The first chart is the yield on the 30-year Treasury bond:
[Note: The 30-year Treasury bond was discontinued for 4½ years – from 10/01 to 2/06 – due to the record budget surpluses bequeathed by the Clinton administration and the Bush administration’s subsequent desire to avoid dealing with the long-term consequences of its return to record budget deficits. Here is the corresponding chart for the yield on the 10-year Treasury.]
As you can see from this chart, the yield on the 30-year Treasury bond dropped steadily from the early/mid-‘80’s until the early part of this decade and has held pretty steady since (with the exception of a big dip during last year’s financial crisis as money sought a safe haven in Treasuries). As I write this, the yield is 4.24% (3.28% for the 10-year Treasury), close to the lowest it has been in 50 years with the exception of that dip last year. (By contrast, it was 8.9% when Ronald Reagan left office.) Basically, the US government is enjoying just about the easiest time it has had financing its debt in generations.
Now for the second chart: The rate of job loss during the current Great Recession compared with the rate of loss in all previous post-WWII recessions:
The unemployment rate, at 10.2%, is the highest it has been since the Great Depression. By the broader measure that includes the underemployed and those who have dropped out of the labor force, it is 17.5%. And we continue to shed jobs. (Check out this fascinating time-lapse map showing the increase in unemployment by county by month since the Great Recession began two years ago.)
There you have it, aspiring pundits. Can you guess which is the alarming crisis: a/ the ability of the US government to finance its debt, or, b/ unemployment?
If you guessed, “a/ the ability of the US government to finance its debt,” congratulations! You, too, could be a political pundit for the New York Times, Wall Street Journal or any number of other publications or networks.
You would expect an op-ed in the Wall Street Journal from the chief economist for John McCain’s presidential campaign, Douglas Holtz-Eakin, to hype the deficit threat. But earlier this week, the New York Times published a front-page piece by Ed Andrews (probably that paper’s worst business writer), on the subject (“Wave of Debt Payments Facing U.S. Government”). It quotes legendary Pimco bond fund manager, Bill Gross, but fails to note that Gross has increased his fund’s holdings of US government-related debt from 48% last September to 63% now – the highest portion he has held in US government debt in five years and not exactly the position the world’s greatest bond fund manager would be taking if he expected interest rates on that debt to explode (which would cause the value of his holdings to plummet).
Currently, the US government’s net interest expense as a percentage of GDP is the lowest it has been in 30 years. But Andrews notes that it is projected to increase dramatically over the next ten years – to roughly the level it was when Bill Clinton took office in 1992. That’s certainly undesirable. But as front-page crises go, it doesn’t compare to the immediate problem of unemployment.
And it doesn’t remotely suggest anything like the looming prospect of a US government default on its obligations or a return to hyper-inflation as some of the more alarmist commentary suggests could happen. Take, for instance, a recent op-ed by Robert Samuelson in the Washington Post (“Could America Go Broke? ”), which included bits like this:
“Deprived of international or domestic credit, defaulting countries in the past have suffered deep economic downturns, hyperinflation, or both. The odds may be against a wealthy society tempting that fate, but even the remote possibility underlines the precariousness and the novelty of the present situation. The arguments over whether we need more ’stimulus’ (and debt) obscure the larger reality that past debt increasingly constricts governments’ economic maneuvering room.”
Samuelson cites Japan as an example of government debt out of control, which actually disproves his alarmist rhetoric – Japan’s government debt has increased to over 200% of its GDP (about three times the US level) while the interest rate on its 10 year bonds has actually decreased from over 7% in 1990 to 2.1% now.
Let’s compare the prospect of continuing high unemployment with the risk of a big increase in inflation. Paul Krugman points to the Philadelphia Fed survey of professional economic forecasters. Inflation is forecast to remain comfortably below the Fed’s 2% target while unemployment persists at stubbornly high rates – over 8% well into 2012. The current spread between 10-year Treasuries and the 10-year TIPS (Treasury inflation-protected securities) indicate that the market is forecasting 10-year inflation averaging 1.5%.
That's why it is troubling to read reports like this:
The Obama administration, mindful of public anxiety over the government's mushrooming debt, is shifting emphasis from big-spending policies to deficit reduction. Domestic agencies have been told to brace for a spending freeze or cuts of up to 5 percent as part of a midterm election-year push to rein in record budget shortfalls.With unemployment still rising and nascent economic growth anemic, premature focus on near-term deficit reduction risks a repetition of FDR’s spending cuts and tax increases in 1937 that plunged the economy back into a steep decline before the country had fully recovered from the Great Depression.
While unemployment should be the priority in the short term, deficit reduction should be a long-term priority. Toward that end, it is worth revisiting how we got into our current mess and what that suggests for how we get out of it.
As I have pointed out before, the real explosion in the federal debt began under Ronald Reagan who cut taxes while increasing government spending to levels previously exceeded only during the four years of World War II. (After six years with spending over 22% of GDP and two years over 23%, Reagan left office with federal spending running at over 21%. By contrast, President Clinton left office with spending at 18.5% of GDP.) The result was that the national debt increased more than 400% from less than a trillion when Reagan took office to over $4 trillion when President Clinton and a Democratic Congress finally increased taxes again in 1993. The deficits during those years are even more dramatic when you state them in current dollars. In 2009 dollars (using the OMB year-end debt figures and the St. Louis Fed GDP deflator), Reagan and the first Bush ran up cumulative deficits of roughly $5 trillion. (This despite favorable demographics that resulted in entitlement spending to decline temporarily from 11.9% of GDP in 1983 to 10.1% in 1988. Last year, by contrast, the figure was 12.5%.)
The turning point in this deficit story was the 1993 Budget Act, about which I have written before, which was designed to eliminate the record budget deficits inherited by President Clinton. It included a large overall increase in taxes and extended the pay-as-you-go budget rules. It passed without a single Republican vote in Congress by the closest possible margin – by one vote in the House and with Vice President Gore breaking a 50-50 tie in the Senate. Republicans predicted that the economy would collapse as a result. Instead, it produced record budget surpluses and the strongest economy in a generation. But the Democrats paid a price, as they were crushed in the 1994 elections and lost control of Congress. Unfortunately, the lesson that was learned in Congress was that fiscal responsibility doesn’t pay politically.
George W. Bush inherited record budget surpluses but quickly turned that around. Together with a Republican Congress, he enacted over $2 trillion in tax cuts, increased the military budget even before counting the trillion dollar cost of two wars, and passed the largest increase in entitlement spending (Medicare Part D) since the creation of Medicare in the 1960’s with a ten-year cost of almost a trillion dollars. At least when LBJ created Medicare he also enacted taxes to pay for it. Bush and Congressional Republicans never even discussed any means of paying for their budget-busting initiatives. To pull that off, they had to let the pay-as-you-go budget rules lapse. That left them free to increase spending and cut taxes at will – which they did. The result, predictably, was an increase of over $5 trillion in the federal debt, almost doubling it in just eight years. Together with the quadrupling of debt under Reagan and Bush’s father, that accounted for almost 80% of all debt that had been accumulated in the history of the US government up to that point.
But the trajectory was even worse. Economists have a concept known as “fiscal space.” For example, if you are running a $500 billion surplus during an unsustainable bubble, when the crash comes the budget can take a $1 trillion hit (as a result of a decline in tax revenue and an increase in spending on "automatic stabilizers" like unemployment insurance) and still have a manageable deficit of $500 billion. You have some "fiscal space." But if you are already running a $500 billion deficit during boom times (as Bush did), then when the crash comes, you have a $1.5 trillion deficit. NOT a good thing. That is basically what happened during the fiscal year that ended last September.
As former Reagan official and Wall Street Journal op-ed writer Bruce Bartlett noted recently:
According to the Congressional Budget Office's January 2009 estimate for fiscal year 2009, outlays were projected to be $3,543 billion and revenues were projected to be $2,357 billion, leaving a deficit of $1,186 billion. Keep in mind that these estimates were made before Obama took office, based on existing law and policy, and did not take into account any actions that Obama might implement. Therefore … a deficit of $1.2 trillion was baked in the cake the day Obama took office. … Now let's fast forward to the end of fiscal year 2009, which ended on September 30. According to CBO, it ended with spending at $3,515 billion and revenues of $2,106 billion for a deficit of $1,409 billion. To recap, the deficit came in $223 billion higher than projected, but spending was[I highly recommend these other two pieces that Bartlett wrote in Forbes on budget matters. Also, last June, David Leonhardt -- one of the New York Times' best writers on economic subjects -- had a good in-depth piece on how Clinton's record budget surpluses turned into our current trillion dollar deficits. Very little of it was the result of spending increases after President Obama took office.] Last March, the Obama administration forecast a $1.8 trillion deficit for the fiscal year that began almost four months before they took office. The actual figure came in at $1.4 trillion, largely because the financial sector recovered faster than expected which reduced the taxpayer cost of last fall’s bailout.
$28 billion and revenues were $251 billion less than expected. Thus we can conclude that more than 100 percent of the increase in the deficit since January is accounted for by lower revenues. Not one penny is due to higher spending. It should be further noted that revenues are lower to a large extent because of tax cuts included in the February stimulus. According to the Joint Committee on axation, these tax cuts reduced revenues in FY2009 by $98 billion over what would otherwise have been the case. This is important because the Republican position has
consistently been that tax cuts and only tax cuts are an appropriate response to
the economic crisis. According to the Council of Economic Advisers, as of August the actual budgetary effect of the February stimulus was to reduce revenues by $62.6 billion and raise spending by $88.8 billion. Of the spending, the vast bulk went to transfers such as extended unemployment benefits and aid to state and local governments, which may have prevented cuts in spending that would otherwise have occurred but probably didn't do anything to increase spending. Only $16.5 billion in stimulus funds went to investment outlays for things such as public works. This is a trivial amount of money in a $14 trillion economy.
As a result of the Bush tax cuts and the Great Recession, by fiscal 2009, federal revenue as a percentage of GDP had fallen to 14.9%. That is a staggering figure. That is the lowest it has been since 1951 – 58 years ago. By contrast, it was over 20% when President Clinton left office. The simple fact is that we will never get anywhere close to a balanced budget with today’s tax structure. We barely did it with the much higher tax structure President Clinton left behind (and with 2000 spending at 18.4% of GDP – it’s lowest level since 1961).
Which brings us to the subject of how to reduce the deficit.
Getting back to the earlier discussion, short term the deficit should be larger. We have, as Paul Krugman phrased it, “Fifty Little Hoovers” as tax revenue has fallen off a cliff and state (and local) governments are drastically slashing budgets and raising taxes. Raising taxes and cutting spending during the worst economic downturn since the Great Depression is a REALLY bad idea. For no other reason, 70% of our economy is consumer spending and it isn't going to revive as long as incomes are plummeting and unemployment is increasing. But states have no choice -- their constitutions required balanced budgets. Only the federal government can make up that gap without making the problem worse.
As this graph shows, state governments face almost $500 billion in budget shortfalls over the next three years. Local governments are expected to add another $100 billion or so to that total. That is nearly $600 billion of "anti-stimulus" in the pipeline. So at least to this extent, federal stimulus just offsets the contractionary actions of the “Fifty Little Hoovers.”
But when it does come time to close the federal budget gap again, there are really only three big targets:
2/ Health care spending; and
3/ Military spending.
Everything else is noise. TOTAL non-military discretionary spending -- everything from the entire judicial branch, the entire legislative branch, the Department of Homeland Security, immigration and naturalization, our nationals parks, education, public health, highways, air traffic control, the FBI, water projects, prisons, NASA, state aid, etc. -- is running at around $600 billion a year, less than half the federal deficit and less than military spending alone (which should top $700 billion this year -- even before any escalation in Afghanistan). Realistically, you can’t cut domestic discretionary spending enough to make a serious dent in the deficit.
Taxes: Let's start with taxes because that was the source of thegreatest erosion in the federal budget under both Reagan and Bush and it was the primary means by which the budget was subsequently brought into balance under President Clinton. Almost every Republican member of Congress (172 of 177 Republicans in the House and 33 of 40 Republican Senators) has signed Grover Norquist’s pledge to never raise taxes by ANY amount at ANY time for ANY reason. So right there you can count out any Republican role in any serious deficit-reduction effort. But it gets worse. Not only will no Republican vote to raise taxes, they continue to urge further tax CUTS in the face of trillion dollar deficts and revenue at its lowest level since 1951. Earlier this year, for example, 35 Republican Senators voted for an alternative to the stimulus plan that would permanently cut taxes at a ten-year cost of $3 trillion. This was not a temporary stimulus measure, but a further permanent reduction in revenue that would add $3 trillion to the deficit over the next 10 years. .
This leaves Democrats with the choice of doing nothing on taxes or doing what they did in 1993 -- raise taxes with no Republican support and get crushed in the next election. President Obama, as he does on most issues, has attempted to strike a middle ground, pledging no tax increases on those earning less than $250,000. Unfortunately, that may end up being the worst of both worlds -- an inadquate response to the long-term deficit while still giving Republicans the "tax increase" cudgel.
Health Care Spending: Long-term, health care spending is the biggest problem in the federal budget. Medicare, Medicaid and the State Childrens Health Insurance Program account for about 20% of the federal budget. That doesn't count other federal health care spending on veterans, Indians, military personnel and the health insurance of other federal employees and retirees. Nor does it count the revenue lost from the deductibility of employer-provided health insurance and health savings accounts. Add it all up and it dwarfs any other element of the budget. And the growth in health care costs greatly outstrips inflation. This isn't a government spending problem per se. It is a health care cost problem that affects our entire economy. It is bankrupting businesses and individuals and making our economy less competitive in world markets.
President Obama and Congressional Democrats, to their credit, have taken on this challenge as their top legislative priority after the stimulus. But, as with taxes, they have to do it with no Republican help. Even when the Senate Finance Committee stripped out a public health insurance option and an employer mandate -- the elements that Republicans most object to (and which would actually reduce the cost to taxpayers) -- they were able to secure only one lone Republican vote.
Ron Brownstein had a good piece at The Atlantic site this week where he details the cost-saving measures in the Senate health care bill. It is worth reading the whole thing. He notes:
[Jonathan] Gruber is a leading health economist at the Massachusetts Institute of Technology who is consulted by politicians in both parties. He was one of almost two dozen top economists who sent President Obama a letter earlier this month insisting that reform won't succeed unless it "bends the curve" in the long-term growth of health care costs. And, on that front, Gruber likes what he sees in the Reid proposal. Actually he likes it a lot. "I'm sort of a known skeptic on this stuff," Gruber told me. "My summary is it's really hard to figure out how to bend the cost curve, but I can't think of a thing to try that they didn't try. They really make the best effort anyone has ever made. Everything is in here....I can't think of anything I'd do that they are not doing in the bill. You couldn't have done better than they are doing." Gruber may be especially effusive. But the Senate blueprint ... also is winning praise from other leading health reformers like Mark McClellan, the former director of the Center for Medicare and Medicaid Services under George W. Bush and Len Nichols, health policy director at the centrist New America Foundation.The Republican response to these efforts has been to manufacture lies about "death panels" that will "kill granny". Apparently they were so pleased with the traction they got scaring seniors that they have now made their opposition to efforts to control the long-term growth of Medicare spending the official party position. In August, Republican National Committee chairman, Michael Steele wrote a Washington Post op-ed where he proposed a "Seniors' Health Care Bill of Right":
The Republican Party's contract with seniors includes tenets that Americans, regardless of political party, should support. First, we need to protect Medicare and not cut it in the name of "health-insurance reform."It was reported a couple of days ago that Republican leaders are circulating a list of ten policy positions that any Republican candidate would need to commit to in order to secure the support of the party (a so-called "purity pledge"). Among the required positions is "opposing health care rationing".
So now the Republican Party has become the defender of unconstrained growth in Medicare spending.
Military Spending: Even though we now spend more on the military than the rest of the world combined -- over $700 billion in the current year -- for Republicans, it is never enough. The ten-year cost of the Democratic health care bill, which among other things would extend health insurance coverage to 30 million Americans who currently lack it, is not much more than what we spend on the military in just one year. Defense Secretary Gates and President Obama have begun efforts to trim the most blatantly wasteful military spending -- but, for the most part, without Republican help. For example, earlier this year, when Congress voted on cutting off further funding for the $65 billion F-22 fighter program, a majority of Republicans voted against those cuts despite the fact that the Secretary of Defense (originally appointed by President Bush) and the Joint Chiefs of Staff want to terminate the program after 187 aircraft (the aircraft has never been used in either Iraq or Afghanistan). Republicans are also urging President Obama to send another 40,000 troops to Afghanistan (on top of the 30,000 additional troops he has sent since taking office). That would add $40 billion a year to what we are already spending on that war. Republicans believe in "supporting the troops" -- as long as the cost can be added to our national debt. Forget any tax increase to pay for it.
Where does that leave us? After leaving behind trillion dollar deficits, the worst economy since the Great Depression, and two wars going badly, Republicans are now complaining about the deficit. But they don't want to raise taxes. Or cut the growth in Medicare spending. Or cut military spending. In other words, they don't really want to do anything about the deficit except use it as a partisan weapon. As Dick Cheney famously said as the Bush administration was squandering our budget surpluses: “Reagan proved deficits don’t matter”. IOKIRDI (“It’s OK if Reagan did it”).
Should the Democrats tackle deficit reduction even without Republican support? As the only party serious about governance, they don't have much choice. But to shift the focus to deficit reduction now, while unemployment is still rising, would be economically unwise and politically suicidal. As it is, Democrats have reinstated the pay-as-you-go budget rules that Republicans abandoned and are working to ensure that new initiatives, like health care reform, don't add to the deficit. And much of the deficit will turn around as the economy eventually recovers. But unemployment is likely to still be over 10% on election day next year. If Democrats don't do a lot more to try to bring that figure down, the economy will still be in horrible shape and voters won't care how much progress Democrats have made on long-term deficit reduction. Earning the praise of political pundits who see deficits as the bigger problem will be of little solace to Democratic members of Congress when they have joined the ranks of the unemployed.