Achieving Long-Run Fiscal Sustainability: Why Hasn’t the U.S. Had a Fiscal Crisis Yet?

To explain why the U.S. has not yet faced a major fiscal crisis, Bill Emmons explores the extended peace dividend that emerged after 1945 as high defense spending after World War II and the Korean War declined relative to GDP, in spite of the Vietnam War and defense buildups under Presidents Ronald Reagan and George W. Bush. In addition, there has been a demographic dividend thanks to the Baby Boomer generation (born 1946-64), which caused the labor force to swell and boosted economic growth and tax revenues. Furthermore, women continued to join the paid labor force, further boosting economic growth.

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 why haven't we had a fiscal crisis already? I showed you that especially non-defense spending has been moving up, up, up over many, many years, revenue seems to be basically flat. So how could we have gone 50, 60, 70 years without having had a crisis? So I'm going to suggest a couple of reasons. One, we have had an extended peace dividend. We've been able to reduce military spending relative to the size of the GDP for quite a long time, and that's in effect created room for other kinds of spending. So I'll show you the pictures in just a second. Defense spending, as you know, was enormous in World War II. It was actually very, very large still in Korea relative to the size of the economy. And even as you move up to the present, we've had relatively high levels of defense spending at various periods. But the general trend is down, and that has created a lot of flexibility on the non-defense part of the budget.

The second reason that we've been able to avoid a fiscal crisis is the demographic dividend. We've had the baby boomers—often defined as people born between 1946 and 1964—moving through their most productive years, swelling the labor force, increasing GDP growth, paying taxes, and, of course, at the same time, not collecting as many benefits as say a very young population or a very old population. A second mostly unrelated phenomenon is that women moved into the paid labor force in large numbers. An increasing proportion of women were moving into the paid labor force. And it has the same effect—increases the labor force, increases GDP growth, increases tax revenues. And that also had a very noticeable positive effect on the budget situation.

The third category I would point to is what I would call some good luck and probably some good policy in the 1980s and 1990s. Remember I pointed to the flat spot in a few of those curves in the 1980s and the 1990s. We did have strong economic growth. We had long expansions and short recessions in the 1980s and the 1990s. Those were very good for the budget situation when we have short recessions. The stock market was very strong. As you know, the secular bull market over the 1980s and '90s has a huge effect on tax revenues. We had big geostrategic changes—the end of the Cold War, a huge, huge event, both in terms of demilitarization reducing our defense spending, but also opening up new markets, increasing the global labor supply probably had something to do with the fast economic growth that we and other countries were experiencing during this period. And I think it's also important to say that that policy, fiscal policy, did make some tough choices in the 1980s and the 1990s. You can point to tax increases that were certainly not popular, some spending restraint. And there's something many of you remember, the balanced budget amendment from the 1980s. And I think that had an effect. If nothing else, it was part of the national discussion. People were I think focused on this.

And so in a sense, what we're talking about today, of course, you've heard all this before if you've been listening for some time. We had this discussion in the 1980s. One interpretation of what happened is that we made good progress in the 1980s, in the 1990s, and then for a number of reasons kind of let it slip away. For example, the balanced budget amendment was sunsetted, and so we no longer have the kind of restraint on spending and discipline on tax cuts, for example, that we had at that time. So I think those policy changes interacting with some of the other good luck going on there made that easier to take, some of the fiscal restraint that we had during that period.

Okay. So let me illustrate what I mean by the defense dividend. This is the share—or, I shouldn't say share because it's not a component—but rather—well, I guess it is a component. So the defense spending relative to the size of GDP year by year from 1940 to the present and then the forecast for the next 10 years. So you can see this enormous war effort in World War II, almost 40 percent of GDP in defense spending. Even in Korea it was almost 15 percent of GDP. Very, very large dedication of resources to military spending. Vietnam was about 10 percent of GDP. The buildup in the mid -1980s was over 5 percent; it was about 6 percent of GDP. And then again we had a smaller increase in the decade that just ended. So you can look at just from 1980 forward that this general pattern—there were fluctuations—but generally a downward trend is continuing and is expected to continue. That's built in to all of the forecasts that I've shown you and that you're hearing about, that there will, in fact, be continuing reductions in defense spending relative to the size of the GDP.

Now, for our purposes, the problem is there's just not much left to cut. So if you think about those big cuts from the World War II, Korea, even the Vietnam era, those freed-up resources, if you will, for other kinds of spending, and this doesn't create as much room to absorb say those soaring healthcare costs that we're expecting in the next few decades.

The second dividend I talked about was demographics. There are many ways to think about that. Here's one way to try to illustrate it. This is the share of the total population that's aged 16 to 64. You can define it differently if you like, but this is a pretty broad category that you would think would capture most of the people in the potentially working years. So these are people who are paying taxes, raising GDP directly through participation in the paid workforce. And so clearly the baby boomers are a big force moving up that share of the people in this middle part of the life cycle. And, in fact, we are just at the very peak in our whole history. We have just come across the top of the largest share of the population in this middle-aged category, and we are now on the verge of a very substantial decline in the share of population in the working ages. And that will continue for the next couple of decades, and then it will start to flatten out again.

And so you can see very clearly the imprint of the baby boom as it moved through the population, through the working ages. And as we talked about before, very significant effects on the budget in having a very large number of people in those working years. So as we move to an older, permanently older population, one consequence—of course, there are other things going on—but one direct consequence is that economic growth is likely to be slower. Because economic growth is in a sense the sum of the labor force inputs that we have available, people available to work, and the productivity with which those labor inputs are used through capital and technological advances. So as we have a smaller share of the population available for work, it's going to have a slowing effect on overall economic growth.

So this picture shows real GDP growth smoothed over a five-year period, so each point is the five years leading up to that. And so you can see that back in the 1950s we had 4 percent annual GDP growth, but that was in part because we had rapidly increasing labor force. It slowed. Here's the good luck period maybe and good policies in the 80s and 90s, but it now looks like we're going to be slowing down toward—at least for the foreseeable future—much more like a 2 percent, maybe a bit above 2 percent average economic growth rate. So that is going to make it more difficult to finance any given amount of spending. And, of course, that's part of the reason why those projections look more daunting as we go into the future. We're expecting lower economic growth, and that, of course, has direct implications on tax revenues.

So that's kind of discouraging. So maybe should we all just pack up and go home now? Well, of course not, of course not. All of these things are—you know, we can make decisions, we can decide how much to tax and how much to spend, so those things are not without potential solutions. But what I want to suggest is that, of course, getting there. How do we specifically get those decisions made is really the task that we face.