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CBO’s new budget projections are an opportunity to take stock of the country’s fiscal situation. At the risk of oversimplifying, the report contains one piece of good news, and two of bad news. The bottom line: The sky is not falling but policymakers have fallen short of solving the long-term fiscal problem.
The good news is that current annual budget deficits are at very reasonable levels, relative to the size of the economy. The deficit will be about 2.6 percent of GDP in 2015, CBO says, a figure that is both manageable and much lower than even a few years ago. The decline in the deficit can be attributed to many factors, most notably the economic recovery, the budget deal in 2011 and the tax increases that took place in 2013. Those policies may not have been well-advised from a short-term stimulus perspective, but they have helped reduce the deficit.
The first piece of bad news is that the high deficits of recent years have boosted the current stock of public debt to record peace-time highs relative to the size of the economy. The debt-GDP ratio stands at 74 percent, up from 35 percent in 2007. In the half-century before the Great Recession, the debt-GDP ratio averaged 37 percent. The only time in U.S. history that it has been higher than it is now was during and just after World War II, when the massive mobilization raised debt to more than 100 percent of GDP.
The recent increase in debt-GDP was due largely to the Great Recession that depressed revenues, and, to a much smaller extent, the stimulus package.
The current high level of debt is not a crisis by any means. We are not Greece or even close and do not need immediate spending cuts or tax increases. Indeed, they would probably be harmful to overall growth, as the economy is still in recovery mode. But the high debt level is not good news, and it is a problem to keep an eye on.
Following debt peaks after the Civil War, and world wars I and II we paid down approximately half our debt (as a share of GDP) over 10-15 years through budget cuts, inflation, and economic growth.
But – and here is the second piece of bad news – there are no such solutions on our horizon. The debt-GDP ratio is slated to remain roughly constant for the next five years and will then start gradually rising again. So, we are entering new territory – permanently high and rising debt-GDP ratios.
There is a price to such high debt. Countries don’t normally let their debt-GDP ratio rise as high as ours is now. Before the financial crisis, for example, Italy was the only one of 30 OECD countries that had higher debt-GDP ratios than we do now. (To make this comparison on an apples-to-apples basis, you have to compare debt at all levels of government.)
Higher levels of debt reduce long-term growth by crowding out other capital accumulation and the effects can be sizable. Illustrative calculations by Douglas Elmendorf and Greg Mankiw suggest that raising the national debt by 50 percent of GDP reduces net output by more than 3 percent. A study by IMF researchers finds that a higher initial debt-GDP ratio of 10 percentage points reduces growth by in subsequent years by 0.15 percentage points.
It is worth noting that CBO revised its long-term growth rate downward in this most recent report to a level significantly lower than the rates experienced in the 1980s and 1990s. Much of the decline is due to projected slow growth in the labor force, but a big debt overhang does not help.
Cutting the debt-GDP ratio in half, which would get us back to historically typical ground, would require a major policy adjustment. Alan Auerbach and I estimate that we would need immediate and permanent tax increases and/or spending cuts exceeding 3 percent of GDP, even if we allowed 25 years to get there, instead of the 10-15 years it took after previous peaks. If we wait five years to implement the cuts, we’d have to raise taxes or cut spending by almost 4 percent of GDP.
Despite significant deficit reduction over the past five years, there is still a ways to go. The CBO report helps frame the challenge. Now, it’s up to policy makers to respond.
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