- The Washington Times - Monday, September 22, 2008

As the U.S. government embarks on a financial-rescue mission - whose cost is impossible to predict - the nation is already headed for a sustained period of budget deficits on a scale never seen before, said Peter R. Orszag, director of the Congressional Budget Office.

Mr. Orszag recently outlined a scenario in which $7 trillion in cumulative deficits could be piled up over the next 10 years.

The so-called “on-budget deficits,” which exclude Social Security surpluses, would exceed $9 trillion over the next 10 years, CBO data reveal.

Under the plausible fiscal-policy scenarios detailed in CBO’s latest “Budget and Economic Outlook,” which was released earlier this month, the budget deficits for 2017 and 2018 could exceed $1 trillion each year.

Trillion-dollar deficits would be arriving just as the cash-flow surpluses from Social Security turn into cash-flow deficits, a development that would require the federal government to use general revenues to meet Social Security benefit payments.

If the projections hold true, these deficits would become the primary force that would add $10 trillion to the national debt, more than doubling it by 2018.

“Unfortunately, that’s the good news,” Mr. Orszag said, “because thereafter we start to experience the longer-term budget pressures that are at the heart of the long-term fiscal problems the nation faces.”

David M. Walker, the former comptroller general of the United States, said, “It is very possible that the numbers could be worse” than the 10-year, $7 trillion deficit projected by the CBO director. Mr. Walker, who, as head of the Government Accountability Office, conducted a nationwide Fiscal Wake-Up Tour chronicled in the documentary “I.O.U.S.A,” recently became president and CEO of the Peter G. Peterson Foundation, which was established to alert Americans about the forthcoming fiscal crisis.

The impact of $700 billion deficits

If the deficits unfold as Mr. Orszag projects, “it would clearly have an adverse long-term effect on our economic position, but the scarier thing is that it is just the beginning. Baby boomers don’t begin retiring in big numbers until after 2018, when a fiscal tsunami could swamp our country,” Mr. Walker said.

It is worth noting that none of these figures includes a dime of costs that the taxpayer might be forced to bear after the government’s recent takeover of mortgage-financing giants Fannie Mae and the Federal Home Loan Mortgage Corp. (Freddie Mac) and other bailouts.

Mr. Orszag estimated deficits averaging $700 billion per year would “hover” in the 4 percent to 5 percent range of gross domestic product (GDP).

Except during the 1940s, when budget deficits during World War II averaged 22 percent of GDP, the 1980s was the only decade since the beginning of the 20th century when deficits averaged more than 4 percent of GDP. According to a study by Lawrence H. Summers, the Harvard economist who served as Secretary of the Treasury under President Clinton, real (inflation-adjusted) interest rates for short-term business loans averaged 4.1 percent during the 1980s, a level higher than any other decade since 1900.

In the near term, the U.S. budget deficit will likely exceed half a trillion dollars for the first time ever in fiscal 2009, which begins Oct. 1, Mr. Orszag said. That’s more than three times the $162 billion budget deficit for 2007.

Compared with the $236 billion surplus in 2000, America’s annual fiscal situation will have deteriorated by three-quarters of a trillion dollars in 2009.

The sobering deficit numbers would seriously complicate the tax and spending policies of the incoming administration, regardless of who is elected. “The next president, whoever he is, will be forced to tackle this problem,” said Maya MacGuineas, president of the nonpartisan Committee for a Responsible Federal Budget.

“Deficits of that magnitude or even smaller magnitude do impose economic costs because they slow the rate at which we’re accumulating capital over time for the future and thereby impair our future income,” Mr. Orszag said.

“Most economists would say that budget deficits of that scale would tend to push up interest rates in the United States,” said Robert E. Scott, a senior international economist at the Washington-based Economic Policy Institute. The rising interest rates would apply to government borrowing, to mortgages for home buyers, to bonds financing business investment and to loans for interest-rate-sensitive consumer purchases, such as automobiles, Mr. Scott said. As a result, “rising interest rates could slow the U.S. economy,” he said.

“For the past decade, there has been tremendous demand for U.S. financial assets, and we haven’t seen a big run-up in interest rates despite recent large budget deficits,” Mr. Scott acknowledged. “But the housing debacle could change that by raising the risk premiums.”

If annual deficits were sustained at a $700 billion level, they would damage the U.S. economy in both the short term and long term by pushing up interest rates and crowding out investment, which would lower future productivity gains, explained Brian A. Bethune, chief U.S. financial economist at Global Insight.

Diane Lim Rogers, chief economist at the Concord Coalition, a nonpartisan grass-roots organization dedicated to eliminating the budget deficit, agreed that current and ongoing fiscal irresponsibility would exact a price in terms of future economic growth.

“We are going to see higher interest rates because even the world capital markets have limits, and we are testing those limits,” Ms. Rogers said. “We have been lulled into the sense that borrowing is cheap, but that is about to change as we bump up against the world’s capital constraints.”

If America postpones closing today’s fiscal gap by making it even larger by running deficits averaging $700 billion per year, it simply means that the cost of closing the gap today will become three times as high after we dig the fiscal hole deeper and deeper, she estimated.

“Such a large, sustained budget deficit would usually be expected to put upward pressure on interest rates, especially in an economy with such a low savings rate - at least if it is not offset by large inflows from abroad on very generous terms,” said Brad W. Setser, a fellow for geoeconomics at the Council on Foreign Relations and the author of the “Follow the Money” blog. “Running sustained, large, long-term deficits in a country with such a low private savings rate is risky.”

Mr. Setser also said that relying on the rest of the world, especially foreign governments, to prevent upward pressure on U.S. interest rates would require a huge inflow of financial capital from the rest of the world and likely from central banks intervening in the market to keep their currencies down. Moreover, the attendant external trade deficits would be unhealthy for the U.S. economy, would exacerbate trade-protectionist sentiments in the United States and would worsen the currency conflicts the United States has with China, he said.

Budget deficits for the previous 40 years have averaged 2.4 percent of GDP. The 2009 deficit of $530 billion would be 3.6 percent of GDP, and that assumes the economy grows by 0.8 percent in fiscal 2009. The enactment of a second economic-stimulus package could easily tip the 2009 deficit above $600 billion, and a recession could shift it above $700 billion, or more than 5 percent of GDP.

The largest post-World War II deficit in relation to GDP - 6 percent - occurred in fiscal 1983, when unemployment averaged more than 10 percent. In contrast, CBO projects the unemployment rate will average 5.1 percent for the 2009-2018 period, when deficits would “hover” in the range of 4 to 5 percent of GDP. Worth noting is the fact that from 1983 through 1987, when budget deficits averaged 4.8 percent of GDP, real interest rates were exceptionally high.

International dimensions of U.S. debt

Deficits in the range projected by Mr. Orszag almost certainly would require the United States to become increasingly indebted to foreign countries, which owned 45 percent of America’s publicly held debt at the end of fiscal year 2007 (up from 15 percent in 1985).

“The federal debt will grow at an unsustainable rate, which means more borrowing from China, more borrowing from Japan and more borrowing from oil exporters like Saudi Arabia,” said Sen. Kent Conrad, North Dakota Democrat, who chairs the Senate Budget Committee. As foreign investors hold larger shares of U.S. government debt, interest payments on that debt would increasingly go abroad.

Years ago, a standard Economics 101 argument held that the national debt was not a problem because we owed nearly all of it to ourselves and Americans received the interest payments. If that was true in 1970, when foreigners owned 5 percent of publicly held debt, it cannot be true today, with foreign investors owning 45 percent of that debt.

If foreign investors balk at financing ever-larger U.S. government debts, perhaps because they fear a depreciating dollar, then the deficits would have to be financed internally. This, too, would tend to raise interest rates because the U.S. economy has so little savings today.

Presidential promises

Just as President Clinton felt compelled to break his campaign promise to enact a middle-class tax cut in order to concentrate on reducing a budget deficit that averaged 4.6 percent of GDP during 1990 and 1991 and 4.8 percent throughout the 1980s, the next president may be forced to rearrange priorities in the face of the unending onslaught of red ink that will greet him on Inauguration Day.

Inheriting an annual budget deficit north of $500 billion, which is far more likely on its way to $1 trillion than to zero, a President Obama could feel constrained by the markets, if not by a Democratic Congress, in his efforts to dramatically expand government-subsidized health-insurance coverage ($65 billion per year) and to eliminate the “doughnut hole” in the Medicare prescription-drug program ($43 billion per year). Those are only the health programs.

Just as Mr. Clinton deep-sixed his middle-class tax cut in 1993, will Mr. Obama feel obliged to cancel or delay his refundable “Make Work Pay” tax credit ($72 billion per year), his refundable “Saver’s” tax credit ($21 billion per year), his refundable college tax credit ($13 billion per year) and his refundable “Universal Mortgage” tax credit ($13 billion per year)? What will become of his $15 billion per year green-technology program, his $6 billion per year infrastructure-reinvestment bank and his $15 billion per year increase in basic research? (The cost estimates were provided by the Committee for a Responsible Federal Budget.)

In an environment of half-trillion-dollar deficits on their way to being doubled, where might a President McCain find the funds to finance the reduction in the top corporate income-tax rate from 35 percent to 25 percent, which could cost $68 billion per year?

Impact on the national debt

Large budget deficits will, of course, raise the national debt, which was $5.6 trillion at the end of fiscal 2000. It is now $9.6 trillion. Before consideration of any costs from the Fannie and Freddie takeover, the national debt would increase by $10 trillion during the next 10 years under the plausible scenario that Mr. Orszag outlined.

The national debt, which exceeded 120 percent of GDP at the end of World War II, reached its postwar low of 33 percent of GDP in 1981. It is 67 percent today. Under Mr. Orszag’s fiscal scenario, the national debt would reach 87 percent of GDP in 2018. That also assumes no recessions, which always cause the deficit and the national debt to rise faster than otherwise.

CBO’s plausible scenario

To arrive at the 10-year, $7 trillion deficit, CBO made several assumptions, which mostly extended current policy. For example, CBO assumed the Bush tax cuts, which are scheduled to expire at the end of 2010, would be extended through at least 2018.

In addition to extending virtually all of the Bush tax cuts, Republican presidential nominee Sen. John McCain, as noted, would also cut the top corporate income tax rate from 35 percent to 25 percent. Sen. Barack Obama, the Democratic nominee, would extend all the Bush tax cuts for those earning under $250,000, while giving substantial tax relief to lower- and middle-income households.

CBO also assumed the routine extension of other tax provisions, such as the popular research and development tax credit, which both candidates support. CBO assumed Congress and the White House would continue to adjust the alternative minimum tax (AMT) for inflation, a position each presidential candidate embraces. In fact, Mr. McCain has promised to eliminate the AMT.

CBO assumed that the number of troops in Iraq and Afghanistan would be reduced from about 175,000 today to 30,000 by 2011. Given that the United States already has more than 30,000 troops in Afghanistan and that both presidential candidates want to expand that force, this assumption seems very reasonable, if not overly optimistic.

Finally, CBO assumed that discretionary spending, excluding funding for the global war on terrorism, would grow at the same rate as nominal GDP. That would mean discretionary spending would remain at the same percent of GDP that it is today.

Notwithstanding both candidates’ pledges to continue increasing U.S. military forces and the need to replace much of the equipment lost in Iraq and Afghanistan, this last CBO assumption still might seem overly generous on the spending side, according to James R. Horney, the director of federal fiscal policy at the D.C.-based Center on Budget Policy and Priorities.

If discretionary spending, which excludes interest payments and entitlements such as Social Security, Medicare and Medicaid, were to grow only by the rate of inflation, CBO projects that the 10-year cumulative deficit would total $5.75 trillion, or $575 billion per year. Mr. Horney estimates a deficit that size would average about 3.1 percent of GDP, comfortably above the average for the past 40 years.

Looking at the past, Ms. MacGuineas of the Committee for a Responsible Federal Budget believes CBO’s assumption about discretionary spending is realistic. Since Democrats would be very aggressive in meeting their perceived pent-up spending needs, the pursuit of “a faster growth rate of spending is not at all out of the realm of the possibility, and seems likely to occur if Democrats control both the White House and Congress,” she said.

“Deficits averaging $700 billion per year are certainly outside the comfort zone,” Ms. MacGuineas said. “Given that this is the first year baby boomers have become eligible for Social Security, there is no excuse for not saving in advance.”

“If you think these numbers are bad,” said Mr. Walker, the former GAO head, “you ain’t seen nothing yet. We are headed for unprecedented deficit and debt levels that threaten our future economy, our standard of living, our international standing and our national security.”

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