I spoke yesterday at the annual economic policy conference of the NABE, the National Association for Business Economics. The theme of the conference was The New Normal? Policy Choices After the Great Recession, and naturally I discussed fiscal policy choices. My slides and remarks were based on CBOs January report on the budget and economic outlook and preliminary analysis of the Presidents budgetreleased last Friday.
The first part of my presentation focused on the next few years. CBO forecasts that the economic recovery will be fairly slow, with the unemployment rate returning to near its long-run sustainable level of 5 percent only in 2014. One factor underlying that forecast is declining support for economic activity from fiscal policy. CBOs baseline budget projection, which follows current law, shows the budget deficit dropping from about 9 percent of GDP in this fiscal year to about 4 percent of GDP two years from now. That decline of roughly 5 percentage points would be the sharpest two-year reduction in the budget deficit that we have seen since the end of World War II.
Most of that decline can be attributed not to improving economic conditions (although those play some role) but to the diminishing impact of last years stimulus legislation and the scheduled expiration of earlier tax reductions. The effects of last years stimulus package on government outlays and receipts peaks in fiscal year 2010, as can be seen in the following picture, and CBO estimates that the effects of the package on output and employment will begin to wane later this year.
Estimated Budgetary Effects of ARRA (Billions of Dollars)
In addition, economic growth will be dampened, under current law, by the scheduled expiration of the 2001 and 2003 tax cuts and by the increasing reach of the AMT.
Therefore, the key choice for near-term policy is whether to enact additional tax cuts or spending increases to provide more stimulus to the economy or to allow stimulus to be withdrawn quickly as under current law. That choice involves a trade-off between potential short-term benefits and long-term costs. CBOs January analysis of various policy options found that further fiscal actions, if properly designed, would promote economic growth and increase employment in 2010 and 2011. However, despite the potential economic benefits in the short run, such actions would add to the already large projected deficits and, all else equal, make future incomes lower than they otherwise would be.
The second part of my presentation looked beyond the next few years. CBO projects that the budget deficit and debt are on a trajectory that poses significant economic risks and ultimately becomes unsustainable. U.S. government debt in relation to GDP is quickly entering territory that is unfamiliar to us and unfamiliar to most developed countries in recent years. Therefore, the key choices for medium-term and long-term policy are how quickly and in what way to restrain federal borrowing. In thinking about those choices, it is helpful to understand the evolution of different components of the budget over time.
I showed the following table comparing budget components in 1970, 2007 (before the recession), and 2020 (based on CBOs current-law projection). The figures are expressed as shares of GDP because overall output and income are the ultimate source of resources that can go to government activities.
Components of the Federal Budget
In 2007, both revenues and outlays represented about the same shares of GDP that they had in 1970. (Revenues were down a little, and outlays were up a bit, making the deficit somewhat larger relative to GDP.) The most striking increase in outlays was for Social Security, Medicare, and Medicaid, which used 4.4 percent of GDP more resources in 2007 than they did in 1970. Defense spending moved in the opposite direction, declining by 4.2 percent of GDP, on balance, between those years. All of the other programs of the government represented about the same share of GDP in 2007 that they did in 1970.
One should not minimize the variation in some of those budget components (relative to GDP) during the past several decades. However, looking across the whole 40-year period, the basic story of U.S. fiscal policy is fairly simple: The country financed an increase in Social Security, Medicare, and Medicaid spending by reducing defense spending relative to the size of the economy. Essentially, the increased costs of those three big entitlement programs were absorbed by a decline in spending (as a share of the economy) that was not very noticeable to the public because it occurred in an area that most people do not directly observe.
Because defense spending is much smaller relative to those programs today, that approach to funding growth in those programs is not feasible in the future. Furthermore, the projected increases in spending for Social Security, Medicare, and Medicaid are greater than those we have experienced in previous years. So, we will have to finance most of the future growth in Social Security, Medicare, and Medicaid through a noticeable increase in the tax burden or a noticeable reduction in other domestic programs relative to the size of the economyor we will have to take noticeable policy actions to reduce the growth of those programs. The alternative of continuing large increases in federal borrowing would pose a serious threat to the future of the U.S. economy.