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The End of Peter Pan Fiscal Policy
How to think about America's budget problems.


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The bond vigilantes have pulverized Greece, and New York University economist Nouriel Roubini (a.k.a. “Dr. Doom”) is warning that they may eventually target the United States. Southern Europe’s riot-torn basket case has come to epitomize a nightmare scenario of budgetary meltdown triggered by unsustainable government spending. To be sure, Greece has also been hobbled by cultural factors — widespread corruption, tax evasion, extremely low birth rates — and we should be wary of drawing superficial comparisons between countries. But the Greek crisis does highlight an inescapable truth about America’s public finances: At some point, the era of Peter Pan fiscal policy will have to end.

Crunch time may arrive sooner than previously expected. The Congressional Budget Office (CBO) estimates that under President Obama’s 2011 fiscal blueprint, net interest payments on the national debt would represent 18.7 percent of total federal tax revenues in 2018. As Investor’s Business Daily reports, this level of debt service would push the U.S. toward “
the outer limit of AAA-territory” established by Moody’s, the credit-rating giant. For that matter, “under more adverse scenarios than the CBO considered, including higher interest rates, Moody’s projects that debt service could hit 22.4 percent of revenue by 2013.” Obama’s budget would increase the relative size of publicly held federal debt from 63.2 percent of GDP in 2010 to 90 percent of GDP in 2020, reckons the CBO. Ninety percent is the threshold above which public debt is “associated with notably lower growth outcomes,” according to economists Carmen Reinhart of the University of Maryland and Kenneth Rogoff of Harvard.

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America’s public-debt-to-GDP ratio is already higher than it has been since the 1950s. Writing in National Affairs, economist Donald Marron, who served as acting CBO director and a White House economic adviser under Pres. George W. Bush, says the most immediate objective of U.S. fiscal policy should be to stop that ratio from rising. He stresses that this would not require balancing the federal budget; indeed, it would be possible to run moderate deficits while simultaneously trimming the debt-to-GDP ratio, provided the economy was expanding at a fast enough pace.

Think of it this way: To maintain a constant debt-to-GDP ratio, we would have to maintain an identical deficit-to-growth ratio. For example, writes Marron, if we had a debt-to-GDP ratio of 60 percent and a deficit equal to 3 percent of GDP, then nominal GDP growth (that is, real growth plus inflation) would have to reach 5 percent in order to keep the ratio from increasing. The fact that such a humble aim — holding the debt-to-GDP ratio steady — seems so quixotic in the short run indicates the severity of America’s fiscal plight. Marron, who is now director of the Urban-Brookings Tax Policy Center, believes a practical, attainable medium-term goal should be to reduce the ratio to 60 percent by 2020. But over the long haul, he adds, even 60 percent would be unacceptably steep. From the mid–20th century through the early 2000s — until the Wall Street panic — the average ratio was roughly 40 percent.

Given the magnitude of our budget problems, it is unrealistic to think that tax hikes alone, or spending cuts alone, or economic growth alone, would be sufficient to fix them. Let’s say that real annual GDP growth averaged 3.8 percent over ten years. That hasn’t happened since the 1960s and 1970s, Marron reminds us, and it is very unlikely to happen in the decade ahead — but even with that level of growth, the federal government would still see only modest deficit reduction without serious fiscal reforms.

No, we don’t have a “silver bullet,” but we do have empirical evidence to guide our policy decisions. Marron cites a paper by Harvard economists
Alberto Alesina and Silvia Ardagna, who studied OECD data from 1970 to 2007 and concluded that “spending cuts are much more effective than tax increases in stabilizing the debt and avoiding economic downturns.”


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