In the past three weeks, the Congressional Budget Office (CBO) has released two reports that seem to justify contradictory fiscal policies. The first calculated that the U.S. economy could be thrown into recession because of existing legislation to reduce the deficit sharply next year (the so-called fiscal cliff). The second projected that the U.S. will face an eventual financial crisis if the deficit is not reduced sharply. So what are we supposed to do? Obviously, America’s debt is a problem — but is it a clear and present danger, or just something we need to deal with as circumstances permit? To understand how to make smart policy choices that address both these issues, it’s helpful to take the debt numbers apart.
There are lots of ways to calculate debt. All the sources have different numbers. And all the figures are slightly out of date. So let’s proceed by setting some approximate benchmarks. If you compare the debt of national governments to their countries’ annual gross domestic product (GDP), the European Union averages 83% and Canada around 85%. Call that normal. Individual European countries that are in the worst financial shape have debt levels that are a lot higher — see Italy’s 120%. Call that bad.
How does the U.S. compare? Officially, our figure for debt to GDP is 102%, which makes it seem as if we’re well on the way to having Italy’s problems. But our number is inflated by the peculiar way the government accounts for Social Security and a few other programs. The Social Security Trust Fund is debt that the government owes to itself. It’s really just an accounting device indicating that money is promised for future Social Security payments. If you look at only debt held by the public, U.S. debt to GDP is just 71%, well below the danger zone.
There are other ways of calculating debt that need to be considered too. One is to include state and local obligations, which boosts the total government debt figure by as much as 20 percentage points. Another approach is to consider all debt, both public and private. This is important to look at because in some countries, government debt is not the main problem. Spain’s government debt, for instance, is less than that of Germany, France and Britain. What has brought Spain to the financial brink is bank debt that is largely the result of real estate loans incurred during the country’s building boom.
Here’s what this all adds up to: U.S. government borrowing by itself does not become dangerous for more than 10 years.
Entitlements are another question. A recent study by USA Today calculated that if Social Security, Medicare and all other entitlements are counted, then U.S. debt is growing at four times the rate reported by the government. By that standard, we are already bankrupt. In addition, the indebtedness of state and local governments, as well as the debt carried by banks and other private-sector financial institutions, shouldn’t be ignored. Both areas are potentially fragile.
But translating these projections into commonsense policies isn’t very hard, as long as you don’t get tangled up in politics. Here’s what it boils down to:
Discretionary spending should be trimmed slowly. Government spending needs to be steadily brought down, but we have more than a decade to do it, and we don’t have to make big, slashing cuts at the moment when the U.S. is extremely vulnerable to a downturn.
Entitlements, particularly health care, are the big risks. The government simply won’t be able to pay for all the things it has promised. Social Security is fairly easy to fix. Cuts can be made in ways that are almost imperceptible by altering the formula for calculating initial benefits, tinkering with inflation adjustments and nudging up the cap on the amount of income that is subject to taxation. Medicare, and health care generally, is the area where runaway spending is really scary.
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More-orderly policies are needed to deal with local financial crises. Some state and municipal governments are in terrible financial shape and will go bankrupt or have to make big cuts in pensions and other benefits. But the legalities of such moves are unclear. Stockton, Calif., for instance, is embroiled in court fights over potential changes to pension and health care plans that could occur if the city goes bankrupt. We need consistent and fair procedures for dealing with such disputes.
There should be a tougher regulatory system for banks. Judging by JPMorgan Chase’s recent unexpected $2 billion–plus trading loss, there is still insufficient oversight in banking. Proper regulation should discourage banks and other private-sector financial institutions from becoming overextended and also ensure that a crisis in one area of finance will not spread. The greatest risk is that losses in investment banking, for example, will lead to cutbacks in commercial lending and home mortgages and thereby stall the entire economy.
We have to weigh the short-term effects of reining in the deficit against the threat posed by soaring debt over the long term. Reducing the deficit too quickly — whether by spending cuts or tax increases — can backfire. Indeed, the CBO study figured that the tax cuts expiring at the end of this year plus the spending cuts scheduled to go into effect in 2013 would cause an effective reduction in stimulus next year of more than $500 billion and probably push the U.S. into recession. However much the country needs to cut spending over the long term, it has to be done more deftly than that.