The Time-Bomb Keeps Ticking

The Wall Street Journal recently carried an essay by David Wessel, author of the forthcoming book, “Red Ink: Inside the High-Stakes Politics of the Federal Budget”. It provides an excellent breakdown of the budget crisis looming over the federal government.

Perhaps the most striking fact contained in the essay is that 63 percent of the budget is on auto-pilot: “Social Security benefits get deposited. Health-care bills for Medicare for the elderly and Medicaid for the poor are paid. Food stamps are issued. Farm-subsidy checks are written. Interest payments are dutifully made to holders of Treasury bonds.” In technical jargon, this is non-discretionary spending – unless Congress actively stops it, such spending continues every year without the need for any further authorization. Throw in an ageing population and inexorably rising healthcare costs, and it becomes clear that such spending is only heading in one direction – skywards.

What is most worrying is that the federal government currently only funds 66 percent of its spending through taxes. For the rest, it has to borrow. And while that may be bearable in the short-term, as nervous investors around the world pile into US Treasuries and push bond yields to record lows, it spells big trouble in the medium- to long-term. Every cent the government borrows now means more debt interest payments – and even more non-discretionary spending – in the future.

For an idea of just how bad it could get, take a look at this 2010 working paper from the Bank of International Settlements. Its projections indicate that without a policy shift, US public debt would rise to more than 400 percent of GDP by 2040. That would translate into annual debt interest payments equaling 23 percent of GDP – well in excess of total federal tax revenues, which have averaged a little over 18 percent of GDP since the Second World War. Such a scenario is plainly impossible: the US would be forced to default on its obligations long before things reached that point.

The policy implication here is straightforward enough: non-discretionary spending programs like Social Security, Medicare and Medicaid need urgent, drastic reform to put them on a more sustainable footing. The problem is politics: neither party is really serious about dealing with this fiscal time-bomb. Politicians’ electorally-driven time horizons are just too short to permit the sort of significant, structural changes that are required. Perhaps a rise in Treasury yields will force the issue. Maybe another showdown over the debt ceiling will do the trick. But I won’t be holding my breath. As the Austrian economist Detlev Schlichter puts it, when it comes to debt, governments around the world are determined to “extend and pretend”. Sadly, it is only a matter of time before reality catches up with them.