Will It Take a Crisis to Fix Fiscal Policy?

Abstract

Unless current policies are reformed, the national debt will continue to grow relative to GDP until a sovereign debt crisis, like those in Ireland and Greece, is inevitable. Although the nation is becoming more concerned about spiraling debt and a presidential fiscal commission and other groups have suggested reforms, the president and congressional leaders have been unwilling to recommend specific policy reforms. Consequently, it is becoming more and more likely that policymakers will not undertake necessary reforms until a financial crisis forces their hand. (This paper will appear in the April 2011 issue of Business Economics.)

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The Size of the Problem

It is not a pretty picture. Unless U.S. fiscal policy is changed dramatically, the national debt will grow at an increasing rate and far outpace economic growth. Using a reasonable definition of current policy, the Congressional Budget Office (CBO 2010) projects that the national debt in the hands of the public will reach 185 percent of the gross domestic product (GDP) by 2035. Of course, those buying our debt will likely go on strike long before we reach that point.

The arithmetic underlying CBO's projection is extremely simple. Two program areas—Social Security and health—will be responsible for about 50 percent of total federal spending once the stimulus program of 2009 phases out. Spending in both areas is rising faster than GDP and faster than tax revenues. Tax revenues, on the other hand, have been remarkably constant historically, varying between 17 and 19 percent of GDP for all but 11 of the past 50 years. If programs other than Social Security and health and the tax burden remain roughly constant relative to GDP, the deficit and the national debt will grow rapidly. Eventually, the interest cost of the debt begins to dominate the budget and ultimately the system explodes.

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