Achieving Long-Run Fiscal Sustainability: To Worry or Not To Worry about a Fiscal Train Wreck?

April 07, 2013

Bill Emmons of the St. Louis Fed cites two reasons not to worry about a U.S. fiscal train wreck: 1) The U.S. will not default on its sovereign debt, given that the U.S. Treasury can borrow at less than 3 percent for 30 years and 2) The Fed is determined to prevent a surge in inflation. These are the “easy” ways to escape an unbearable fiscal burden, by taking explicit default and high inflation off the table. This leaves political action as the only way to achieve fiscal sustainability. However, the U.S. political system currently seems gridlocked—and is designed to be resistant to change. At the same time, many members of the American public are hesitant to make sacrifices. Emmons concludes that the only plausible route to long-run fiscal sustainability is through political courage and leadership, in addition to the public acceptance of the need for shared sacrifice. A more transparent separation of the government’s insurance functions from redistribution would also be beneficial.

Presentation (PDF)


William Emmons: So I'm going to suggest some reasons that we shouldn't worry. It is a reasonable conjecture that the U.S. government will not default on its debt in the foreseeable future, at least the next 30 years. How can I be so confident? Well, if you look at the yield on 30-year U.S. Treasury debt, it is under 3 percent, incredibly low. So this is saying that investors—now, certainly some of those are non-market investors, including, say, the central banks of other countries. To some extent, the Federal Reserve is not a market-based player. Nevertheless, there are investors out there still willing to hold 30-year unsecured Treasury debt at less than 3 percent. So if there were some significant risk of default in the minds of those presumably sophisticated investors, you'd be hard pressed to explain why they would be willing to accept that small of a yield. So that gives me some comfort that this is not a danger, this is not something that we should worry a great deal about. Maybe some of you have different views, but I just find it hard to take seriously the idea that the United States will default on its debt if we have investors willing to hold long-term treasuries at less than 3 percent.

The other piece is, of course, inflation. A lot of people are worried about inflation. The Federal Reserve has created lots of reserves. Isn't that going to create inflation? Again, I would look at the financial markets—markets that we don't control. The difference between the nominal long-term Treasury and the inflation index Treasury—that is where the government, I guess you have to presume that the government will follow through on that promise—but it is a legal promise to pay the inflation that's occurred between the time you buy the bond and the maturity. That difference is only 2 1/2 percentage points. Economists typically interpret that as saying that investors are only requiring or demanding 2 1/2 percentage points of compensation to bear the risk of inflation between now and that 30-year horizon. So again, it's hard for me to take seriously that there's an imminent inflation risk if investors are willing to take such little compensation to be unprotected against inflation.

So those are two good reasons not to worry. We're not going to default, and we're not going to inflate away the debt. However, in a sense, you know, maybe there's a paradox there. These are easy ways in a sense countries can get rid of a lot of debt by just walking away from it. They can get away from a lot of debt by inflating it away. I've just said that's off the table, we're not going to do that. So these easy ways to escape the unbearable burden are off the table. The only way then that's left is through political action. We're going to have to fix it. The spending and the taxes are going to have to somehow make this all add up. Unfortunately—I don't think I'd get a lot of objection if I make this assertion that the political system currently does not seem capable of making those decisions. And it's hard to imagine that you could get very dramatic changes in the way the political system is operating, whether it's changes in representation or the filibuster rules. I mean, you can see just how difficult it is, how resistant parties are to making even those changes in the political system. And I would say based on those opinion polls and, of course, other things that we know, most members of the public do not want to sacrifice. They would be happy if you sacrifice, but they don't want to be the ones making those sacrifices.

So I would suggest what we need to do—I'm just going to sort of start the discussion this way, and Kevin's going to have some ideas and then I hope some of you have some ideas, too—somehow we need to convince our political leaders to understand, help us understand, help the public understand spending and taxing realities. I think that requires leadership, insight and courage for it to be a conversation about we're all in this together. And that must involve straight talk about healthcare costs and the role of the aging population as being the main cost drivers. I think it would also involve straight talk about taxes, that it's unrealistic to think that we can push up income tax rates without damaging the economy to the extent that we would need to raise the kind of revenue to cover those costs.

So that leads to the conclusion that we need a different or an expanded way, a broader way of thinking about taxes, what's commonly termed tax reform, which would include things like consumption taxes. Dirty word, right? Or taxes on pollution or other bad things. There are ways to collect revenues other than on just income tax or income-based tax measures. And somehow the public perceptions, the public conversation needs to change so that people will agree that there will be sacrifices required. Not all equally, some in terms of more tax contributions, some in terms of less spending benefits that they receive. But sometimes missing I think in the discussion is the idea that everyone needs to be involved in this. This can't be solved by the burden being borne by only some people.

So I would say a step in this direction—this is sort of the contribution of an economist what is inherently a political discussion—is that we could I think help people become less confused if we separated the insurance function of government from redistribution and the way we talk about these. So what I mean is I think we at the Fed, many of you at your employer, receive a statement every year that tells you what the total cost of your healthcare was. Some of us probably don't even pay attention, but some of us look at that and say, wow, I didn't realize that my healthcare is costing this much. I may not pay that much out of pocket, but just to know how much it actually costs somebody to pay that. So if that degree of transparency could be made more readily available if everybody understood what the cost of providing a certain amount of coverage or a certain benefit would be, I think that would be an important step. And, of course, obviously the healthcare insurance and retirement annuities are the big ones that we need much more information about.

As a separate discussion, if we think that the costs are too great for some and we want to subsidize them, that is certainly part of the political discussion but it needs to be kept separate. And the reason I'm really hammering on this is that in the current discussion there's a huge amount of confusion about what the implications of the Affordable Care Act will be, for example, for health insurance premiums. And the two factions are using different criteria. One is talking about before subsidy and the other is talking about after subsidy. Well, those are totally different items and yet the headline writers are not doing a good enough job and our political leaders are not doing a good enough job to explain that to people, that the after subsidy cost is not the true cost of this benefit. So I think if we could keep those separate, that would be a huge step forward.

So just summing up and then I'm going to hand it over to Kevin. I think under current circumstances—this was my premise—that under current circumstances, under the discussion that we're having today publically, it is an irresistible force meeting an immovable object. It has been a series of temporary fixes that have prevented a fiscal crisis from occurring already, and those fixes are gone. That, plus of course the financial crisis, are the reason it's all coming to a head now. Since we are not going to default on our debt, we are not going to inflate away our debt, the only solution is political. We have to get the taxes and the spending to add up, and that's going to require shared sacrifice. That's my view. And I think a more transparent, more straightforward discussion of what the benefits actually cost and who is receiving subsidies to help them pay those costs, I think that would be a big step forward.

So I want to ask you again: How confident are you that the United States will achieve long-run fiscal sustainability within the next 10 years? All right, so that is 76 percent, so about three quarters say not very confident or not at all confident. So we have a lot of work to do. I think we can maybe think of ourselves as ambassadors if we can help push this discussion forward. Because it's not going away, so we might as well get this discussion started and hopefully get some constructive discussion going.

So I'm going to ask Kevin in, too. Yeah, okay, we're going to have everybody come up, and then Kevin and Julie will join us here. Thank you.

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