Fannie Mae and Freddie Mac are paying back their subsidies but have not established adequate reserves against likely losses. The Federal Housing Administration faces rising losses and bad debts. Even the Postal Service is still losing money.
Moreover, the entitlement tsunami — Social Security, Medicare, Medicaid and now health insurance subsidies — will not have fully developed by 2023. As a result, warned CBO, without substantial policy changes “debt will rise sharply relative to GDP after 2023.”
Put everything together and economist Laurence Kotlikoff figures that unfunded federal liabilities currently exceed $220 trillion.
There’s more. Because federal debt crowds out private investment, CBO figures every additional dollar of government debt reduces national saving by 57 cents. As a result, the baseline scenario would see a GDP drop of 4% or more by 2038. Under the alternative scenario the reduction would be 7%, or perhaps more.
Unfortunately, additional negative feedbacks would be many. Said CBO: “Lower output implies less income and, thus, less tax revenues.” Higher interest rates would hike federal debt payments. Uncle Sam would have to raise taxes or borrow ever more.
Under the alternative scenario the official (exclusive of Social Security‐Treasury transfers) debt‐to‐GDP ratio would run around 190% by 2038, greater than Greece at its worst.
In a paper for the U.S. Monetary Policy Forum earlier this year, economists David Greenlaw, James D. Hamilton, Peter Hooper and Frederick S. Mishkin posited one scenario under which “The debt/GDP ratio would rise much more rapidly, hitting 304 % of GDP by 2037.”
Moreover, explained CBO, “Growing federal debt would increase the probability of a fiscal crisis, when investors would lose confidence in the government’s ability to manage the budget, and the government would thereby lose its ability to borrow at affordable rates.”
Based on international experience, David Greenlaw and his colleagues warned that “countries with high debt loads are vulnerable to an adverse feedback loop in which doubts by lenders lead to higher sovereign interest rates which in turn make the debt problems more severe.”
The economists concluded “that countries with debt above 80% of GDP and persistent current‐account deficits are vulnerable to a rapid fiscal deterioration as a result of these tipping‐point dynamics.”
In that case, federal liabilities likely would explode, as in the 2008 financial crisis. CBO pointed to the impact of manifold credit and insurance programs, as well as implicit promises: “In the event of a financial crisis, for example, federal policymakers may decide to provide monetary support to the financial system, as they did during the recent financial crisis.”
The feedback loop would continue to worsen. Noted Greenlaw et al., “If U.S. government finances are not put on a sustainable path, … then the public might expect the Federal Reserve to be forced to monetize this debt. What would then unhinge inflation expectations would be the fear of fiscal dominance, which could then drive up inflation quickly.”
Amazingly, noted Greenlaw et al., “As recently as the 1990s, the United States government was running budget surpluses and there was serious discussion of what would happen if the federal government was able to retire its debt.” That world is long gone, probably forever.
Still, Washington is celebrating Good News! For the first time in five years, the annual federal deficit has dropped below $1 trillion.
Alas, the cheery interlude will be brief. Soon the red ink again will be growing, and the more government spends and taxes, the worse will be the economic impact. No wonder CBO warned of “the unsustainable nature of the federal government’s current tax and spending policies.”
Washington only faces “difficult choices.” America’s political leaders should be choosing among them instead of passing another dishonest feel‐good budget agreement.