As Posner indicates, the US is facing an immediate debt problem, a medium term deficit problem, and long-term debt and deficit problems. We have discussed several times the long-term fiscal problems (see, for example, my discussions on 11/07/10 and 7/17/11), so I will concentrate here on the shorter-term deficit-debt issues.
With the sole exception of the mid-1990s, the federal debt ceiling has always been raised on time during the past 60 years to accommodate the growing level of the debt. Although little time remains to raise the ceiling I do not believe either party will risk the political fallout from not adjusting the ceiling before the government effectively defaults on its obligations. Certainly Republicans remember the political cost to them after the Gingrich-inspired shutdown of the federal government in 1995. So I would be quite surprised if a deal is not reached this time before the US government is forced to delay payment on some of its implicit obligations, such as Medicaid and Medicare payments.
Of course, an absolute ceiling on the debt that is just raised continually makes little economic sense. the relevant size of government is not measured by the absolute level of its debt since large economies tend to have much more debt than do small economies.
etter metrics of the debt burden would be the ratio of debt to GDP, or the ratio of interest payments on the debt to GDP, or perhaps the share of interest payments in total government spending.
Even the ratio of government debt to GDP does not measure the size of the government’s impact on the economy. The present and future impact is better measured by the ratio of government spending to GDP, including any trend in this ratio, plus various harder to calculate measures of the magnitude and scope of government regulations in product, labor, and capital markets.
The major legitimate concern over the growing federal government impact on the economy comes from the rapid growth in the share of government spending to GDP during the past several years. Moreover, this share is projected to continue to grow in the future unless GDP grows by at least 3% per annum over the next 20 years and effective controls are introduced over entitlements for the elderly.
The share of federal government spending to GDP hovered between 18% and 21% from 1995 to 2007, when it was 19.5%. During the next three years, government spending took off and grew rapidly, GDP stagnated spending to GDP reached 25% in 2009. This share is projected at about 25% in 2011. Some of the in federal spending was needed to fight the financial crisis, but much of the increase also reflected the desire of many in control of the federal government to increase role in the economy.
In a Wall Street Journal op-ed piece by George Shultz, John Taylor, and myself on April 4th (Time for a Budget Game-Changer”) we lay out a general strategy to gradually lower this share once again to 19.5% by 2021. This strategy reduces government spending by a mere $19 billion in 2011, or only by about 0.1 percentage point of total federal spending. It also allows nominal federal spending to grow on average by 2.7% per year from 2010 until 2021.
Our approach also assumes that nominal GDP will grow by 4.6% during this eleven-year period. considerably faster government spending the share of government in the economy is reduced by over 4 percentage points by 2021. If we assume an average inflation rate of 1.7% per year during , our analysis allows government spending in real terms to grow from its already high level in 2010 by 1% per year until 2021.
GDP (after adjusting for the assumed 1.7% annual inflation rate) is a little less than 3% per annum over this period, with about 1% growth per year due to increases in the American population. Three percent per year in real GDP is the long-term growth rate of the American economy since 1880. This is considerably below the usual growth rate of GDP in a decade after a major recession. This is why I believe three percent growth is achievable with tax reform (that would include some tax increases), and with major controls over the growth of spending.
Keeping real federal spending growth to 1% per year will be a huge challenge since entitlements, like Medicare, will grow much faster than that over the next decade without sizable entitlement reforms that greatly cut their cost to the government. Still, the spending growth rate is doable. A major start would be to cut back some of the sizable expansion of federal spending since 2007. That combined with serious reforms that cut government spending on Medicare, especially for the elderly with decent financial means, would go a long way toward keeping the real growth of federal spending in the range of 1% per year for a decade.