Achieving Long-Run Fiscal Sustainability: Can the U.S. Avoid a Fiscal Train Wreck?

Bill Emmons likens the future fiscal situation in the United States to the physics paradox of an irresistible force meeting an immovable object; in this case, the outcome of an irresistible fiscal force of non-defense spending growth meeting the immovable fiscal object of tax revenues as a share of GDP. The fiscal train wreck that would occur from such an impact would include high inflation; a default on government debt and drastic benefit cuts and tax increases. Emmons then delves into whether it is possible for the U.S. to avoid such a scenario.

Presentation (PDF)

• Part 1: Welcoming Remarks, Julie Stackhouse and Introduction, William Emmons (7:24)
• Part 2: Can the U.S. Avoid a Fiscal Train Wreck? (11:51)
• Part 3: Can We Slow Spending Growth? (12:44)
• Part 4: Why Hasn’t the U.S. Had a Fiscal Crisis Yet? (10:01)
• Part 5: Can We Achieve Long-Run Fiscal Sustainability? (7:38)
• Part 6: To Worry or Not To Worry about a Fiscal Train Wreck? (10:52)
• Part 7: Is Fiscal Sustainability Possible? (5:47)
• Part 8: Question-and-Answer Session with the Audience (15:14)
• Part 9: Question-and-Answer Session with the Audience Continued (9:47)

Transcript:

William Emmons: So what I want to try to impress upon you today is that this is a very difficult issue. Anybody surprised to hear me say that? I don't think so. I want to characterize this as a physics problem. We have an irresistible force that is about to hit, or is in the process of hitting, an immovable object. And I mean these both almost literally. Irresistible force. You cannot stop it. And an immovable object, you cannot lift it. What do I mean by that? An irresistible fiscal force, as I'll try to convince you of, is non-defense spending. It is rising and you can't stop it. It is an irresistible force, and I'll explain exactly the sense in which I mean that. Not just the dollars we spend, but the spending relative to the size of the economy is growing. It's increasing. And I'm going to suggest that at least under current circumstances, it is virtually irresistible to stop that. The immovable fiscal object, of course, is tax revenues. So the share of taxes that we collect relative to GDP just can't go up under current tax rules, under our current tax system.

So if you accept that—and I'm going to come back and try to convince you of this or explain what I'm talking about—if something doesn't change, I think everybody kind of understands something bad is going to happen, or maybe a collection of bad things. And so that's, of course, this imagery I'm trying to give you. There's going to be a train wreck, some sort of a fiscal train wreck. And based on history, based on what we can sort of expect to happen, I think you could put them in maybe these three categories. You could imagine a period of very high inflation, maybe even hyperinflation. And we've had many, many historical episodes in which countries' inflation rates have gone up into the double digits, into the triple digits, even higher than that, and that would be a disaster.

We could have default on government debt, and let me point out, this is people paying for a loaf of bread with wheelbarrows full of money back in Germany in 1923. And, of course, we've had episodes of hyperinflation much closer to our current time in Latin America, for example, and some places in Eastern Europe. So that's one bad thing that could happen. Another is outright default on government debt. And, of course, we know that that happens. There are instances throughout history. There are very real possibilities we might see this in Europe in the not too distant future. In fact, you could argue that it already happened in Greece. The bondholders in Greece now have a smaller claim than they had before the restructuring of last year.

Another version of a fiscal train wreck could be some sort of drastic and almost emergency unplanned benefit cuts and tax increases. Just sort of decrees that come out of the government from one day to the next. And the point here is that, if it's an outright default on debt or if it's drastic benefit cuts and tax increases, there's a real possibility of social unrest. You could have people in the streets. And, again, we've seen that. We've seen people in the streets in Europe in the last couple of years. So those are countries that are very much on the way to their own fiscal train wreck. And the question I'm posing is, can we in the United States avoid all of those outcomes?

So what I want to do today in three broad areas is show you some trends in federal spending and taxes relative to the size of our economy. That's important. We want to keep track of really the capacity to pay for the spending that we're doing. So I'm going to express everything in terms of the relationship to the size of our economy. Those trends are going to be disturbing. And, of course, many of you know that, certainly as you look further out into the future. But what I want to try to convince you of is that it's actually much more frightening even when you look backwards than maybe most people realize.

And that then leads to the next point. How have we, in fact, avoided a fiscal crisis so far? Because some of the trends that are in place seem that we would have already had a lot of trouble. And then third, I'll give you my interpretation of how we have avoided a fiscal crisis so far, some of the important reasons. And then finally turn to the question of, given what appears likely, given the trends that we see looking out into the future, can we achieve long-run fiscal sustainability? How can we do that? And as Julie suggested, we really don't have the answers, and we're very interested in letting you think about it, make suggestions and have a discussion. Because I think one of the things that this program and the other Dialogue with the Fed programs are all about is getting people thinking, presenting information, trying not to give you a strong point of view, let you have your own point of view, but really encourage you to think about it and, of course, be out and be active in the public discussion of these issues.

All right. So first scary chart—I have a few of them. One of them is federal non-defense spending to GDP ratio. So this is everything that the federal government spends except defense and relative to the size of our economy. So this starts in 1940. These are annual numbers for fiscal years. And then the vertical black line there is the present to the left and the forecast to the right, and all these projections are going to be from the Congressional Budget Office. And so I think if you think about the long sweep of the last seven decades or so, it's generally been an upward trend. And so you could say from about 1945—this point here—it was about 5 percent of GDP. And it's been generally rising with something of a flat spot maybe here. But really looking into the future, it looks more like a resumption of the previous trend to my eye than anything radically different than what we've seen before. So you could say between 1945 and the present, non-defense spending ratio has quadrupled from 5 up to about 20 percent, and the projections are that it will continue. So this is our irresistible force.

Through all sorts of different historic periods, for all sorts of different reasons, non-defense federal spending has relentlessly grown faster than the overall economy. That's what this rising ratio means. So what is it that's driving that? The single largest budget item today is Social Security. But that's not actually the long-term problem. It's the healthcare costs. So this chart also shows Medicare outlays to GDP. That's the second line working from the top, the blue line. And then the third is all other federal healthcare outlays except Medicare, so that includes Medicaid, the CHIP program for children's health and others. And I'll show you some projections looking forward. Of course, the Affordable Care Act also will have some implications for that non-Medicare spending as we look out into the future.

So to sum this up, you could say health and retirement spending has increased from literally zero in the immediate post-World War II period—or almost zero—up to 10 percent of GDP, and you can see the trend lines are still headed up. And so, in fact, if you break down all federal spending into four categories, that's what this picture shows and so we'll work through this.

Now we're looking forward. So the black vertical line here is the present day. Everything looking out into the next three decades are projections made by the Congressional Budget Office. So let me first start with that red line, the ratio of major healthcare programs to GDP. So that's Medicare, Medicaid, CHIP and everything else that's projected to be in force in the next three decades or so. So you can see it's currently about 6 percent of GDP, and it's expected to double over this horizon in the next three decades to close to 12 percent of GDP.

The second one that I want to talk about is Social Security. And as you see, that actually isn't as frightening as we look forward. Because, in fact, much of the increased spending on Social Security already has happened. And there will be some upward movement in that, but it's only going to grow slightly faster than GDP. It's the healthcare programs, that red line, that are growing much, much faster. Those combine not only the aging population but also, of course, healthcare costs which have been growing very fast.

The third line I want to point to is this black dash-dot line. That's everything else but healthcare and Social Security, and that's, in fact, flat. It's declining over the next few years and then expected to kind of flatten out over this 30-year projection period.

There's one more line on the chart that I haven't yet explained and that's the green line, the green dots, which is the ratio of net interest that we pay on the debt. And if we ran this chart historically, you would see that this is a relatively low level. How can that be? We have an enormous debt outstanding that has to be continually rolled over and refinanced. Well, we're paying very, very low interest rates on that debt. So in fact, even though the debt is large, the financial burden, the financing cost, is historically very, very low right now. So the CBO projects, and I think most economists would project, that interest rates won't stay this low forever. We will go back up more toward more historically normal levels. That combined with deficits that are expected in the coming years will combine to create a fairly rapidly growing debt which will become much more costly to finance. And so you can see that this line runs from under 2 percent, rises steadily, and so by the end of this period, in fact, becomes the single-largest item on the budget. And if you projected this even further out into the future, that trend would become even more stark. And so in the long run, that's what's going to push us over the edge—if we ever get that far down the road—is that actually just financing the debt itself will become unsupportable.