Achieving Long-Run Fiscal Sustainability William R. Emmons, Assistant Vice President and Economist April 8, 213 The views expressed here are those of the speakers, and do not necessarily represent the views of the Federal Reserve Bank of St. Louis or of the Federal Reserve System. 1
What Happens When an Irresistible Force... 2
... Meets an Immovable Object? 3
Can We Avoid a Fiscal Train Wreck? The irresistible fiscal force Non-defense spending growth 4
Can We Avoid a Fiscal Train Wreck? The irresistible fiscal force Non-defense spending growth The immovable fiscal object Tax revenues as share of GDP 5
Can We Avoid a Fiscal Train Wreck? The irresistible fiscal force Non-defense spending growth The immovable fiscal object Tax revenues as share of GDP What would a fiscal train wreck look like? High inflation Default on government debt Drastic benefit cuts and tax increases 6
Overview of the Discussion Trends in federal spending and taxes relative to GDP How have we avoided a fiscal crisis so far? Can we achieve long-run fiscal sustainability? 7
Federal Non-Defense Spending-to-GDP Ratio Has Quadrupled Since 1945 Percent 25 2 Ratio of federal nondefense outlays to GDP History Forecast 25 2 15 15 5 5 4 5 6 Source: Haver Analytics 7 8 9 Sources: Congressional Budget Office / Haver Analytics 2 3 Annual data through fiscal year 212; 213-23 projections as of Feb. 213 8
Health and Retirement Spending Has Increased from Zero to Percent of GDP 6 Spending relative to GDP (percent) 6 Percent 5 Ratio of Social Security outlays to GDP 5 4 4 3 2 Ratio of Medicare outlays to GDP 3 2 1 45 5 55 6 65 Source: Haver Analytics 7 75 8 85 Sources: Congressional Budget Office / Haver Analytics 1 Ratio of health outlays other than Medicare to GDP 9 95 5 15 2 Annual data through fiscal year 212 9
Health, Retirement and Interest Payments Are Projected to Rise Further Percent 14 12 Under the CBO s alternative scenario Forecast Ratio of all other spending to GDP (includes defense) Ratio of major healthcare programs to GDP 14 12 8 8 6 6 4 2 Ratio of net interest expenditures to GDP Ratio of Social Security outlays to GDP 4 2 15 Sources: CBO /Haver 2 25 Sources: Congressional Budget Office / Haver Analytics 3 35 4 Forecasts from June 212
Can We Slow Spending Growth? 1. The major federal programs are extremely popular. A March 24, 213, CBS News poll asked respondents what cuts they would make to reduce the budget deficit. Of those giving an opinion: 82 percent opposed reducing spending on Medicare. 81 percent opposed reducing spending on Social Security. 6 percent opposed reducing spending on defense. Source: CBSNews.com, Poll: 8% of Americans unhappy with Washington, March 26, 213 11
Can We Slow Spending Growth? 2. Program cost drivers are very difficult or impossible to affect. A substantial and permanent aging of the population is inevitable. Health care costs have risen faster than GDP for many decades and are expected to continue to do so. We are not winning the war on poverty millions of U.S. citizens face genuine need. 12
Meanwhile, Federal Revenue-to-GDP Ratio Has Been Flat Since 1945 Percent 25 2 Ratio of federal revenues to GDP History Forecast 25 2 15 15 5 CBS News poll March 213: 68 percent oppose personally paying more taxes. 5 4 5 6 7 Sources: OMB, CBO /Haver 8 Sources: Congressional Budget Office / Haver Analytics 9 2 3 Annual data through fiscal year 212; 213-23 projections as of Feb. 213 13
Result: Budget Deficits Will Explode... Under the CBO s alternative scenario 4 Forecast 4 Percent 3 Ratio of all federal spending to GDP 3 Annual federal budget deficit relative to GDP 2 2 Ratio of all federal revenues to GDP 15 2 25 3 Sources: Congressional Budget Office /Haver Analytics 35 4 Projections as of June 212 14
... And Federal Debt Held by the Public Will Reach Dangerous Levels Federal debt held by the public as a percentage of GDP Percent 9 8 7 6 5 4 3 2 Ratio of federal debt held by the public to GDP History 7 75 8 85 9 95 5 15 Sources: Congressional Budget Office /Haver Analytics Forecast 2 Alternative fiscal scenario Baseline (current law) 25 3 35 4 9 8 7 6 5 4 3 2 Annual data through fiscal year 212; 213-23 projections as of Feb. 213 Both are unsustainable trajectories. Even the CBO s best (unrealistic) fiscal scenario results in long-run disaster. 15
So Why Haven t We Had a Fiscal Crisis Already? An extended peace dividend Defense spending was very high after World War II and Korea. Even with Vietnam and defense buildups under Presidents Reagan and G.W. Bush, defense spending declined over decades relative to GDP. A demographic dividend Baby Boomers (born 1946-64) swelled the labor force, boosting economic growth and tax revenues. Women continued to join the paid labor force, boosting economic growth. 16
So Why Haven t We Had a Fiscal Crisis Already? Some good luck and good policy in the 198s and 199s Economic growth and the stock market were strong, reducing deficits. The Cold War ended, allowing rapid demilitarization after the Reagan defense buildup. Policy changes (tax increases, spending restraint, balanced-budget amendment) were less painful because of the first two pieces of good luck. 17
Defense Spending Continues to Decline From WW II Peak Percent 4 World War II History Forecast 4 3 3 2 Ratio of federal defense outlays to GDP 2 Korea Vietnam Reagan Bush II 4 5 6 7 8 9 Source: Office of Management and Budget /Haver Analytics 2 3 Annual data through fiscal year 212; 213-23 projections as of Feb. 213 18
Not Much Defense Left To Cut! Percent 9 History Forecast 9 8 8 7 Reagan 7 6 5 4 3 2 Bush I Clinton Ratio of federal defense outlays to GDP Bush II Obama Future presidents 6 5 4 3 2 1 1 8 85 9 95 5 Source: Office of Management and Budget /Haver Analytics 15 2 25 Annual data through fiscal year 212; 213-23 projections as of Feb. 213 19
The Demographic Dividend Will Become a Demographic Deficit Percent 7 68 66 Share of population aged 16-64 e ce t History Forecast 7 68 66 64 64 62 62 6 6 58 58 56 56 54 54 52 52 5 6 65 7 75 8 Source: Haver Analytics 85 9 95 Sources: Census Bureau / Haver Analytics 5 5 15 2 25 3 35 4 Annual data through 212; projections as of Jan. 213 2
One Consequence: Our Economic Growth Potential Has Declined Significantly Five-Year Trailing Average of CBO Estimate of Real Potential GDP Growth Annualized percent change Percent 5 History Forecast 5 4 4 3 3 2 2 1 1 5 55 6 65 7 75 8 85 9 95 Source: Congressional Budget Office /Haver Analytics 5 15 2 25 Annual data through 212; CBO projections of 213-24 as of Feb. 213 21
In Light of These Obstacles, Can We Achieve Long-Run Fiscal Sustainability? Neither of the political factions nor the public are willing to address political and economic reality. The irresistible fiscal force: One faction will not admit that the welfare state is extremely popular and cannot be significantly curtailed through democratic means. The immovable fiscal object: The other faction will not admit that the tax revenues needed to pay for the ever-expanding welfare state are neither politically nor economically feasible under current tax system. 22
What Is a Fiscal Crisis? History is full of countries that lost control of their fiscal situations, ending in crisis. See Carmen M. Reinhart and Kenneth S. Rogoff, This Time Is Different: Eight Centuries of Financial Folly, Princeton University Press, 29, especially chapters 4-9 and 12. Default on sovereign debt is more common than you might think. For example, Spain has defaulted 15 times during the last 45 years and may do so again in the near future! 23
Implicit Defaults Are Defaults, Too Implicit default on debt through inflation or currency devaluation is less obvious, but no less common. The United States effectively reneged on its financial promises three times during the 2th century: Devalued the dollar against gold in 1933 Broke the link between the dollar and other currencies in 1971 Inflated away most of the purchasing power of a dollar 24
Implicit Default: One Dollar in 1933 Is Worth 5.6 Cents Today Purchasing Power of One Dollar, in Cents Base period is 1933 Purchasingpower index: 9 What one dollar could buy in 8 each year, relative to the 7 purchasing power of one 6 dollar in 1933 5 4 3 2 9 8 7 6 5 4 3 2 2 3 4 5 6 7 8 9 2 Sources: Bureau Source: of Labor Haver Statistics Analytics / Haver Analytics Annual data through 212 25
Reasons Not To Worry The U.S. government will not default on its debt in the foreseeable future. The U.S. Treasury can borrow for 3 years at less than 3 percent. The Federal Reserve will not allow inflation to surge in the foreseeable future. Investors demand a tiny 2.5 percentage points of annual compensation for inflation risk during the next 3 years. 26
Reasons To Worry These easy ways to escape an unbearable fiscal burden (explicit default and high inflation) are off the table. The only way to achieve fiscal sustainability is through political action. But our political system currently seems gridlocked and is designed to be resistant to change. Most members of the public do not want to sacrifice. 27
We Need Two Big Changes To Achieve Long-Run Fiscal Sustainability Our political leaders must help the public understand spending and taxing realities. Health care costs and the aging population are the main cost drivers. Tax reform is needed to raise more revenue. The public must agree to make sacrifices not all equally, but everyone should be involved. 28
Changing the Discussion: Be Honest About the Cost of Benefits A step in the direction of fiscal sustainability: Separate the insurance function of government from redistribution. Make the actual cost of government insurance programs transparent so that everyone knows how much it costs to provide services especially health care and retirement annuities. If we decide to subsidize some recipients, make that transparent, too. Bottom line discuss insurance and redistribution separately. 29
In Sum: Can We Achieve Long-Run Fiscal Sustainability? Federal non-defense spending and tax revenues are, respectively, an irresistible force and an immovable object. We ve avoided fiscal crisis since 1945 by declining defense spending and the youth of the Baby Boomers. Those fixes are gone. 3
In Sum: Can We Achieve Long-Run Fiscal Sustainability? The only plausible route to long-run fiscal sustainability is through political courage and leadership and public acceptance of the need for shared sacrifice. A more transparent separation of government s insurance functions from redistribution would help, too. 31