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Relatively strong growth in 2011 may fade when the Fed's second round of quantitative easing ends in June and the second stimulus is withdrawn in December. Against this backdrop, the 112th Congress must address a serious budget problem; the ratio of debt to gross domestic product (GDP) will continue to rise without aggressive deficit-reduction measures. Policymakers can arrest the slow death of the US economy by following prescriptions similar to those of the bipartisan deficit commission: cut federal spending, lower tax rates, stabilize the debt-to-GDP ratio, and avoid deflation. Waiting for a fiscal crisis to occur before taking action is unwise. Japan's failure to address its debt problem has caused an erosion of living standards over the last decade and a half, and the United States could follow suit if it does not learn from Japan's mistakes.
Key points in this Outlook:
The United States must take the following actions to reduce the federal deficit:
- Cut federal spending to less than 22 percent of GDP;
- Lower tax rates to boost future growth and temper the initial pain of deficit reduction;
- Stabilize the debt-to-GDP ratio to avoid steady economic decay like Japan has experienced; and
- Avoid deflation by sustaining nominal GDP growth of around 5 percent.
Now is the time for US policymakers to undertake these measures. This Outlook explains why.
Reducing the federal deficit will be difficult because it is so easy to postpone the process. The recently released Obama budget, which envisions spending increases of more than 4 percent per year over the next decade, while foolishly assuming that tax revenues will increase by 8.5 percent per year over the same period, is unnerving. It demonstrates that President Barack Obama does not understand how to deal with the US budget crisis seriously nor does he see the need to do so. The Oxford English Dictionary defines a crisis as a "state of affairs in which a decisive change for better or worse is imminent." For now, no decisive change appears imminent, at least if the president has his way.
This Outlook examines the many barriers--beyond the president's lack of leadership--to the deficit reduction the United States requires. It is unwise to count on a crisis to prompt action. False starts have already been made. Japan's huge debt buildup since 1997 offers many lessons for the United States today, among them the importance of avoiding deflation and not raising tax rates while trying to cut the deficit.
Stimulus Complicates Deficit Reduction
In December 2010, a bipartisan agreement between Obama and the Senate Republican leadership provided a second stimulus package of tax cuts and extended unemployment benefits that will add about $800 billion to deficits over the next two to three years, according to Congressional Budget Office estimates. That package was a major strategic victory for the president. It plucked a large but temporary boost for the economy from a lame-duck Congress that had seen the majority Democrats take "a shellacking," to use the president's characterization of the election out-come. The economic reality--fear of the early 2009 stimulus package wearing off and threatening to leave the economy with very weak growth and higher unemployment--ironically trumped the budget "crisis" story that had helped elect Republicans.
The tax cuts enacted and the tax increases delayed by the December 2010 stimulus, along with the Fed's November promise of an additional $600 billion purchase of Treasury notes and bonds, sharply boosted growth projections for 2011 and 2012. The 4 percent growth likely during the next several quarters will act as a double-edged sword for efforts to reduce the deficit. On the one hand, it will encourage deficit reduction by lending plausibility to the notion that the economy can "stand" the spending cuts that Republicans want and the tax increases that Democrats want. On the other hand, it will make some more thoughtful members of Congress wonder what will happen to growth and unemployment rates when the December 2010 stimulus is undone. The 2 percent payroll tax cuts and extended unemployment benefits will be reversed at the end of this year along with the balance of the first stimulus package, imparting a large fiscal drag--4 percent of GDP--early in 2012. In addition, the Fed's second round of quantitative easing, in the form of Treasury-bond purchases, will end in June 2011. The Fed may further reduce monetary accommodation by phasing out purchases of Treasury securities to replace the maturing mortgage-backed securities in its portfolio.
The fact is that current fiscal and monetary stimulus will be rapidly withdrawn during or immediately after the time when Congress will be trying to address a budget "crisis" with a combination of multiyear spending cuts and tax increases. To suggest that economic and political realities will be clashing hard later this year is an understatement.
The United States certainly has a serious budget problem that needs to be addressed before it becomes a debilitating drag on the economy. The bipartisan deficit commission appointed and then ignored by the president has suggested the right path for Congress to follow in addressing the budget problem. It calls for reduced spending growth, including the reduction of currently mandated spending levels on entitlements. It also calls for tax-rate cuts financed by broadening the tax base and phasing out special tax breaks that cost tax-payers almost $1 trillion annually. Lower tax rates are a critical part of any program of deficit reduction because they help boost future growth and thereby temper the initial pain of deficit reduction.
One of the serious problems confronting those attempting to engineer credible multiyear deficit reduction is suggested by Japan's experience during the lost decade after its disastrous consumption-tax increase in 1997. Japan's unsuccessful effort to address its deficit and debt problem meant that its ratio of debt to GDP grew so rapidly that by late January 2011, Standard and Poor's (S&P) reduced its sovereign-debt rating on Japanese government debt from AA to AA-. The disconcerting lesson from Japan's experience since 1997 is that the consequence of not addressing serious budget imbalances is not so much a crisis as a steady reduction in underlying growth, along with persistent deflation that further increases the burden of debt. Japan's continuing erosion of living standards over the last decade and a half provides a more compelling reason for the United States to begin to address its budget problems now than does the prospect of some immediate financial crisis that may or may not force us to act.
The Danger of Assuming Deficits Will Fall
Sadly, Obama's new budget proposal, which raises spending as well as tax rates, is the equivalent of a person experiencing dangerous weight gain, and then expecting praise for not planning to add even more weight or for resolving to gain pounds more slowly from now on. After a trio of trillion-dollar-plus deficits--with the latest for the current year at over $1.5 trillion, or more than 10 percent of GDP--that have boosted the ratio of net federal debt to GDP from below 40 percent in 2007 to over 70 percent by the end of 2011, the president is proposing another cumulative $7.2 trillion in deficits over the next decade.
Beyond that, Obama's budget proposal contains jarring inconsistencies. Despite assumed sharp tax-revenue increases that, as already noted, average 8.5 percent per year over the next decade, with a 20.8 percent tax increase in 2012 and a 14.3 percent increase in 2013, the president's budget proposal assumes that growth will accelerate to a 4 percent annual rate during 2012, then to a 4.5 percent rate during 2013, just as the most rapid tax increases are taking place. The president's revenue outlook is further boosted by the assumption that inflation will rise to 2 percent over the next several years. But if that occurred and the growth projections were also realized, it would mean that nominal GDP growth, usually a good proxy for the interest rate on ten-year Treasury notes, would reach over 6 percent for 2013 and 2014. The president's budget, however, assumes that the yield on ten-year Treasury notes would rise only to 4.2 and 4.6 percent during those two years.
One of the best ways to reduce projected budget deficits and debt accumulation relative to GDP without reducing the primary deficit by cutting the growth of government spending or enacting tax increases, or both, is to assume that nominal GDP growth exceeds nominal interest rates by a healthy margin. If that gap is 1.5 percent, as the president's budget assumes, the result is a reduction in the growth of the debt-to-GDP ratio by at least that same amount. The actual reduction will be greater since the average interest rate on outstanding government debt is below the yield on ten-year Treasury notes due to a shorter average maturity.
The president's budget proposal, beyond its internal inconsistencies and shockingly sharp implied tax increases over the next several years, is troubling in another way. True, it is clearly not the last word on the prospects for fiscal policy over the next decade, especially in view of the efforts already underway in the House to reduce spending growth and in the Senate to effect the deficit commission's proposals. But the lack of any market response that would belie a budget crisis is problematic. It has often been suggested that a failure to proactively address the US deficit and debt accumulation will result in a sudden collapse of the US bond market or the US dollar that will force us to act. While such an outcome is always possible, based on the experience of postbubble Japan during the 1990s and the first decade of the new century, it is not the most likely. Further, if the US bond market were to collapse and push up interest rates that threaten to slow the economy, would sharp cuts in government spending or tax increases to cut the primary deficit be immediately forthcoming from Congress? That is doubtful. Just the threat of lower growth at the end of last year absent a bond-market crisis was sufficient to prompt additional stimulus supported by both parties.
The Burden of Rising Debt Builds Slowly
The real problem with a large accumulated stock of government debt and the burden it places on the economy is more insidious and slower acting than most suppose. Consequently, solving the problem requires undertaking proactive measures, mostly multiyear cuts in the growth in spending, accompanied by permanent reductions in tax rates to reduce the burden on the economy of collecting existing revenues. These measures, broadly outlined in the deficit commission report, would help bring down the debt-to-GDP ratio both by reducing the primary deficit (government spending less tax revenues) and by providing a sustained boost in growth as opposed to the temporary and reversible increase in growth that is currently resulting from last December's temporary tax-rate cuts. A reliable reduction in the debt-to-GDP ratio over time resulting from lower spending growth and permanent tax-rate cuts would lower interest rates and thereby further reduce the debt-to-GDP ratio. Well-founded efforts at deficit reduction, while painful in the short run, carry with them substantial medium- and long-term rewards.
It is instructive to compare the outlook for US deficits and debt with Japan's experience over the last decade and a half. Japan's deficits and debt run-up were even more alarming than those predicted for the United States; yet, as already noted, no crisis occurred sufficient to prompt the Japanese government to undertake comprehensive budget reform measures. Rather, the drag on the economy, and the nervousness emanating from the Bank of Japan about potential inflation resulting from large deficits, produced an extended period of weak growth, high unemployment, and deflation that contributed to the rise in the debt-to-GDP ratio.
Over the last six years, Japan's debt-to-GDP ratio rose at about 6.5 percent per year, a fairly alarming pace at which the debt-to-GDP ratio doubles in just eleven years. Japan started at an 82 percent debt-to-GDP ratio in 2004, which would mean an alarming 165 percent debt-to-GDP ratio by 2015, a plausible outcome that is not far from the International Monetary Fund's conservative projection of a 153 percent ratio (see figure). By way of comparison, even Greece's debt-to-GDP ratio is not expected to rise above 150 percent over the next half decade. Of course, the market's treatment of Greek debt is substantially different from its treatment of Japanese debt, with interest rates on ten-year government bonds in Japan still at about 1.3 percent, while interest rates on ten-year Greek debt are over 10 percent. Much of Greek debt is externally held, and the Greek government's credibility regarding its ability to manage expenditures and collect taxes is low.
What about the United States? Its debt-to-GDP ratio rose even faster than Japan's between 2004 and 2010, at an annual rate of about 7.7 percent, implying a doubling of the ratio in just ten years. Such rapid growth that accelerated sharply after 2007--along with the greater size of the US economy--probably accounts for greater global concern about the United States' deteriorating fiscal picture than Japan's experience prompted. Also, the United States relies more heavily on external financing for its deficit than Japan does. With the US debt-to-GDP ratio at about 42 percent in 2004, if it were to double over ten years, the ratio would be 84 percent by 2015. That would leave the US debt-to-GDP ratio just above the debt-to-GDP ratio of Japan in 2004. While the external financing of a large part of the US debt has also been viewed as a potential source of crisis, the heavy buying of dollars to date to prevent currency appreciation--especially by China--has provided adequate support of the US government-debt market. In that way, the feared foreign buyers of US debt are actually the enablers of continued large deficits.
Understanding what causes the debt-to-GDP ratio to change helps us evaluate the significance of prospective changes and helps us compare the experiences of the United States and Japan. The percent change in the debt-to-GDP ratio is determined by two components: the difference between the interest rate on outstanding debt and the growth of nominal GDP, and the primary deficit (government spending minus tax revenues divided by the stock of the debt).
Japan has been plagued by larger primary deficits and by episodes of sharply negative nominal GDP growth, driven by deflation. Japan experienced very weak nominal GDP growth from 2004 through 2007 and sharply negative nominal GDP growth thereafter until the start of 2010. Since it lowers nominal GDP growth, Japan's persistent deflation has contributed heavily to a steady increase in the debt-to-GDP ratio. In a sense, Japan's fiscal failure has been twofold. First, the government failed to cut spending enough to reduce the primary deficit, and second, the Bank of Japan failed to move the economy out of deflation, allowing persistently negative nominal GDP growth to boost the debt-to-GDP ratio and thereby push up the burden of debt. The average interest rate on Japan's outstanding debt (average maturity about five years) is only about fifty basis points, but the average negative 4 percent growth rate of nominal GDP during 2008 and 2009 contributed mightily to the rise in Japan's debt-to-GDP ratio, boosting it by 2.8 percent in 2008 and by a record (since 1981) 7.2 percent in 2009.
Japan is in a debt trap because deflation has boosted the real burden of debt and the debt-to-GDP ratio. That rising burden in turn forces the government to continue trying to cut government spending and even flirt with tax-rate increases, both of which are counterproductive because they further depress growth. Clearly, the example of Japan's debt dilemma lies behind Federal Reserve chairman Ben Bernanke's strongly stated determination to avoid a drift from disinflation into deflation in the United States. In a real sense, Japan's fiscal dilemma, which led to the most recent S&P downgrade of its bonds, is an answer to the question, Why is it important for governments with sharply rising debt burdens to avoid deflation?
In contrast to Japan, much of the sharp 20.8 percent rise in the US debt-to-GDP ratio during the 2009 fiscal year (which began in October 2008 just after the Lehman Brothers crisis) was due to a large rise in the primary deficit tied to the Troubled Asset Relief Program. While the drop in US nominal GDP growth boosted the debt-to-GDP ratio by 4.5 percent during 2009 (given an estimated 2.5 percent interest rate on outstanding debt), the nominal GDP growth rebound in fiscal year 2010 reduced the debt-to-GDP ratio by 0.8 percent. The overall 11.4 percent rise in the US debt-to-GDP ratio during 2010 was mitigated by stronger nominal GDP growth despite the large primary deficit. Japan's persistently weak nominal GDP growth contributed to the continued rise in its debt-to-GDP ratio in 2010.
While the US debt burden is not as serious as Japan's, when measured by the outlook for the ratio of government debt to GDP, it is certainly time to take decisive action to reduce the prospective deficits over the coming five to ten years. The burden of mitigating the rise in the debt-to-GDP ratio need not fall entirely on adjustments to the primary deficit if tax rates are reduced to encourage a higher sustainable growth rate while monetary policy avoids disinflation or deflation. With a growth rate averaging about 3 percent from 2011 to 2016 and an inflation rate rising gradually from the current core inflation rate of 1.0 percent to an average of 1.9 percent in 2013-2016, an average nominal growth rate approaching 5 percent, coupled with spending cuts and stabilization of tax revenues, would mean a debt-to-GDP ratio of about 75 percent in 2016. While not ideal, that is only modestly above the 70 percent level projected for this yearand still well below Japan's 2004 level of 82 percent. But, as Japan's experience after 1997 shows, the hope for higher growth of nominal GDP in the Congressional Budget Office's outlook and the president's budget proposals will not occur without tax reform--lower marginal tax rates financed by gradually phasing out distortionary tax preferences. It will also be critical to avoid deflation, which, despite current inflation fears, should not be considered a remote possibility. Growth in postbubble Japan after 1997 and the post-bubble United States during the Great Depression saw deflation emerge amidst cries of incipient inflation.
Achieving higher nominal growth and a more modest increase in the debt-to-GDP ratio provides a further benefit: the likelihood of lower nominal interest rates. Empirical research by Thomas Laubach at the Federal Reserve Board of Governors demonstrates that a 10-percentage-point reduction in the five-year forward debt-to-GDP ratio would, other things being equal, reduce the five-year forward yield on Treasury notes by about fifty basis points. Substantial progress toward reducing the debt-to-GDP ratio below levels currently expected would provide a double bonus by reducing the nominal interest rate on outstanding Treasury debt and thereby reinforcing a further drop in the debt-to-GDP ratio.
The other reason for seeking stabilization of the US debt-to-GDP ratio arises from the extensive research conducted by Carmen Reinhart and Kenneth Rogoff in their widely cited 2009 book This Time Is Different: Eight Centuries of Financial Folly. They show that a debt-to-GDP ratio above 90 percent sharply increases the chance of a financial crisis associated with a rapid increase in sovereign debt. While not a hard-and-fast rule, this result makes considerable sense. Examining the proximate determinants of the debt-to-GDP ratio--if one allows for a negative impact on nominal GDP growth arising from a reduction in the primary deficit--the higher the debt-to-GDP ratio, the more likely is the paradoxical outcome whereby a reduction in the primary deficit actually boosts the debt-to-GDP ratio because of a negative impact on nominal GDP growth. This situation is akin to that faced by many southern European countries, where highly stringent fiscal measures are depressing growth so much that aiming for a smaller primary deficit actually results in a higher debt-to-GDP ratio and thereby a debt trap. Japan too could be vulnerable to this debt trap given its tendency toward deflation-driven negative GDP growth. The United States is not at this crisis point, but the extreme undesirability of getting into such a debt trap should prompt action by Congress to undertake aggressive and credible deficit-reduction measures that operate over the coming decade to stabilize and then reduce the debt-to-GDP ratio.
It is not too late for the United States to rescue itself from a debt trap like the one that has encompassed Japan and some distressed sovereign governments in southern Europe. The year 2011 is the best time to adopt credible multiyear deficit-reduction measures because growth is relatively strong and it is not an election year. We should not rely on, nor should we wish for, a bond-market collapse or a dollar collapse because neither is desirable and neither is likely to occur in the near term when deficit reduction should be undertaken. Meanwhile, the Fed's job is to move proactively to avoid deflation and help sustain nominal GDP growth of around 5 percent. Congress needs to cut federal spending from the 25.3 percent of GDP projected in the president's budget in 2011 to below 22 percent by 2015. Such difficult yet necessary steps would help reduce the rise in the debt-to-GDP ratio, actually reduce interest rates on outstanding debt, and thereby help make way for the rise in private borrowing that will accompany a sustained US economic recovery.
John H. Makin ([email protected]) is a resident scholar at AEI.
1. National Commission on Fiscal Responsibility and Reform, The Moment of Truth (Washington, DC, December 2010), www.fiscalcommission.gov/sites/fiscalcommission .gov/files/documents/TheMomentofTruth12_1_2010.pdf (accessed February 25, 2011).
2. Thomas Laubach, "New Evidence on the Interest Rate Effects of Budget Deficits and Debt," Journal of the European Economic Association 7, no. 4 (June 2009): 858-85.