Austerity: The False Cure

Democratic and Republican politicians, prestigious media commentators, and other prominent opinion leaders have recited the causes and grim consequences of large federal deficits with such incessant consistency that many citizens have come to accept their ominous story. The proposed cures, however, remain as perverse and unpopular as ever because social outlays are highly valued.

We are told that current deficits are higher than they have ever been and will grow to unsustainable levels as overly generous entitlement programs like Social Security and Medicare plunge the nation into deeper and deeper debt. If benefits provided by those unaffordable programs aren't cut soon, the nation is at risk of following Greece toward bankruptcy -- or at the very least, becoming more dangerously indebted to China. The only hope for salvaging a decent future for our children, supposedly, is a commitment to a smaller, more austere federal government.

While the prospect of federal debt spiraling out of control in the 2020s and beyond is a genuine cause for concern, the nature of the fiscal threat has been exaggerated, the explanations for the problem have been built on misleading claims and outright falsehoods, and the set of options put forward has been unnecessarily narrowed to steps aimed primarily at advancing an ideological anti-government agenda.

The Threat. This year, publicly held debt as a share of the economy is about 62 percent -- a level last reached in the mid-1950s, back when the debt was steadily declining from its post-World War II peak of 109 percent. Projections by the Congressional Budget Office, based on a highly uncertain set of assumptions, show that the debt level will rise fairly steadily to 87 percent by 2020, then eclipse the previous U.S. record in 2025, continuing ever upward thereafter. The Office of Management and Budget forecasts a slower climb, reaching 77 percent in 2020, based on somewhat higher expectations for economic growth. The CBO's "alternative" forecast, which assumes that most of the Bush tax cuts remain in effect, shows annual budget deficits declining from today's 9 percent of gross domestic product to between 4 percent and 6 percent as the economy recovers -- still high levels that would lead to steadily mounting debt. Even ending the Bush tax cuts for high-income earners, as President Barack Obama proposes, leaves debt rising relative to GDP.

There are legitimate reasons to be concerned about high future deficits. Too much governmental borrowing could someday cause interest rates to rise to the point where they would choke off private investment. Under that scenario, servicing the federal debt could also crowd out government spending on other purposes, further constricting both the economy and needed public outlays.

Another related risk is that expectations could rise that government debt will be monetized, generating high inflation. That would require a deep recession to restore price stability. Also, as interest rates revert to more normal, higher levels, an increasing share of the federal budget would become devoted to interest on the debt.

However, this worst-case scenario many years from now is a more hypothetical menace than the very real and current problems of the Great Recession. If high unemployment persists, it will be that much more difficult to address the deficit and debt trajectory without crushing cuts in public services. With both inflation and interest rates now near zero, additional government borrowing to promote job creation, jump-start stronger economic growth, and strengthen safety-net protections would be low-risk and relatively inexpensive. But rather than address the crisis that's actually occurring, Washington has become paralyzed over exaggerated worries about the future.

Alarmism about America's foreign debt lacks logical grounding. Other nations currently maintain significant holdings of U.S. Treasuries because they value the security of investments backed by the full faith and credit of the federal government. That confidence is now so high that interest rates on Treasuries have fallen to historically low levels. If those investors were to lose faith in the U.S. government's debt, their flight from American assets would cause the value of the dollar to fall relative to other currencies. That would reduce the cost of goods and services produced in the United States, providing an export-led boost to the American economy while improving the government's fiscal condition. In any case, it is unclear which other country would come to be perceived as a haven safer than the United States.

For all the flaws with America's governmental institutions, our tax-collection systems, central-banking infrastructure, and accountability mechanisms are far more sophisticated than the severely distressed European nations. Moreover, nations with weak economies would ordinarily devalue their currency, which would enable them to boost their economies through exports. But Greece and Portugal, which use the euro, are unable to do that. The U.S., by contrast, retains monetary sovereignty.

The Causes. The blame for the federal government's fiscal condition is routinely assigned to "entitlements" -- the nation's three major social-insurance programs of Social Security, Medicare, and Medicaid. But that accusation is misleading on several levels. Just under half of the current budget deficit is attributable to legislation enacted during the George W. Bush administration and a little more than half to the economic collapse and the government's response to it. Under Bush, forecasts of large and growing surpluses following the Clinton administration quickly transformed into deficits due to a combination of big tax cuts, increased defense and homeland-security spending, and the unfunded Medicare prescription-drug benefit.

The Economic Policy Institute compared the CBO's long-term budget forecast in 2001 with actual spending in 2009 and found that 42.4 percent of the gap that emerged between the projected surplus and the actual deficit was attributable to Bush-era policies. Most of the remainder arose from plunging revenues and increased safety-net spending caused by the economic collapse, plus responses like the stimulus legislation.

As for the poor long-term budget outlook, the entire problem is that health-care costs are expected to continue rising about 2.5 percent faster than overall inflation. If borne out, that would cause Medicare and Medicaid to expand rapidly without a commensurate increase in revenues. The new health-care reform legislation takes some steps toward bringing medical costs under control, which could potentially make the budget situation much more favorable. In the CBO's recently released long-term "extended baseline" forecast, for example, the 50-year fiscal gap between federal spending and revenues declined from 2.6 percent of GDP in its previous report to 0.8 percent -- entirely because of the effects of the health-care law. More health-care reforms will be needed to make our highly fragmented and inefficient system as cost-effective as the more comprehensive arrangements in other advanced countries. If that could be accomplished, the deficit problem would be fully resolved.

The reliance of deficit hawks on the "entitlements" label is intended to conflate the genuine problem of medical inflation with the finances of Social Security, which are close to balanced and require only minor adjustments (see "Social Security and the Deficit" by Nancy Altman and Eric Kingson, page A22).

Red Herrings. Deficit hawks commonly make disturbing claims that sound plausible but don't withstand scrutiny. For example:

"There is no [Social Security] trust fund, just IOUs that I saw first hand that future generations will pay. Imagine -- the retirement security for future generations is sitting in a filing cabinet." -- President George W. Bush.

When Social Security faced a genuine crisis back in 1983, with dedicated taxes on the verge of falling short of promised benefits, Ronald Reagan signed into law a set of changes that included increases in payroll taxes to a level that would be more than sufficient to cover payments owed to existing beneficiaries for many years. The plan, which received broad bipartisan support, credited the surplus revenues to Social Security trust funds that would build up over time to guarantee that payments would be made to the large generation of baby boomers when they retired. By committing U.S. Treasury securities backed by the full faith and credit of the government to the trust funds, the reforms ensured that general revenues would supplement payroll taxes to cover future obligations. The deal was that the boomers and subsequent generations would pay more during their working years for the assurance that they would later receive benefits. Reagan called the reforms an "ironclad commitment," which they still are.

"Entitlements cannot be a one-way street, with older generations always receiving and younger ones always giving." -- Peter G. Peterson, billionaire sponsor of anti-deficit organizations.

First, both Social Security and Medicaid directly pay benefits to many millions of non-elderly Americans, including children. Second, all social-insurance programs, by enabling retirees to live more independently, relieve younger family members of obligations to house and otherwise finance the care of older citizens. One of the great accomplishments of the past century was the reduction in poverty rates among the elderly from more than 35 percent before 1960 to about 10 percent today -- a decline almost entirely attributable to Social Security, Medicare, and Medicaid. Moreover, all kinds of legislation has been enacted in recent years that benefit younger generations, including the health-care reform act, the education provisions of the stimulus bill, and the Children's Health Insurance Program. Further, none of the deficit hawks is exactly crusading for more spending on the young; rather, they are promoting across-the-board budget cuts.

"Preserving the status quo will erode trust in government. A government that has lost control of its fiscal future, with most of its budget on automatic pilot and a fifth of its expenses unpaid for, cannot garner much respect from its citizens. ... The erosion of trust that fiscal indiscipline engenders will, over time, leave the party that wants to use government for progressive ends unable to win elections." -- Isabel Sawhill, the Brookings Institution.

In an April New York Times poll, 76 percent of respondents said that "the benefits from government programs such as Social Security and Medicare are worth the costs of those programs," versus just 19 percent who disagreed. Even among the 18 percent of the population who identify as Tea Party supporters, 62 percent concurred with the statement. Given such broad support, it is difficult to see how reducing social-insurance benefits for people who have paid dedicated payroll taxes for those programs would become more enthusiastic about the government.

Policy Options. With unemployment still unacceptably high, the priority for now should be to reignite the economy with another round of stimulus and productivity-enhancing investments in public and social infrastructure. Putting more Americans back to work and restoring growth would improve the fiscal outlook. Once unemployment falls below 6 percent or so, then a combination of revenue increases and spending reductions will be needed to reverse the escalation in the debt until the central challenge of constraining medical costs is achieved.

Deficit hawks like to joke that there's little choice but to cut social-insurance programs because, as the bank robber Willie Sutton would say, entitlements are "where the money is." But in fact there are better alternatives. For example, a bipartisan task force organized by the Project on Defense Alternatives recently issued a report spelling out specific defense cuts that would save $960 billion between 2011 and 2020 alone. The report emphasizes how those changes would not weaken American security.

Another obvious target is so-called tax expenditures -- government subsidy programs that take the form of tax breaks. The CBO has identified 165 tax expenditures that will cost the federal government more than $5 trillion over the next five years. Curtailing inefficient, regressive, and ineffective write-offs, both by eliminating the most wasteful and restricting how much any particular taxpayer and corporation could benefit from them, would also greatly strengthen the fiscal outlook. So, too, would taxing income from investments at the same rate as earnings from work.

Large future deficits can be reduced to manageable levels after the economy rebounds without weakening the government's most effective and popular programs. The only thing to fear is alarmism itself.