Debt Problem Unsolved

Citi GPS Opinion Article

6 February 2013 – The last-minute agreement to avoid the US “fiscal cliff” — with an increase in only the top marginal income tax rate, some limits on tax deductions and exclusions, and delays in spending cuts — has generated a legitimate relief about the U.S. fiscal outlook, but also complacency about a poor structural budget imbalance.

Fiscal tightening could have been far more severe had the full “cliff” hammered all taxpayers to a greater extent and new spending cuts had begun straight away. We share a bullish outlook with market participants who are relieved that the U.S. hasn’t succumbed to self-defeating fiscal tightening. Yet, in our view, a lack of significant structural spending reforms at such an opportune and critical time leaves a U.S. economic vulnerability wide open.

Resisting the austerity measures seen in parts of Europe, at least to the most extreme extent, has been rewarded in financial markets, which, in turn, supports the immediate strength of the U.S. economy. After the severe retrenchment of 2008–09 and a significant repositioning of the business and consumer sectors, we believe U.S. growth will reach about 3% in the second half of 2013 and persist — providing a stronger pace than seen over all but short bursts of the recovery to date. The absence of further fiscal tightening has strengthened the outlook without generating a much higher price for U.S. borrowing.

With unemployment still widespread and historically high, immediate tax increases and spending cuts always seemed poorly timed. However, some have now taken to arguing that beyond the modest tightening steps just announced, no significant further attention to debt and deficits is warranted. “There’s a reasonable argument for leaving the question of how to deal with future problems up to future politicians,” wrote economist Paul Krugman in the New York Times on January 17, 2013. As we see it, this seems akin to relying on future technological advancements in medicine to justify smoking and a high-fat diet. Practically speaking, we believe attention to the long term would make the immediate task of achieving a full recovery easier, not harder.

The Case for Near-Term Support

The Organization for Economic Co-operation and Development (OECD) estimates that a multi-year persistent rise of one percentage point in the U.S. unemployment rate above its sustainable trend is consistent with a 0.2 percentage point increase in the structural or sustainable unemployment rate (i.e., the rate of permanent unemployment). This is because the long-term unemployed see a degradation of their skills and hence their ability to become reemployed — so-called labor market “hysteresis”.(1)

At present, the U.S. has seen the unemployment rate average about three percentage points higher than estimates of full employment over a full five-year time frame. Unemployment throughout the period has also been higher than measures assumed within the Congressional Budget Office’s (CBO’s) long-term budget projections. It seems likely that some of the 3–4 million individuals actively seeking work for a year or longer (and many others who have been reluctant to search) have been harmed with respect to their more lasting employment prospects. As such, the sustainable non-inflationary full employment rate or “natural” rate may have already drifted toward 6% from pre-crisis estimates of 5%– 5 ½%.

Evidence suggests a one percentage point trend rise in the unemployment rate could worsen the U.S. structural budget deficit by about ½ percentage point of GDP and potentially much more over a shorter-term window. The longer-term implications for U.S. interest costs from funding this deficit — including the effects of compounding — depend on whether the increase is offset with greater fiscal tightening steps, which conceivably might increase the negative impact somewhat further.

Today’s lack of interest rate pressures doesn’t mean an absence of all negative impact from budget deficits. Deficits require savers to finance them. Those savings flows could ordinarily be used for building up the productive capital stock of the U.S. economy. This is not a concern we have on a short-term or cyclical basis when the economy is depressed as it is now, but it is acute when considering the impact on long-term economic performance.

The structural U.S. budget deficit — the deficit the remains when estimated cyclical weakness is adjusted away — was last estimated by the CBO in 2012 at -4.4% of U.S. GDP. The permanent tax increases of about 0.5 percentage point of GDP that were announced in January would lower that estimate to below 4% going forward. But labor market hysteresis could move the estimate in a negative direction by at least an equal magnitude. Thus, large budget deficits would re-emerge in coming years even after an improvement in the economy.

The growth in the private capital stock has historically and rather consistently been the best determinant of real economic growth and wages paid per worker. Structural budget deficits that absorb savings from other uses (whether through higher taxes or just higher government consumption) contribute to slower potential economic growth and real incomes, even if there is no crisis-induced interest rate spike in sight. Persistent budget deficits may be consistent with maintaining the low interest rates and weak real economic growth expectations currently priced in markets, rather than spiking them higher as often feared. The point of deficit reduction is not the achievement of higher or lower interest rates in isolation. Instead, economic stability and future living standards are in question.

Why Not Ignore the Long Run for Now?

Evidence, in our view, seems to side with the case that immediate recovery will have benefits for the fiscal outlook that outstrip the long-run costs of current budget deficits.

So, why pay any attention to deficit reduction at all? For the simplest reason, long-term structural reforms would provide room for less immediate austerity. A test of this will be seen as Congress alters or fails to alter the immediate onset of sequestration in about a month’s time. These are the large immediate spending cuts of about $85 billion over the remainder of 2013 and $110 billion per year in the following nine years. These nearly arbitrary cuts to defense and non-defense federal spending were set by the Budget Control Act of 2011 as a blunt attempt to force more carefully crafted spending restraints.

As noted, to the extent that federal spending cuts in the coming few years hold back full recovery, they will also tend to worsen long-term unemployment. This carries its own lasting fiscal consequence.

As an easy example of the structural reforms that could offset some of the immediate tightening under sequestration, we consider the impact of a slightly less generous inflation adjustment for Social Security payments and future tax brackets by switching to a so-called “chained Consumer Price Index (CPI)” from the current fixed-weight index basket.

A first impact is to very slowly alter the growth of Social Security transfer payments by 0.3 percentage point a year. This provides a very sizeable 10-year budget savings estimated in 2010 by the CBO at about $108 billion; or nearly equal to a full year’s spending cuts under the Budget Control Act (sequestration). The impact of slower upward adjustments to income tax brackets (meaning gradually higher taxes) and savings on federal pensions sums up to a larger $113 billion. (2) For all components, such a change alone could offset nearly one fifth of sequestration, if so desired.

Most likely reflecting a different 10-year window under which calculations are based, our own more recent calculations show a permanent and immediate switch to the chained CPI would save $175 billion from Social Security Cost of Living Adjustments alone. More interestingly, the same calculation shows $810 billion in nominal savings in the following 10 years and $2.1 trillion in the decade after. This is largely because Social Security payments — the smaller imbalance in long-term mandatory spending programs — are expected to grow faster than the underlying economy in coming decades. (For 30 years, we estimate $2 trillion in savings in real, 2012 dollars).

The so-called CPI fix could represent a structural fiscal tightening of perhaps 0.4 percentage points of GDP without making a single outright spending cut. This estimate excludes the measureable fiscal impact from slower adjustments to tax brackets and other inflation indexed federal programs that would nearly approach the savings in Social Security.

Importantly, a slower growth rate of payments may seem imperceptibly small in the near term. Under such a change, total Social Security payments would rise $34 billion in the coming year instead of $36 billion, we estimate. For recipients, the average monthly benefit would likely increase about $50 instead of $53. In contrast, sequestration if implemented would make sizeable outright spending cuts and have little if any permanent value for the long-term budget imbalance.

Implementing a CPI change would do several things at once. It would simultaneously improve the long-term fiscal deficit and extend the solvency of the Social Security system itself. It could also allow a partial alternative to near-term spending cuts that would contribute to higher structural unemployment and budget deficits.

The “fairness” of adjustments to the CPI can and will be hotly debated. But both the sustainability and cost of the program should be considered in the calculus. If the public would prefer higher tax rates to fully fund it, a boost to the inflation adjustment could be made instead of a cut.

Why should Social Security be forced to “economize” a bit or even run surpluses at the expense of beneficiaries? Standing alone, it shouldn’t. But because healthcare spending is causing a downward spiral in other budget priorities including education and infrastructure, in our view, it seems unreasonable to shield other forms of age-based social supports from all economic spillovers. Our estimates suggest eliminating long-term funding shortfalls in entitlement programs would take a rough tripling of current Social Security and Medicare tax rates. In our view, the public should be given the choice to either fully fund these programs or gradually alter their scope and size.

Aside from providing greater flexibility to avoid near-term tightening in the sequester battle, it’s clear to us that the longer the U.S. waits to make adjustments to the fiscal imbalance, the more difficult the ultimate adjustments will prove. In a 2010 study, the CBO estimated that required fiscal adjustment to stabilize federal debt — whether through tax increases or benefit cuts — roughly doubles if the onset of adjustment is put off by 10 years. (3)


In the aftermath of the January 1 budget agreement, some Republicans rejoiced as future tax increases are now absent from current law, even as taxes are insufficient to fully fund future spending commitments. Some Democrats, meanwhile, rejoiced that no ground at all was conceded on entitlements. But why not rally around saving Medicare and Social Security for the long run? Why act as though the stabilizing long-term reforms are mere bargaining chips or sad compromises?

We don’t want observers to be overwhelmed by the many mere extrapolations inevitable in long-term analysis. One recent CBO scenario showed the U.S. paying off all Federal debt by 2070, another had the federal debt/GDP ratio tripling by 2040. There are many great uncertainties, but our outlook is for a cyclical, if stunted, recovery in the U.S. fiscal position. With it, the momentum for needed long-term reforms may die. If so, the latter CBO scenario would seem the more likely.

(1) Please see “Assessing the Impact of the Financial Crisis on Structural Unemployment on OECD Countries”, Guichard and Rusticelli (2010), OECD Economics Department Working Papers, No. 767 and “Fiscal Policy in a Depressed Economy”, J. Bradford Delong and Lawrence H. Summers, March 20, 2012.

(2) Please see from the CBO, “Social Security Policy Options”, July 2010 and “Choices for Deficit Reduction”, November 2012.

(3) Please see “Economic Impacts of Waiting to Resolve the Long-Term Budget Imbalance”, CBO, December 2010.