Shedding Light on the Deficit Problem

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With a growing chorus of support for the establishment of an independent budget commission, I thought it wise to weigh in. But before we get to the budget commission itself, let’s first discuss the underlying policy issue: deficits.
 
The deficit problem is not the result of the recovery act, the financial bailout, earmarks, or pretty much anything else conservatives are trying to scapegoat. Short-term deficits are the result of the economic recession, and long-term deficits are the result of private health care cost growth. Thus, the solutions to the deficit problem are policies that promote economic growth and comprehensive health care reform.
 
Confused? OK, let’s back up. The deficit problem should actually be understood as two separate problems: high short-term deficits and persistent long-term deficits. The difference is simple: short-term deficits are the deficits we face today and expect to face for the near-term (there is no official definition of “near-term,” but let’s say five years). Long-term deficits, on the other hand, are those we are projected to face for the next several decades—the Congressional Budget Office even makes 75-year extended baseline projections.
 
The drivers of these two deficit problems are completely different. Short-term deficits are highly responsive to the business cycle—that is, the boom-bust pattern of the economy  A healthy economy causes the deficit to shrink because high profits, incomes, and spending fuel higher tax revenues. And as unemployment falls, fewer people are reliant on the social safety net, so federal spending falls. An unhealthy economy, on the other hand, depresses tax revenues and raises the cost of the social safety net because more people are now dependent on it. In other words, the deficit in any given year is to a large extent determined by whether the economy is healthy or unhealthy.
 
We are, of course, in the worst economic recession since the Great Depression, and this has driven our current-year deficit to unprecedented levels. But this won’t last forever—after all, the economy will recover at some point, and the faster it does, the sooner the deficit will shrink to a manageable size. Much-maligned policies such as the Recovery Act (stimulus) and the financial bailout have played a vital role in averting an even larger recession that would have inflicted much more damage on the federal balance sheets. In other words, total deficits for the next few decades or so likely would have been higher without the recovery act and financial bailout.
 
So in the short term, the most important deficit-fighting tool is economic recovery, which is why we need more policies that promote job creation and investment. These policies often cost money in the short term, but as the economy recovers they more than pay for themselves.
 
The long-term deficits, on the other hand, are structural rather than cyclical, meaning that it is a problem independent of the boom-bust cycle and thus a lot more difficult to eliminate. Figure A shows the long run 70-year deficit projection, and it’s pretty grim: total spending rises from about 22 percent of the economy to 44 percent, while revenues rise from about 18 percent of the economy (2007, before the recession) to 26 percent. 
 

 
But unfortunately, this graph isn’t very informative—after all, what causes spending to skyrocket?
 
Figure B shows long-run federal spending projections.  As you can see, all spending except Social Security, Medicare and Medicaid remains flat. Social Security—despite all the hoopla that the baby boomers will bankrupt us—increases only slightly, from about 4.8 percent of GDP now to a little more than 6 percent in 2031. It then hovers between 5.7 percent and 6.1 percent of GDP through 2080. Not exactly the scary boogeyman the media portrayed it to be, is it?
 

  
No, the real drivers of long-term spending growth are (1) health care, which rises from 5 percent of GDP to 18 percent in the next 70 years; and (2) the interest payments necessary to finance that additional health care spending.
 
But what causes this health care spending growth?
 
Figure C looks at what drives federal spending growth for entitlements (including not just Medicare and Medicaid but also Social Security, which we’ve established is only a small piece of the puzzle). Aging does play a role, driving entitlement spending from 10 percent currently to about 14 percent in 2080.  But as the graph indicates, once it hits 13 percent in 2038, spending becomes more or less flat.
 

 
The primary driver of long-term entitlement spending is the excess cost growth of health care itself—that is, how much the health care industry charges for services. Remember, most of this spending is on coverage, while the health care services are nearly always privately provided (military veterans provide the exception to this). So as the cost of private health care services grows by about 6 to 9 percent each year—well in excess of economic growth—the federal government’s spending grows as well.
 
Couldn’t we just cut Medicare and Medicaid benefits? While it is true this would improve the long-term deficit outlook, the country would still be left with a situation where health care costs are rapidly growing. By 2080, they are projected to consume nearly 50 percent of the economy. By draining resources from other parts of the economy, these rising health care costs would severely depress economic growth, which would then lead to higher deficits anyway! In fact, data suggests that the government actually does a better job of keeping health care costs down (private health care costs grow faster than those under Medicare and Medicaid), so pulling the federal government out of the insurance market might actually cause health care costs to rise even faster. In the end, rising health care costs must be dealt with head-on with comprehensive health care reform.
 
Economic recovery and health care reform… the only path to true fiscal responsibility. Next week: Why the budget commission is set up to fail.  Stay tuned!
 
If you found this piece on the deficit problem informative, take a look at this post on the flat tax.
 
(Photo from Flickr by B,K & G; C.C. 2.0)