What you need to know about the debt debate that will dominate the 2012 election, thanks to the supercommittee's failure to come up with a deficit deal
The collapse of the supercommittee in November guarantees that arguments over U.S. debt won't go away in 2012. Instead, the presidential race should only intensify partisan bickering over our debt, who's responsible for it, and what we can and should do about it.
Consider this your end-of-year glossary and guide to next year's debt debate. Despite the noise, there are some objective facts underlying the debate to which we can anchor ourselves. Only after we understand these facts about the U.S.'s actual and projected fiscal health can we define a set of rational policy responses to remedy what everyone agrees is a looming, and potentially devastating problem.
The Budget of the United States
The Budget Process
The Budget of the United Sates is a plan, submitted by the President to Congress around the beginning of each calendar year, for raising revenues and allocating funding to various government agencies, programs and other expenses over the following year. For example, the budget for 2013 will set forth the President's view of how to best raise revenues and allocate funding during 2013, and will be submitted to Congress in early 2012. After the budget is submitted by the President, legislative wrangling follows, as Congress sets out to generate a bill containing Congress' answer to the President's budget. After this bill is passed by both chambers of Congress, it is presented to the President, who can then sign it, or veto it.
The United States Treasury
The Treasury manages the cash flows of the Government by collecting revenues, borrowing and making payments on behalf of the Government. In the vernacular, Congress makes appropriations, while the Treasury makes outlays. That is, Congress authorizes federal agencies to incur liabilities, and then the Treasury makes payments on behalf of those agencies. For example, if in the Budget for 2013 Congress authorizes funding for a $1 billion space mission carried out by NASA, those funds will probably not be paid out in 2013. Rather, as the mission develops over time, the Treasury will issue payments to contractors and service providers on behalf of NASA in connection with the mission. The Treasury is also authorized to borrow funds on behalf of the Government, subject to a now infamous cap, commonly referred to as the debt ceiling.
Budget Deficit and Surplus
The Government's primary resource for generating revenue and funding outlays is its power to impose taxes, tariffs and other fees on the businesses and individuals operating under its jurisdiction. If in a given year outlays exceed these revenues, then there is a budget deficit in that year. In contrast if revenues exceed outlays, then there is a budget surplus in that year. Note that deficit and surplus are cash flow concepts. That is, whether there is a deficit or surplus in a given year is determined only by outlays and revenues, not the amount of funding appropriated by Congress during that year. For example, returning to the space mission above, the $1 billion authorized by Congress would not be included in the calculation of the budget surplus/deficit for 2013, whereas the funds actually paid out by the Treasury in connection with the mission during 2013 would be included.
Whenever the Government runs a deficit in a given year, the balance of outlays over revenues is funded by borrowing from the public. For example, if in 2013 the Treasury collects $3 trillion in revenues but spends $5 trillion, the deficit of $2 trillion must be financed through borrowing. The Government borrows from the public by issuing various debt securities, the vast majority of which are treasuries.
Treasuries enter the financial system through auctions conducted by the Treasury and the Federal Reserve Bank of New York. At these auctions, investors bid on treasuries by submitting interest rates rather than prices. The lower the interest rate, the more competitive the bid, but the less interest the investor will receive if the bid is successful. When demand for treasuries is high, investors will bid aggressively, which will result in low interest rates on treasuries. Because treasuries are the primary source of funding for the government's budget deficits, the average interest rate on treasuries is a good estimate of the interest rate that the Government pays to finance its deficits. So if in 2013 the Government runs a deficit of $2 trillion, the Treasury will conduct auctions for treasuries with an aggregate value of around $2 trillion over the course of 2013, and the cost of financing that deficit will be determined by the demand for treasuries at that time.
The National Debt
The most straight forward measure of the national debt is the aggregate amount of Government debt held by the public at any given time. Accepting that definition for the moment, let's examine its economic substance. Assume that in each year from 2012 through 2015 the Treasury has revenues of $3 trillion (i.e., revenues are flat). Additionally, assume that outlays are $4 trillion in 2012, and increase by $1 trillion per year thereafter.
Since there is a deficit in each of these years, the Treasury will have to borrow to finance these deficits, borrowing $1 trillion in 2012, $2 trillion in 2013 and so on. Even though the deficits grow in a straight line, the total debt outstanding grows much faster, since it aggregates over all prior deficits. This implies that the amount of interest paid on the national debt every year, known as debt service, also grows at that faster rate. For example, assume that treasuries have an average interest rate of 1%. Borrowings made in 2012 would add an additional $10 billion (1% of $1 trillion) per year to the debt service, whereas total borrowings by 2015 would add an additional $100 billion (1% of $10 trillion) per year to the debt service. Note that the debt service won't shrink if the Treasury stops borrowing after 2015. For example, if in 2016 the Government runs a balanced budget, it will still have that $10 trillion in debt outstanding, which means debt service will have to be paid during 2016 and every year thereafter, until that debt is paid down. This implies that in order to reduce the debt service, the Government must at some point run a surplus and pay down its outstanding debt with the surplus funds.
Refinancing and Interest Rate Risk
Since our national debt has been growing steadily, we know that the U.S. is not paying back it's existing debt. Instead, it refinances existing treasuries by issuing new treasuries. So for example, if $100 billion of treasuries are about to mature, rather than pay back the $100 billion from revenues, the Treasury could borrow an additional $100 billion from the market by issuing $100 billion in new treasuries, and use the proceeds of that new borrowing to pay down the existing treasuries. When it issues the new treasuries, the interest rates on the new treasuries will likely be different than the interest rates paid on the existing treasuries, and as described above, will be determined by the market's demand for treasuries. So despite the fact that the interest rate on each individual treasury is fixed, the actual borrowing costs of the U.S. are determined by the market, since it must continue to borrow to finance its existing debt and its deficits. This implies that the U.S. is exposed to interest rate risk, which is in this case the risk that interest rates on treasuries will increase.
Interest rates demanded by the market can turn an otherwise sustainable debt level into an unsustainable level since interest rates determine the debt service. For example, assume that in 2015 the U.S. national debt is $10 trillion. In our previous example, we assumed an average interest rate of 1%, which would require $100 billion per year in debt service. If we allow interest rates to vary, but keep the level of national debt constant at $10 trillion, we see that each 1% increase in the average interest rate adds an additional $100 billion to the annual debt service (e.g., a rate of 2% would require $200 billion per year). As is evident, when the national debt is high, even small changes in interest rates can have a dramatic impact on the debt service. If the debt service reaches a threshold that the market views as unsustainable, there is a possibility that interest rates will spike in a very short period of time. For example, if the market believes that the U.S. can afford at most $500 billion per year in debt service, then once interest rates near the 5% mark, investors will take seriously the possibility that the U.S. will default. Once default becomes a serious possibility in the near term, investors will demand interest rates far in excess of 5%, since they will want to be compensated for the risk that they won't be repaid, which will cause interest rates to jump to levels that imply a high likelihood default. This dynamic, commonly referred to as a debt crisis, can materialize without much warning and spiral out of control quickly, despite the fact that the conditions that gave rise to it may have taken decades to develop.
The Primary Drivers of Spending
The two biggest line items in Obama's proposed budget for 2012 are health care (22.62%) and Social Security (20.04%). Together, these two line items account for 42.66% of the proposed budget for 2012. According to the Congressional Budget Office, all of the projected growth in government spending as a share of GDP over the next 25 years is attributable to health care and Social Security. That is, the CBO expects all other areas of government spending to grow in tandem with GDP, but expects health care and Social Security spending, commonly referred to as entitlement spending, to grow much faster than GDP. Entitlement spending is expected to balloon over the coming decades because of two factors: (i) the "baby boomer" generation will begin to qualify for Medicare and Social Security benefits and (ii) the cost of health care is expected to increase. Because of these factors, entitlement spending is expected to generate tremendous deficits over the coming decades, and eventually cause the national debt to swell to unsustainable levels.
Medicare provides health insurance to (i) individuals who are 65 or older, (ii) the disabled and (iii) individuals that qualify under other very specific criteria. Medicare pays 80% of approved medical costs, and beneficiaries cover the remainder either through supplemental insurance or by paying out of pocket.
In the diagrams and discussions above, we analyzed the government's entire budget by breaking it into two parts: outlays and funding. And as noted, funding comes from two primary sources: revenues and borrowing. Whenever outlays exceed revenues, the remainder has to be made up through borrowing. We can apply a similar analysis to individual government programs to get a better handle on how well-funded a particular program is.
The vast majority of Medicare's funding comes from three sources: (i) a dedicated Medicare payroll tax, (ii) premiums paid by beneficiaries and (iii) general revenues of the federal government. Whenever outlays made under Medicare exceed the revenues generated by the Medicare payroll tax and Medicare premiums, the balance has to be taken from the general revenues of the federal government (i.e., the unallocated, general revenues of the Treasury). According to the Trustees of the Medicare program, in 2010, the Medicare program had revenues of $486 billion, with $204 billion funded from general revenues. Over the next several decades, Medicare is expected to become increasingly reliant on general revenues. That is, outlays under Medicare will grow faster than the revenue generated by the Medicare payroll tax and the premiums paid by beneficiaries, leaving the balance to be made up by drawing on general revenues. Because there is no dedicated source of funding for that growing balance, it is technically unfunded.
Entitlement spending is expected to grow as a result of a looming shift in the population's demographics and the expectation that health care costs will continue to increase. The CBO expects the share of the population aged 65 or older to grow from about 13% today to about 20% in 2035. This shift means that the share of the population that contributes to Medicare through the Medicare payroll tax will shrink accordingly, while the number of beneficiaries will grow accordingly. Although beneficiaries pay premiums, which contribute to revenues for Medicare, the revenues generated from premiums paid by new beneficiaries will not be sufficient to offset the increase in outlays attributed to new beneficiaries. In addition to shifts in the population, the cost of health care is expected to continue increasing, which means that the cost per beneficiary will increase at the same time that the number of beneficiaries increases, compounding the increase in outlays. To put it bluntly, there will be a lot less money coming in the door and a lot more going out. According to calculations done by the CBO, the increases in Medicare spending over the next 20 years will be driven primarily by the aging of the population. However, in the long run, the situation is expected to reverse, with increases in Medicare spending being driven primarily by increases in the cost per beneficiary.
Medicaid and the Children's Health Insurance Program
Medicaid and the Children's Health Insurance Program (CHIP) are programs jointly administered and funded by the federal government and state governments that provide health care to low income, low net worth families and individuals. The federal government sets broad guidelines for both Medicaid and CHIP, but the states are otherwise free to administer their individual Medicaid and CHIP programs. Because states are free to administer both Medicaid and CHIP within these federal guidelines, both the services provided and the types of individuals that qualify for services vary by state (unlike in the case of Medicare).
Federal contributions to Medicaid and CHIP vary by state, both in absolute terms and in terms of the percentage of Medicaid/CHIP spending within a state that is federally funded. Federal law sets the percentage-wise boundaries of federal contributions, with a minimum of 50% for the "wealthiest" states and a maximum of 82% for the "poorest" states. So for example, if in 2012 Minnesota (one of the wealthiest states) spends $100 million on Medicaid coverage, $50 million will come from the federal government, with the balance covered by the Minnesota state coffers. Similar rules define the boundaries of federal contributions to CHIP, except the percentage of federal contributions is generally a bit higher when compared to Medicaid. Historically, the average federal contribution to Medicaid has been 57% while the average federal contribution to CHIP has been 70%. However, due to the expansion of Medicaid coverage under the health care legislation passed in March 2010, according to the CBO, the average federal contribution to Medicaid is expected to increase to 61% by 2020.
In 2010, total outlays were $273 billion under Medicaid and $7.9 billion under CHIP. Although Medicaid is not expressly aimed at the elderly and disabled, the elderly and disabled account for approximately two-thirds of all Medicaid spending. As such, Medicaid spending is expected to increase as the population ages and the cost of care increases, in much the same way that Medicare spending is expected to increase. However, unlike Medicare, federal funding for Medicaid and CHIP is drawn entirely from general revenues, and as such, both programs are completely unfunded.
Social Security provides income to (i) retired workers and their survivors and dependents and (ii) disabled workers and their dependents. For non-disabled workers, the age at which people qualify for benefits depends on the year the person was born, but all are eligible for full benefits by the age of 67 (assuming the person paid sufficient taxes into the program). The amount of income a person initially receives from Social Security depends on their lifetime earnings, and then going forward, that income is adjusted for inflation. Social Security is the most expensive program in the federal budget. According to the Trustees of the Social Security program, Social Security outlays totaled $712.6 billion in 2010 and are expected to reach $1.241 trillion by 2020. For context, department of defense outlays totaled $683.67 billion in 2010.
Social Security is funded by two dedicated revenue sources: (i) a Social Security payroll tax split between employer and employee and (ii) taxes on Social Security benefits paid to certain "high earning" individuals. According to the CBO, the vast majority of Social Security's funding comes from the payroll tax (about 96%). Social Security has historically run a net surplus (i.e., revenues dedicated to Social Security have generally exceeded outlays), but that surplus cash does not remain in an account dedicated to the program. Instead, the Treasury takes the surplus cash and in exchange issues debt to the program, paying interest on that debt. As a result, even though the Social Security program ran a deficit in 2010 (i.e., outlays exceeded dedicated revenues), because the Treasury owes the Social Security program a substantial sum of money, the program is still technically solvent. According to the CBO, approximately 56 million people will receive Social Security benefits in 2011, and that number is expected to grow to about 97 million by 2035 as the population ages. As a result, according to the CBO, the Social Security program will become insolvent (i.e., the program will have insufficient cash flow and assets to pay full benefits) sometime between 2036 and 2038. But unlike Medicaid and Medicare, there is no automatic back-stop from the general revenues to cover the shortfall. As such, without legislative action, the program will simply fail to pay the benefits it owes.
Policy Responses and Implications
For all the clamor and confusion surrounding the national debt, the reality is that we have exactly three options: we can increase revenues, reduce outlays or make use of some combination of the two. Given the magnitude of the problem, the third option (some combination of raising revenues and reducing outlays) seems to be the only realistic option. The CBO predicts that the national debt could reach 190% of GDP by 2035, leading to an unsustainable and potentially ruinous level of debt service (the CBO estimates that debt service could reach 9% of GDP by then). While there will undoubtedly be justifiable disagreement about the precise contours of the "right" solution, there is no room for discussion concerning wrong solutions: any policy response that is not projected to bring the national debt down to sustainable, economically viable levels is simply not a solution. The debt of the U.S. government plays a singular and fundamental role in the financial markets, touching literally every corner of the global financial system, so default is not an option - we are not Argentina. As a result, if we fail to implement a timely and sufficiently robust solution, we could find ourselves saddled with an immovable economic siphon, and in the long run, occupy the inglorious position of being the world's penultimate super power.
Although the national debt is a grave threat to the long term prosperity of the U.S., it also presents an opportunity for serious discussions about the kind of society we want to live in, and the tools we need to create the future we imagine. In some sense, to respond to adversity with ambitious and idealistic policy is definitively American, but the tools that implement these policies must be rooted in pragmatism, and judged with a brutal intellectual honesty. Hope undoubtedly inspired us to walk on the moon, but hope doesn't fuel rockets, and it doesn't reduce deficits. Fixing this deficit will require more than hope: it will require a genuine, long term commitment to fiscal responsibility, and the political will to see it through.