunch will fade, presumably through some combination of vibrant economic growth and fiscal conservatism in Washington.
On the first point, last week's surprisingly strong report on economic growth in the third quarter of 2009 is encouraging those who think that a robust, "V-shaped" recovery will follow the sharp downturn of the Great Recession. The economy grew at a 3.5 percent annual rate in the third quarter, after contracting in each quarter of the previous 12 months. About 1 percentage point of that gain came from retailers replenishing their inventories, a signal of confidence in the months ahead. Viewed another way, however, about two-thirds of the gains were tied directly to temporary stimulus from the government -- extended unemployment benefits, the "cash-for-clunkers' rebate to boost car sales, and a tax credit for first-time homebuyers. After rising through the spring, consumer confidence has returned to levels normally associated with a recession.
A Slow Recovery
Rogoff is hoping that the economy will rebound strongly, but his research indicates that recessions caused by financial crises result in unusually slow and shallow recoveries. On average, he said, housing markets contract for five years, unemployment doesn't turn around for almost that long, and stock markets take three and half years to recover. In Rogoff's compendium of crises, the story for other nations is pretty much what has been the story for the U.S. so far: asset bubbles, inflow of foreign capital, huge borrowing by consumers, business, and government. As the accompanying charts show, in the best of conditions, deficits and debt in the United States follow the same script.
For their part, the Obama administration and CBO are counting on an unusually strong recovery. As sobering as OMB's long-term "plausible baseline" is, the agency is still expecting sluggish growth of 1.7 percent in 2011 and meteoric growth beyond -- an average of 4.7 percent a year for 2012 and 2013. That would be a more robust expansion than for any two yearsduring the 1990s boom, and the fastest for any two years since 1983-84. If growth is slower, and especially if there is another recession, the deficit and debt picture gets much worse, very fast.
Another lesson of Rogoff's book is that rich countries' experiences with debt crises are very similar to that of poor nations. Other countries have been hit by crises with public debt levels as low as 70 percent of GDP, or avoided them with debt as high as 150 percent, but none of those nations had the advantage of America's dominant role in the global economy and its control of the dollar, the "reserve" currency for most of the world. One paradox of the recent recession is that, as bad as it was here, it was more severe in most of Europe and Japan, prompting a surge in foreign purchases of U.S. Treasury bills just when the government needed to sell them. Since the crisis hit, the share of worldwide wealth held in U.S. dollars has risen from about 65 percent to 70 percent.
Marron is skeptical that low long-term rates reflect confidence in Washington's ability to solve the debt problem. "I don't know what the evidence would be for that." It could be, he speculated, that investors are engaging in the kind of wishful thinking that brought about the financial crisis. Based on recent experience, Marron said, "we know that is a possibility."
It may also simply be a matter of what gets investors' attention. In 1992, one of the larger components of federal spending was servicing the national debt. In the past year, the debt has increased by more than 30 percent, but the projected cost of servicing it actually went down, Marron notes, because of the sharp cut in interest rates. Money is nearly free for big banks at the moment, and running up the national debt is nearly free, too.
This is where the two policy challenges of the budget and the money supply converge. Once interest rates start rising, the cost of government debt will climb sharply; at the same time, investors are going to notice thattheirborrowing costs are also higher. That's what happened from 1990 to '92, when Wall Street and Washington suddenly decided that the budget and debt were an emergency. If interest rates were to rise 2 percentage points, Rogoff said, a national debt that will be close to $10 trillion in 2011 would cost an extra $100 billion to service.
Taylor, Rogoff, Marron, and Gale all think that it will be a year or two before the recovery is strong enough to trigger the inflationary signals that lead the Fed to start raising rates. But all four also say that a shift in investor confidence could come suddenly and sharply. When the shift does arrive, the need for drastic action in Washington will be greater than it was in the 1990s, when Republicans and Democrats put aside their differences to reach comprehensive budget deals that ushered in an era of lower deficits and the only balanced budgets since 1969. Given the pressure of dealing with entitlements, Marron says, "the job will be much bigger" than what Washington faced in that earlier era.(See "What to Do?" p. 28.)
Not coincidentally, 1990 to '92 was a time when difficult decisions on fiscal and monetary policy converged. While Congress and President George H.W. Bush were reaching a budget deal in 1990, Fed Chairman Greenspan was resisting pressure from the White House to lower interest rates. Greenspan sensed inflationary pressure in the pipeline, and he held off. The result was a recession that surely cost Bush a second term. Likewise, tougher stances on fiscal policy can have electoral consequences. Voters then were also angry that in reaching a budget deal in 1990, Bush broke his vow of no tax hikes. Gale says that Obama
will similarly have to go back on his promise to protect the middle class from tax increases, if he is to have any chance of getting a handle on the deficit. "Do I expect that [soon]? No."
