From the frenzied political battle and clashes of opinion of recent weeks, an observer might conclude the US faces fiscal catastrophe. It does not. The fiscal position has improved dramatically and poses no medium-term risks. The only fiscal crisis the US faces is one inflicted by a purported desire to avert one. The real issue is what government Americans want and how they choose to pay for it.
Between 2007 and 2009 the fiscal deficit of US general government, including state and local, jumped from 2.7 per cent of gross domestic product to 12.9 per cent as a result of the financial crisis. But the latest International Monetary Fund forecast is for a deficit of 5.8 per cent of GDP this year and 3.9 per cent for 2015. Much of this tightening is thought to be structural, with a deficit of just 3.9 per cent this year, down from 8 per cent in 2010. Fiscal tightening of 2.6 per cent this year helps explain poor growth. As fiscal drag slows, growth should pick up.
The latest long-term forecasts of the non-partisan Congressional Budget Office also justify medium-term optimism. They show a fall in the ratio of federal debt to GDP held by the public over the next decade, from 73 per cent to 71 per cent.
These forecasts are, as always, based on current laws. Last year this approach created difficulties for the CBO. It responded by providing two forecasts: a baseline and an alternative. The baseline assumed that the George W Bush-era tax cuts would expire, as required by law. As a result of this and other factors, revenues would reach 24 per cent of GDP by 2037. This was believed by the CBO to be implausible - rightly, as it turned out: the Bush tax cuts would not expire in toto. The CBO provided an alternative. The tax cuts (and relief from the alternative minimum tax) were assumed to be extended through 2022. Thereafter, revenues were assumed to stay at their 2022 level of 18.5 per cent of GDP. The new forecasts, which show debt reaching 100 per cent of GDP 25 years hence, are worse than last year’s baseline, in which the Bush tax cuts expired, but far better than the CBO’s earlier alternative.
Is this long-run forecast a disaster? No. The US could probably sustain debt held by the public at 100 per cent of GDP. It is high, but borderline manageable. The costs of doing so would depend on the real rate of interest. If that were to be no higher than the real rate of growth (consistent with long-run experience), the country would not even need to run a primary fiscal surplus to stabilise the debt ratio. Moreover, revenue enhancements and spending cuts needed to keep debt at 73 per cent would be 0.8 per cent of GDP now and 1.3 per cent in 2020. That is small relative to what has been achieved in recent years.
The CBO states that “bringing debt back down to 39 per cent of GDP in 2038 – where it was in 2008 – would require a combination of increases in revenues and cuts in non-interest spending totalling 2 per cent of GDP for the next 25 years”. The 2012 forecasts suggest letting the Bush tax cuts expire would have delivered much of this decline. Since the US economy did well in the 1990s, before these unaffordable cuts, it is extraordinary that Barack Obama did not let them expire when he had the chance in the fight over the “fiscal cliff” in late 2012. It would have given the president the leverage he now lacks to obtain a balanced fiscal adjustment. Instead, he has left the country on the rack of sequestration.
Yet it is quite possible that no further fiscal adjustment will be needed to reduce the debt. In the second quarter of 2013, GDP was 14 per cent below its 1980-2007 trend. It may well recoup much of this. Indeed, former US Treasury secretary Lawrence Summers noted, forecasts for the difference between the far larger numbers for revenue and spending over a quarter of a century are wildly uncertain.
Growth is not only uncertain, but amenable to intelligent policy making over both the short and longer term. The US does not confront any medium-term crisis of fiscal sustainability. It could wait until the 2020s before deciding to do any more. Yet this does not mean no important fiscal challenges exist. It is easy to see at least five.
First, the sequestration process is arbitrary. It needs to be changed. Second, as Ezra Klein of The Washington Post notes, the federal government is “an insurance conglomerate protected by a large, standing army”. The CBO forecasts that spending on social security will rise from 4.9 per cent of GDP to 6.2 per cent and spending on healthcare from 4.6 per cent to 8 per cent over the next quarter of a century. Other spending, including on science and education, will be badly squeezed. If spending on defence were to be 4 per cent of GDP, other spending, apart from on social security and health and interest, would be 3 per cent of GDP in 2038 – too low to sustain essential services.
Third, a part of the solution is to curb spending on pensions and medical costs. On the latter, there is an opportunity. The US government spends as much on health as a share of GDP as many European welfare states, while covering a far smaller share of the population. It must be possible to deliver much the same at lower costs or more at much the same cost. Fourth, the US needs fiscal reform. Here the room for greater efficiency and equity is huge.
Finally, the share of GDP taken in revenue will need to rise. The 19.7 per cent of GDP now forecast by the CBO for 2038 is too low, unless the Tea Party slashes spending on social security and Medicare. Given that group’s age composition, this looks very unlikely. The CBO data suggest that a rise in federal revenue to 22 per cent of GDP may be needed.
That is surely achievable. Yet this also defines the nature of the debate. It is not about the debt. It is about whether Americans will pay the taxes needed to fund the government they have legislated. The US has created major social programs. But it seems unable to agree on the taxes needed to pay for them, while sustaining essential state functions at a reasonable level. This struggle is disguised behind the rhetoric on unsustainable debt and disincentive effects of modest rises in taxation.
If the US does create a huge fiscal problem for itself, it will be because agreement on the balance between what government does and how it is financed is impossible. But, first, the factitious crises of recent weeks simply have to stop.
Copyright The Financial Times Limited 2013.