Maybe I Was Too Optimistic
In the post where I described out things could get really bad I suggested that the federal deficits for the next two years could hit $1 trillion or more for both years. A new paper by Alan Auerbach and William Gale suggests that is too optmistic.
In 2009, the federal deficit will be larger as a share of the economy than at any time since World War II. The current deficit is due in part to economic weakness and the stimulus, and in part to policy choices made in the past. What is more troubling is that, under what we view as optimistic assumptions, the deficit is projected to average at least $1 trillion per year for the 10 years after 2009, even if the economy returns to full employment and the stimulus package is allowed to expire in two years.
They reach this number after making a number of adjustments such as seperating out the funds for Medicare and Social Security since both of those programs are already in actuarial imbalance.
How can so large a fiscal gap be closed? Even under the most optimistic estimates just rovided, for the CBO baseline without the stimulus package, closing the gap would translate into a permanent reduction in non-interest spending of 22.8 percent or a permanent increase in revenues of 28.9 percent, both calculated relative to their projected trajectories. Narrower means of closing the gap would be even more Draconian — a 51.6 percent increase in income taxes, for example; and eliminating nearly all discretionary spending. Because the fiscal gap measures the size of the required immediate fiscal adjustment, the required adjustment also rises if action is delayed, and would be substantially larger when computed relative to the adjusted baseline.
The federal fiscal outlook is both bleak and uncertain. The CBO baseline budget projection shows shrinking unified deficits over the next 10 years. However, under assumptions that reflect the conduct of fiscal policy in recent years and more appropriate treatment of the retirement funds, the nation faces significant medium-term shortfalls and massive long-term deficits.
The authors do list some caveats such as that growth could turn out to be higher than predicted and Congress and policy makers could dsicover a new passion for fiscal restraint once the current crisis is over.
And there is this rather disturbing portion,
First, the trend in the data clearly shows a visible uptick in the likelihood of default on U.S. Treasury bonds, a notion that was virtually unthinkable in the past. Second, if one assumes a higher recovery rate than 40 percent in the event of default, then the implied default rate is higher, not lower, than reported in the table. Third, the figures relate to default in the next five years, not to long-term liabilities associated with Medicare and Medicaid. While we find these figures hard to reconcile with our own views of the current creditworthiness of the U.S., especially over the next five years, it is also worth pointing out that the data show similar or even higher credit default prices and implied default probabilities for other countries. In any case, it may well be that long-term fiscal problems will beset us much sooner than one might have expected in the past.
Now the idea of fiscal austerity right now is not a good idea. Cutting spending at all levels of government would likely make the current economic climate even worse. Still, we could take steps to mitigate the problems facing us in the medium to long term. Raise the retirement age for Social Security and Medicare. Look at means testing, however I’d like to see something in there that penalizes to some degree those who had high income, but saved very little. These two things, at the very least would help.