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US fiscal ‘crisis’

July 24th, 2011 · No Comments

Entirely man made..


Amongst all the hoopla it’s good to see some down to earth solid calculations from non-politicized sources, like the Congressional Budget Office.

  1. Go to page 14 of the Congressional Budget Office long-term budget outlook. You’ll find a graph (see below) setting out two scenarios for the public debt of the United States and the consequences for the debt/GDP ratio until 2035
  2. Scenario 1 is the “extended-baseline scenario” which involves letting the Bush tax cuts expire, implementing the Affordable Care Act as scheduled and making the Medicare cuts prescribed by the 1997 Balanced Budget Act
  3. Scenario 2 is the “alternative fiscal scenario” involving extending the Bush tax cuts, repealing the Affordable Care Act and protecting doctors from Medicare cuts
  4. Guess what the outcome is.. Under scenario 1, the debt stabilizes at a fraction over 80% of GDP while under scenario 2 the debt keeps on rising to a whopping 185% of GDP (and counting).

Is this surprising? No. Some basic facts to keep in mind:

  • Despite the very large figures involved, the stimulus and TARP are basically one-offs, hardly relevant for the long-term fiscal position of the Federal Government
  • Even the very large budget deficits of the last couple of years are mostly caused by the economic downturn, slashing tax receipts and increasing spending automatically
  • The single biggest factor determining the long-term sustainability of public debt are healthcare costs. These are rising inexorably because difficulty of productivity gains in the healthcare sector, increasing availability of new interventions and treatments, and rising age of the population. It has to be said that, in international comparative, the US does particularly badly with respect to healthcare cost, spending 1.5-2 times as much as a part of GDP as most other developed economies and getting, on average, worse results. It remains to be seen whether ‘Obamacare’ can dent this disadvantage. If not, further reforms are needed.

One might also keep in mind that:

  • Since the private sector is still deleveraging (witness for instance the falling credit demand from households in the graph below) and monetary policy is particularly ineffective in the present state (liquidity trap with interest rates near zero), now it would not be a particularly good time to implement immediate large austerity measures. This would risk tipping the economy back in recession, which could very well worsen the fiscal position further (as countries like Greece have experienced). This is no surprise, as there is a collective action problem with households not spending because they are repairing their balance sheets, are suffering from a large fall in their house values and high unemployment, and business is not investing because households are not spending.
  • The best policy would be to produce a credible long-term strategy to deal with the underlying structural factors of fiscal imbalance, while maintaining fiscal stimulus in the short-term. The latter is not a significant factor in the long-term fiscal position (unless stimulus is maintained for decades, of course).
  • Responsible fiscal policy means running surpluses during good times.

Tags: Sovereign debt crisis