He went from fiscal policy being sober to we are in dire straights just like that! Oh my the sky is falling. We have to take away those Social Security benefits that my generation have been paying into for 35 years. We cannot afford Federal health care spending. After all those tax cuts for the rich can never be reversed. Yes John Cochrane is part of the Starve the Beast crowd even if granny starves from these supposedly required reductions in transfer payments.
But let’s note why Cochrane flip flopped in his update:
Jeff Miron wrote to chide me gently for apparently implying the opposite, which is certainly not my intent. One graph from his excellent “US Fiscal Imbalance Over Time”.
Having read this Cato paper, it is time for my critical review that I promised. The review will start with the technical finance which in one way is a lot better than Cochrane’s rants but still troubling in certain ways. I will next turn to the policy if not political issues where this paper is even worse than Cochrane’s update. Beware – we will have to cover a fair amount of numbers but I hope to keep this within the context of my present value model:
Let g = the ratio of Federal expenditures excluding interest payments to GDP and t = the ratio of Federal taxes to GDP. If we assume a steady state model, the present value of future primary surplus is simply V = (t- g)/(r – n), where r = the real interest rate and n = the long-term growth rate. As long as V is at least as great as the debt/GDP ratio, we are not on the bankruptcy path that economists were talking about when Reagan initiated his 1981 fiscal fiasco. Tax rates were massively cut and defense spending spiked and had this fiscal stance continued forever, then the debt/GDP ratio would have exploded. Of course it didn’t as there were future tax increases and the peace dividend.
Miron is using the same basic model, which he expresses as:
Fiscal Imbalance = Present Value of Future Expenditure – Present Value of Future Revenue + Outstanding Debt
What I like about this equation is its focus on future spending and revenue not historical decisions which can be summarized as the current level of debt in terms of our model. Cochrane’s rant was a bit weak in this regard. May I suggest Cochrane rent the 1989 movie and check out this scene as the Joker gets basic finance! While I may quibble with Miron with respect to his forecasts, my big problem the use of nominal figures to draw his graph – which is far from “excellent”. Note his measure doubled in nominal terms since 2000 but so has nominal GDP (higher prices, more people, and higher income per person). Which is why this title and introduction is misleading:
U.S. Fiscal Imbalance over Time: This Time Is Different. The U.S. fiscal imbalance—the excess of what we expect to spend, including repayment of our debt, over what government expects to receive in revenue—is large and growing.
Evsey Domar introduced “The Burden of Debt” in 1944 by expressing everything as a percentage of GDP. While his approach was first order differential equations, our present value approach done properly is easier to follow and perhaps more policy relevant. But let’s be clear – Domar was trying to figure out how high tax rates needed to be to cover past fiscal decisions captured in the debt/GDP plus the present value of expected future government spending. We will return to the policy implications of this shortly. Back to Cochrane’s ranting:
The US fiscal situation is dire. The debt is now $20 trillion, larger as a fraction of GDP than any time since the end of WWII. Moreover, the promises our government has made to social security, medicare, medicaid, pensions and other entitlement programs far exceeds any projection of revenue.
Could he have admitted that nominal GDP now is about twice that of the circa $10 billion per year level in 2000? Back then the debt to GDP ratio was 54% while it is 104% now. Back then the nominal interest cost was 3.5% of GDP which is the same ratio as it is now. Yes the debt ratio has almost doubled but we see both lower inflation rates as well as lower real interest rate. One the things that might puzzle you is how Cochrane paints 2000 as a period of large primary surpluses whereas Miron suggests it was a period of fiscal imbalance. This is where forecasting comes in as it might be naïve to assume that the current levels of g and t are good means for forecasting the future. But before we get into the forecasting which involves politics, let’s talk a bit about r and n by going back and poking a little fun at DOW 36000:
Imagine the whole U.S. corporate sector as if it were a single company. And imagine that this company – and the economy – will grow steadily forever, say at 5 percent nominal (3 percent real plus 2 percent inflation). Suppose also that the interest rate is 6 percent. What is this company worth? The answer should be that it is worth 100 times dividends.
Krugman was assuming real growth = 3% and a real interest rate = 4% back in 2000. Sounds about right for then but I would lower both of these by 1% for today. In either case, the present value of a primary surplus would be 100 times the current surplus in a steady state model. In other words, we would have needed a primary surplus equal to 0.55% of GDP back then but now we would need a primary surplus equal to 1.05% of GDP now. Permit me to quibble a bit with Miron’s assumptions:
I create projections for real GDP, starting in 1965 and going forward as far as necessary. Those projections are calculated by taking actual real GDP in 1965, followed by 2.55 percent growth every year thereafter….All present values assume a real interest rate of 3.22 percent, which equals the average real interest rate on 30-year long-term government bonds in the United States over the past four decades.
Historical averages do not strike me as a reasonable approach to forecasting future long-term growth or interest rates. But this is just a quibble as we are not that far off in terms of our denominator (r – g) so let’s focus on the numerator that is expected cash flows. As I noted:
In 2017, g was 19.5% and t was 18.5% so maybe we should be more concerned especially since we have had another tax cut for the rich as well as a call for a larger defense budget.
Back in 2000 government spending including interest rates was only 19.5% so government spending excluding interest rates excluding interest rates was only 16%. Government revenues exceeded 20% of GDP. If these ratios were expected to continue forever, then one might get Alan Greenspan’s concern that we might pay off the national debt very quickly. Of course we did not and Miron suggests we should have known that government spending would rise over time. Glassman and Hassett’s glaring error in many ways was to have a very stupid model of expected cash flows as they pretended cash flows equal profits even as a firm has to invest some of its profits for new capital in a growing economy. And to think Hassett is now heads the CEA! Miron may be better at forecasting but we need to think about the politics of what he is arguing:
As of 2014, the fiscal imbalance stands at $117.9 trillion, with few signs of future improvement even if GDP growth accelerates or tax revenues increase relative to historic norms. Thus the only viable way to restore fiscal balance is to scale back mandatory spending policies, particularly on large health care programs such as Medicare, Medicaid, and the Affordable Care Act (ACA)… Despite widespread agreement that spending or tax policies must change, however, appropriate adjustments have so far not occurred. Indeed, many recent policy changes have worsened the U.S. fiscal situation. These changes include the creation of Medicare Part D ($65 billion in 2014), new subsidies under the Affordable Care Act ($13.7 billion in 2014), the expansion of Medicaid under the ACA (from $250.9 billion in 2009 to $301.5 billion in 2014), higher defense spending (from $348.46 billion in 2002 to $603.46 billion in 2014), increased spending on veterans’ benefits and services (from $70.4 billion in 2006 to $161.2 billion in 2014), and greater spending on energy programs (average annual spending was $0.52 billion over 1998–2002 but $11.43 billion over 2010–2014).
I’m not a big fan of using terms like mandatory versus discretionary spending preferring to look at defense purchases, nondefense purchases, Social Security payments, and health care benefits. Miron’s figure 9 shows Social Security benefits have risen to 5% of GDP but we knew this would happen back in 1983 when Greenspan chaired Reagan’s Social Security reform commission which led to a large increase in the payroll tax to prefund the Social Security Trust Fund. I guess Greenspan in 2001 had forgotten the notion to “think about the future” that so ably guided him in 1983. Paul Ryan and President Trump at times tells us that they do not want to take away the Social Security benefits that my generation has been paying for since we entered the workforce. Miron also notes:
Defense spending averaged 8.4 percent of GDP in the 1960s, 5.6 percent in the 1970s, 5.6 percent in the 1980s, 3.8 percent in the 1990s, 3.7 percent in the 2000s, and 4.2 percent in the past four years.
While the defense spending/GDP ratio fell below 4% at the end of Obama’s second term, Mitt Romney promised to keep at above 4% had he and Paul Ryan been elected in 2012. Which is odd since Ryan told us that total Federal purchases (defense and nondefense) would be limited to only 3.5% of GDP. President Trump has promised a large increase in defense spending so let’s get more realistic about nondefense purchases than the Ryan promise to run the rest of the Federal government on a budget of negative 0.5% of GDP. Nondefense purchases rose from 2.34% of GDP in 2000 to 3% of GDP in 2011 before falling back to 2.66% of GDP in 2017. While it is true that Trump wants to cut this ratio a bit, he has also promised to fixed the underinvestment in infrastructure . William Galston is not impressed with the Trump proposal:
But there is a void at the core of the administration’s plan: funding. Not only does the administration not specify where it will find the additional $200 billion of direct spending it calls for over the next decade, but also it makes what most experts regard as wildly unrealistic assumptions about the amount of state, local, and private funding this modest increment will spark. Although the word “leverage” is sprinkled liberally throughout the plan, hardly anyone believes that $200 billion federal dollars will produce an additional $1.3 trillion investment from non-federal sources, especially when state and local budgets are being squeezed by rising costs for education and health care.
Privatizing our toll roads was one fiscal trick used by certain states but that turned out to make their long-term financing worse, while their roads will likely be poorly maintained. States could pick up the tab if state taxes are raised in lieu of higher Federal taxes. Or are conservatives saying we should cut education spending as well as police protection? Speaking of healthcare, let’s return to Miron:
even projections that incorporate less rapid health care cost inflation still show Medicare and other health care expenditure growing faster than GDP by enough to make fiscal imbalance large…the main drivers of America’s fiscal deterioration appear to be the ever-growing costs associated with Medicare, Medicaid, and other health programs. Whereas Social Security has accounted for a relatively constant share of expenditure in proportion to GDP, Medicare and Medicaid costs have been growing as a ratio of GDP for the past four decades. This growth is what makes the country’s fiscal path unsustainable.
Most of federal and state budgets are spent on services — law enforcement, education, health care, the courts, and so forth — that are subject to Baumol’s cost disease. Government spending on these categories has grown inexorably in recent decades, and many conservatives see this as a sign that there’s something badly wrong with how the government provides these services. But Baumol’s work suggests another explanation: It was simply inevitable that these services would get more expensive over time, at least relative to private sector manufactured goods like televisions and cars. The rising cost of services is an unavoidable side effect of rising affluence generally. There’s probably no way to maintain our current standard of living while cutting the cost of these services back to the levels of the 1950s.
During the 2012 campaign both Obama and Paul Ryan had plans to reign in the growth of Medicare spending with Ryan wanting to cut benefits to people leaving the obscene profits of the providers untouched as opposed to Obama wanting to expand benefits but reigning in this market power. But let’s be clear – we will spend as a nation more on health care as a share of GDP. The policy question is who pays for it. Ryan’s proposals on Medicaid are akin to Trump’s on infrastructure – force this burden on state governments and if they do not choose to raise their taxes, let the private sector pick up the slack. On both issues, the private sector does a poor job of providing services equitably. If we want an honest debate on fiscal policy these discussions from Cochrane and Miron fall miserably short in their arbitrary rejection of the possibility that we cannot raise taxes as a share of GDP. Let’s add that if the fiscal situation was so dire – why were conservative economists so eager to reduce taxes on the rich? And do not peddle that Laffer canard that reducing the national savings rate will lead to some growth miracle.