Friday’s Fiscal Reality Check: Why the 1990s will never come again

I have heard a number of commentators (here and elsewhere) looking forward to the midterm elections as a replay of the 1994 midterms when Republicans assumed unified control of the House and Senate for the first time since Eisenhower’s first term. This is usually combined with some discussion of the merits of gridlock and the great policy mix that emerged in the 1990s, resulting in trade expansion, a balanced budget and a reduction in the government’s claim on GDP.  And the economy grew (from roughly $8 trillion in 1990 to $11.2 trillion by 2000, in 2005 dollars). Perhaps if Obama can be disciplined by a resurgent GOP, we can return to those halcyon days of old.

I have no doubt that the 1990s were, by most measures, a great decade (although some of the accomplishments were grossly overstated). I also have no doubt that what occurred in the 1990s will not be repeated, at least within our lifetimes. Regardless of what occurs in the midterm elections, this time will be different.

In short, the long-term entitlement problem (predicted for decades) can no longer be avoided, and it will necessarily force higher levels of debt and taxation than we have experienced historically. All of this has negative ramifications for growth. Let me add a few details since the blog is relatively quiet today.

Entitlements: The long-term unfunded liabilities is the largest part of the problem for the future. Existing entitlements are locked in place and, due to demographics, the long-term costs are simply unsustainable.  The Peter G. Peterson Foundation calculates that the real national debt is currently $61.9 trillion (to place this number in context, the US GDP was $14.3 trillion in 2009). The vast majority of this, some $43 trillion,

is what the government has promised to pay in Social Security and Medicare benefits in excess of related revenues. As of September 30, 2009, current and promised future Social Security benefits amounted to $7.7 trillion. And between Medicare’s three programs (hospital insurance, outpatient, and prescription drug), current and future promised Medicare benefits amounted to $38.2 trillion.

These figures were calculated before the 2010 health care law was passed, which only increased entitlement exposure.

Debt: Under the assumptions adopted by the Congressional Budget Office, the combination of projected long-term spending and revenues (assuming the maintenance of the status quo) will have devastating consequences for the debt. In 2000, publicly held debt was 35 percent of GDP. By 2010, it reached 62 percent of GDP. By 2050, it is projected to hit 299 percent of GDP. This is assuming, of course, that debt markets will support this level of indebtedness (a highly unlikely scenario).

The CBO has sought to quantify the impact on capital stock and economic growth. To quote the CBO ( Congressional Budget Office, Long-term Budget Outlook, June 2009, p. 17):

Under the extended-baseline scenario, federal debt would rise substantially after the 2020s. According to the textbook growth model, the debt projected under that scenario would reduce the capital stock by about 5 percent in 2035 and shrink real GNP by about 2 percent, compared with what they would be if debt remained roughly at its 2008 share of GNP (by keeping the spending and revenue shares of GNP at roughly their 2008 levels). By 2080, federal debt would approach 300 percent of GNP, and the capital stock would be reduced by nearly 40 percent and real GNP by almost 20 percent.

So the long-term trajectory would result in a 20 percent reduction in the annual growth rate? Perhaps, but the CBO finds this scenario to be somewhat unlikely for obvious reasons:

In actuality, the economic effects of rapidly growing debt would probably be much more disorderly as investors’ confidence in the nation’s fiscal solvency began to erode. If foreign investors anticipated an economic crisis, they might significantly reduce their purchases of U.S. securities, causing the exchange value of the dollar to plunge, interest rates to climb, and consumer prices to shoot up. Amid the anticipation of declining profits and of rising inflation and interest rates, stock prices might fall, and consumers might sharply curtail their purchases. In such circumstances, the economic problems in the United States would probably spill over to the rest of the world, seriously weakening the economies of U.S. trading partners. All in all, the U.S. economy could contract sharply for a long period.

Taxation: Let us assume, that it is not feasible to allow publicly held debt to grow in the fashion described above. Certainly, the government may decide to renege on some of its promised entitlements; and there is unquestionably room for reform (remember that “waste, fraud, and abuse” they are always talking about). But in the end, higher taxes are unavoidable. Here is a sobering quote from former Comptroller General David M. Walker’s recent book, Comeback America (page 19)

Right now, on average, Americans pay about 21 percent of their income in federal taxes and another 10 percent to state and local governments. By 2030, to pay for our rising bills, that amount could be at least 45 percent—higher than the average 42 percent that most Europeans pay. By 2040, it would be at least 53 percent and climbing. In reality, total taxes in 2030 and 2040 would be even higher than these estimates because of the fiscal challenges facing state and local governments—such as Medicaid costs, unfunded retiree health care promises, underfunded pension plans, deferred maintenance and other critical infrastructure needs, and higher education funding.

Even if one does not buy the logic of the Laffer Curve hook-line-and-sinker, the economic impact of more than doubling existing levels of taxation would be devastating. Like the high debt scenario, the results would be a stagnant economy.

Putting the Pieces Together: Of course, we can pursue some combination of social welfare retrenchment, higher taxes, and higher indebtedness—in fact, we will likely have no choice. But any policy mix is going to inflict significant pain and will carry significant economic consequences.

Regardless of the outcome in the upcoming midterm election, future presidents and members of Congress are going to have to eschew the short-term political calculations of the past and soberly discuss the limited options for (1) reducing the growth rate of entitlement spending; (2) increasing revenues; and (3) reducing the growth rate of the debt.

Perhaps I have missed something and there is some solution that evades me. If so, please comment away.

To chart a course out of this situation, the Right will have to acknowledge that higher taxes are going to have to be part of the solution (a hard thing to write, given my visceral hatred of high taxation). There is no way that the search for “waste, fraud, and abuse” will bear the desired fruits;  there is no way that we can grow our way out of this situation. The Left will have to disabuse itself of the illusion that once “Bush’s wars” are over, all will be right. Yes, the movement toward a balanced budget in the 1990s was, in part, a product of the end of the Cold War. At the height of Reagan’s defense build up, defense spending claimed 6.2 percent of GDP. With the collapse of the Soviet Union this figure shrank steadily and between 1990 and 2000, defense spending fell from 5.2 percent of GDP to 3 percent of GDP. By contrast, with two hot wars , defense spending in 2009 was 4.6 percent of GDP. Assuming we exit Iraq and Afghanistan on schedule, the fiscal impact will pale relative to what was enjoyed in the 1990s and most certainly will not be enough to make more than a minor dent in the long-term situation.

As of 2010, I see few people on either side of the isle willing to act like adults, acknowledge the key dimensions of the long-term fiscal crisis, and soberly move forward with the needed reforms regardless of how they perform relative to some ideological litmus test or before select focus groups. We can perhaps give them a temporary reprieve given the pressing issues at hand (i.e., the global financial crisis)

Bottom line: As a result of demographics, unsustainable entitlement commitments, and the fiscal implications, regardless of what happens in the midterms, this time will be different. The 1990s, I fear, will go down as a golden decade that we will not witness again in our lifetimes. The politics of joy that we experienced in the 1990s will need to be replaced by a politics of resignation.

With that in mind, have a lovely July 4th.

8 thoughts on “Friday’s Fiscal Reality Check: Why the 1990s will never come again

  1. Very nicely done. I agree with most of it. My giddiness about gridlock was not that gridlock will solve our problems, but that it should but the brakes on the disastrous “progressive” agenda that would occur if the leftists were given full reign.

    The problems you mention with debt and entitlements are very real. Reigning in Medicare is the most daunting problem, and we are currently moving in the wrong direction. Reform of benefits (increasing the retirement age, means-tested Medicare premiums, etc.) are going to have to happen, as are tax increases, most likely. I don’t see a path politically to make those happen at this point.

    Although I agree that our debt burden and bloated Federal government can dampen growth, I am more optimistic about the long-run future for GDP growth than you are. As I’ve said, in the long-run GDP growth is driven mostly by technology, but that doesnt’ mean we can’t have periods of stagnation.

  2. For me the worry is that we enter a Japan-like situation, with a crushing debt burden and perpetually sluggish growth.

  3. Do you also count the military/defense entitlements, or is that kind of expenditure magically good instead?

    1. Hi Ozzie. The term “entitlement” describes benefits that have been established via legislation. So, for example, one has a legal entitlement to Social Security old age pensions. In broad terms, all of government spending can be separated into two categories: mandatory (e.g., entitlements, interest on the debt) and discretionary (everything else).

      While there are components of defense spending that are entitlements (e.g., military pensions), the vast majority of military spending falls within the discretionary category.

      I understand the point you are trying to make. Military spending is not included in the discussion of entitlements not because it is “magically good,” but because it isn’t an entitlement. I would exclude whales from a discussion of fish for a parallel reason: whales are mammals.

      Happy 4th

  4. Oh come now. I have optimism for 2013, as Obamacare gets rolled back with a vengeance and his replacement (whoever he is) takes control.

    I just hope he’s also someone who understands basic economics, and basic theories like the laffer curve.

    I’m sure that it won’t be a social “neoconservative” this time however. Just look at what Reagan did, emulate it, and this time add a DON’T SPEND policy on top of it.

    I’m assuming the 2013 president will be a man who comes out of nowhere though.

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