- The Washington Times - Tuesday, July 14, 2009


Last month, the Congressional Budget Office (CBO) published the latest version of what has become a very scary document called “The Long-Term Budget Outlook.” CBO Director Doug Elmendorf is scheduled to walk the Senate Budget Committee through it on Thursday.

CBO, famous for understatement, concludes that “current policies are unsustainable.” This is true whether it looks at the Obama administration’s official budget or a future in which all of the Bush tax cuts expire and the middle class gets swallowed by the alternative minimum tax. What CBO means is, either way, we are doomed.

Here’s what CBO predicts will happen if we continue current policies:

Next year, our debt will exceed 60 percent of our total economic output, or gross domestic product (GDP). We would not meet the standards Poland and Estonia needed to qualify for admission into the European Union.

In 2023, our debt will exceed 100 percent of GDP - the highest level since World War II ended.

By 2076, debt will be more than 6.5 times GDP. Put differently, with current policies, there’s no chance that children born today will get much of their promised Social Security and Medicare benefits.

The really bad news? This bleak scenario is wildly over-optimistic. It assumes that the economy keeps growing at historical rates, and interest rates on government bonds stay low.

But neither is likely to happen. As CBO says, parenthetically, “Starting in the 2060s, projected deficits become so large and unsustainable that CBO’s textbook growth model cannot calculate their effects.”

Translation: We’re heading over a cliff!

CBO’s projections assume that interest rates will stay low. But with these massive deficits, rates will eventually rise to reflect the growing riskiness of government bonds. Berkeley economist David Romer has shown that investors may, overnight, go from being willing to lend to the government at low rates to being afraid to hold T-bills at any price. If this happens, the rise in rates could be extreme - not just a percentage point or two.

Can’t happen? It was just a few months ago when exactly the same fate befell highly rated corporate bonds. Suppose the Treasury held an auction and nobody came?

Ideally, this dismal situation will be averted. Investors should look at the CBO report and demand higher interest rates right now, and progressively steeper rates in the future if our fiscal house is not put in order. This would put pressure on policymakers to cut deficits.

Unfortunately, there are two problems with this self-correcting scenario. First, it might choke off a nascent recovery. Second, it assumes financial markets are rational and foresighted. Yeah, right. And remember much of our debt is held by foreigners whose cash fuels our purchases of their oil and consumer goods. They’ll keep lending - at least for a while - to prop up their own economies.

When the bubble bursts, two things could happen, both bad. One is that the U.S. defaults on its bonds. This would cripple financial institutions that are legally required to hold government securities and create a foreign policy fiasco since other governments hold so much of our debt.

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