Much Ado About Debt

If the United States suffers a debt crisis in the next decade, historians may well look to March 15, 2010 as an inflection point. On that day, Moody's released a report acknowledging that while the United States' debt was still triple-A rated, the government's margin for error had "substantially diminished" in the wake of the recession and trillion-dollar deficits. Like a Rorschach ink blot, the report was many things to many people -- and it mostly served to confirm their deep suspicions. Deficit hawks saw an omen. Others saw ... well, nothing at all.

For those just joining the deficit debate, the first thing to tease out is the difference between short-term deficits and long-term structural deficits. The former are necessary. The latter are pernicious. This year's projected $1.7 trillion short-term deficit has many parts, but the most important are (1) collapsing tax revenue from the recession and (2) growing public spending to reverse the death spiral of private sector thrift. In the next few years, some tax revenue will return and public spending will draw back. But it won't be enough.

The United States suffers from not only a temporary imbalance, but also a deeper rot. Congressional Budget Office Director Doug Elmendorf summed it up this way: "The country faces a fundamental disconnect between the services the people expect the government to provide, particularly in the form of benefits for older Americans, and the tax revenues that people are willing to send to the government to finance those services." Whereas the natural trajectory of rich countries is to support greater services for the elderly and poor with higher tax levels, the United States increasingly "supports" greater services for the elderly and poor with lower effective tax rates and higher borrowing. That is what a looming deficit crisis sounds like. This is what it looks like:
deficit 2009-10.gif

When you look at structural deficits, the thing to keep your eye on is not only the deficit number after the dollar sign, but its relation to GDP. Countries aren't like people. We can finance consistent deficits, but only if we grow fast enough to pay our creditors back. If our structural deficits exceed GDP growth for a prolonged period of time, we get into trouble because our debt grows faster than our ability to pay for it.

The White House's own projections are warning signs. The administration's budget anticipates that by 2020, the budget deficit will outpace GDP growth by about 2 percentage points. Many independent analysts are much more pessimistic. Economic forecasts are always cloudy, but the moral of the story is clear: at the dawn of the baby boomers' en masse retirement, our deficit will already be at a tipping point. Even Paul Krugman, who like me has been dovish on Obama's deficits, acknowledges that the baseline is unsustainable. We'll need to find at least an extra 2-4 percent of GDP in tax increases or cost savings (or economic Miracle Grow) by next decade.

Krugman says this is essentially a political problem. He does not sound terribly concerned that future Congresses will lack the political will to solve it. With all due respect, I would love to know what channel he's been watching (or if he's read his own blog recently) if he has faith in the political system to solve large-scale crises. Two to four percent of GDP means hundreds of billions of dollars in additional revenue. Where are you going to find that kind of money in a system squeezed between tax allergies on the right, entitlement warriors on the left, and a phalanx of special interests in the middle? It seems to me that some brave senators will have to think outside of the current tax system, and import a new tax that can raise billions of dollars without suffocating the economy. I am talking about a broad-based low-rate value added tax, or VAT.

Raising 2 to 3 percent of GDP through a VAT is theoretically achievable. As Bruce Bartlett has written, the experience of other countries with a VAT suggests we can tax about a third of GDP at a rate around 10 percent. That would do the trick, right? Not so fast. A VAT will take years to put in place. It would be whittled and carved out with special interest exemptions over time, just like the tax system we have today. Liberals will demand that we correct its regressivity through tax credits, which will eat away at revenue. Republicans will demand quid pro quo: a new consumption tax in exchange for reductions to corporate income or federal income tax rates. That will also eat away at revenue. The leftovers might amount to one percent of GDP. We will need something more: Social Security reform, Medicare reform, military drawback, tax expenditures out, carbon taxes in... The menu is long. But all of the meals are expensive and hard to swallow.

When will we have to act? Nobody knows how or when the crisis will come. Prognosticators look to the bond markets, but those tea leaves doesn't provide much clarity. Ten-year yields are rising slightly, but historically low. The United States is still borrowing cheap, especially as other countries experience their own debt crises and investors flee for safety. But term premiums, which are a closer measure of the added risk of holding a bond for a long period of time, are at near historic highs. What does it mean? The Economist's Ryan Avent has the right approach: it's better to be vigilant than declarative, for now.

Paul Krugman is right that our deficit challenge is a political challenge. But significant deficit reduction has been political hemlock in modern American history. From Carter to Bush I to Clinton, the clearest lesson has been that Americans say they hate the disease of deficits, but ultimately they punish politicians for finding the cure. Today the biggest gap is not between our revenues and outlays. It is between the size of the looming crisis and the incentive for politicians to do something about it.

Chart: Washington Post