Sizing Up the Fiscal Future

Simon Johnson, former chief economist of the International Monetary Fund, is the Ronald A. Kurtz Professor of Entrepreneurship at the M.I.T. Sloan School of Management and co-author of “White House Burning: The Founding Fathers, Our National Debt, and Why It Matters to You.”

From the tone and volume of some voices during the recent fiscal confrontation in Washington, you might draw the implication that the United States has a clear and pressing need to reduce its budget deficit. Americans continue to hear a great deal about the burden imposed by the current federal debt, as well as dire predictions about what will happen in the near future. And the government was shut down and pushed near default in October for a reason, surely?

Yet in any objective sense, much of the anxiety about fiscal issues is greatly exaggerated. There are some longer-term issues to be confronted, mostly related to the aging of American society. But the precise scale of those problems is hard to determine with great precision from 20-to-40-year forecasts. How much of a fiscal adjustment should you make because long-term forecasts do not look good? A little, yes, but it would be wise not to overreact.

The best place to start any analysis of federal government finances is with publications of the Congressional Budget Office. (I’m on the C.B.O.’s panel of economic advisers, but I’m not responsible for any of the work discussed in this post.) The C.B.O.’s latest long-term forecast appeared in September, and the headline numbers are not rosy. Federal government debt held by the private sector - the right measure on which to focus - will rise to above 100 percent of gross domestic product by the late 2030s.

Congressional Budget Office

There is a great deal in this report that is both sensible and sobering. For example, the C.B.O. now does its own forecasts of life expectancy, rather than relying on estimates published by the Social Security trustees. In the C.B.O.’s view, average life expectancy (at birth) will be 84.9 years in 2060 (see Box A-1 on Page 106). That’s great news - the current number is 82.8 years (for a male born this week) - but also has implications for the budget, as this person will draw a pension from Social Security. (You can learn more than you might want to know about your life expectancy, based on your current age, from the Social Security Administration website.)

The main news, relative to last year’s projections, is of course that Americans had a big tax cut at the start of this year. It probably did not feel that way, but the Bush era tax cuts were due to expire - and the American Taxpayer Relief Act of 2012 (enacted at the beginning of 2013; ask Congress, not me, about the use of dates here) “made most of the tax provisions that had been due to expire at the end of 2012 - including lower individual income tax rates - permanent for most taxpayers” (see Page 103).

This was perhaps not a surprise to many observers, but the C.B.O.’s baseline forecasts use current law - so this change moved the baseline a long way, in terms of debt levels by 2038 (the forecast last year was that federal debt would fall to 52 percent in that year; now it is projected to rise to 100 percent).

Is 100 percent of G.D.P. too high for federal government debt? That is the most important question, and it is very difficult to answer.

The United States is currently able to finance this debt - borrowing from Americans and from foreigners - at very low interest rates. If you think that this interest rate environment can continue indefinitely, there is little reason to worry.

But relying on low interest rates is a big gamble, in part because the United States depends so heavily on foreign investors; about half of its federal debt is currently held by non-United States residents.

What will be their appetite for relatively safe assets? How much will they want to hold denominated in United States dollars, as opposed to in the form of debts issued by some other government?

The United States needs a gradual fiscal adjustment. It needs to control health care spending - and not just health care spending by the federal government. On the impact of rising health care costs on the federal budget, I recommend this nice (and easy to read) blog post by the C.B.O. director, Douglas Elmendorf. Health care has the potential to eat the budget.

At the same time, my recommendation is to strengthen revenue slightly as the economy recovers. For example, over the next 20 years, the United States could phase in a value-added tax that, among other things, would discourage consumption and encourage saving. (In our book “White House Burning,” James Kwak and I explain how to avoid squeezing people on lower incomes with such a tax; this works reasonably well in most other industrialized countries.)

The C.B.O. released its own list of deficit-reduction options on Nov. 13, as it did a year ago. In last year’s report, revenue is on Pages 18-19 and a value added tax is discussed on Page 19 (a 5 percent tax on a broad base would generate $320 billion in 2020, according to these calculations).

Long-term economic forecasts are entertaining and a completely fair topic of conversation. It’s also reasonable to look ahead to the retirement of the baby boomers (and beyond).

But how much weight should you put on a forecast that tells you things will be really good or very bad over the next 40 years? Any consensus fiscal forecast in 1940 would have missed World War II, the postwar baby boom, the creation of Medicare, a remarkable increase in longevity and the beginnings of a collapse in the price of computing.

The real danger is not the current or near-term level of federal debt level per se. The danger is that some form of “debt hysteria” will take over and result in a sweeping fiscal adjustment - most likely big cuts in spending on education, research, infrastructure and the like - with the unintended consequence of slowing productivity growth.