How Governments Hide Their Liabilities

In my testimony to the Senate Budget Committee the other day, I recommended that Congress set specific fiscal targets for bringing our out-of-control deficits and debt under control. My particular suggestion? Get the publicly-held debt down to 60% of GDP in 2020.

By budgeting  standards, that makes for a great bumper sticker: “60 in 20“.

But as the New York Times points out in two articles today, a measurable target isn’t enough. You also need to make sure that the government doesn’t game the accounting to hide its liabilities.

Exhibit A is Greece. The story was originally broken by Der Spiegel earlier in the week, and is described in the NYT by Louise Story, Landon Thomas Jr., and Nelson D. Schwartz in “Wall St. Helped Greece to Mask Debt Fueling Europe’s Crisis“:

As worries over Greece rattle world markets, records and interviews show that with Wall Street’s help, the nation engaged in a decade-long effort to skirt European debt limits. One deal created by Goldman Sachs helped obscure billions in debt from the budget overseers in Brussels. …

Instruments developed by Goldman Sachs, JPMorgan Chase and a wide range of other banks enabled politicians to mask additional borrowing in Greece, Italy and possibly elsewhere.

In dozens of deals across the Continent, banks provided cash upfront in return for government payments in the future, with those liabilities then left off the books. Greece, for example, traded away the rights to airport fees and lottery proceeds in years to come.

Critics say that such deals, because they are not recorded as loans, mislead investors and regulators about the depth of a country’s liabilities.

The winning quote:

“Politicians want to pass the ball forward, and if a banker can show them a way to pass a problem to the future, they will fall for it,” said Gikas A. Hardouvelis, an economist and former government official who helped write a recent report on Greece’s accounting policies.

Exhibit B are all the contingent liabilities of the United States government, of which Fannie Mae and Freddie Mac have been the most prominent (and expensive). In “Future Bailouts of America,” Gretchen Morgenson interviews budget expert Marvin Phaup (now at George Washington University and previously a colleague of mine at the Congressional Budget Office). She writes:

“If we are extending the safety net, extending the implied guarantee to the debts of a lot of other financial institutions, and we know those guarantees are valuable and costly, then we ought to start budgeting for it,” Mr. Phaup sad in an interview. “We can’t reduce the costs of these subsidies if we can’t recognize them.” …

As the number of firms with implicit government backing has risen because of the crisis, so too have the expected costs of those commitments, Mr. Phaup said. And yet, under current budget policy, those costs will be ignored until the recipient of the guarantee collapses — the precise moment when the guarantee is likely to cost taxpayers the most.

If we are going to set an explicit target for the publicly-held debt–60 in 20!–, we need to think carefully about what politicians may strategically omit from the calculation of the 60.


Crisis and Aftermath: The Economy and the Budget

Most of official Washington was closed today in the wake of Snowmageddon. But not the Senate Budget Committee, which went ahead as planned with its hearing “Crisis and Aftermath: The Economic Outlook and Risks for the Federal Budget and Debt.

The three witnesses were Carmen Reinhart of the University of Maryland (famous for her work with Ken Rogoff on the history of financial crises), Simon Johnson of MIT (famous for his blog, The Baseline Scenario), and yours truly.

You can find my written testimony here. You can watch the hearing from a link on the website.

The gist of my message was:

Our nation is on an unsustainable fiscal path. If current policies continue, we will run trillion-dollar deficits in the years ahead—even after the economy recovers—and the public debt will rise faster than our ability to pay it. Persistent deficits and rising debt will undermine American prosperity, threaten beneficial social programs, and weaken our position in the world.

Those threats deserve immediate attention but our economy remains fragile. Payroll employment has fallen by 8.4 million jobs since the start of the recession, and long-term unemployment is at record levels. Recent data have provided some glimmers of hope—strong GDP in the fourth quarter and a decline in the unemployment rate in January—but our economy has a very long way to go.

Policymakers thus face a difficult challenge of balancing concern about current economic conditions with a meaningful response to our looming fiscal crisis. In thinking about that balance, they should keep five points in mind:

1. Don’t expect a rapid recovery. The recession does appear to be behind us, but the economy has much healing ahead of it.

2. Uncertainty has been holding the economy back. Uncertainty discourages investment and hiring and therefore undermines growth. The good news is that economic uncertainty has declined sharply over the past year, creating an environment more conducive to growth. The bad news, however, is that policy uncertainties are enormous. From expiring tax provisions, to uncertainty about the rules-of-the-road in the financial sector, to major policy initiatives on health insurance, climate change, etc., businesses and families are uncertain about the future policy environment. That discourages investment and hiring. Some of these uncertainties are unavoidable as Congress deals with important issues. But lawmakers should look for opportunities to reduce unnecessary policy uncertainty.

3. Persistent deficits and rising debts pose a serious risk to long-term economic growth. Concerns about the near-term economic outlook should not deter Congress from taking steps to strengthen our fiscal position over the next decade. Although major steps toward fiscal consolidation should not take effect in 2010 and 2011, Congress should begin to plan now for deficit reduction and debt stabilization in later years. That plan should include clear goals (e.g., a target trajectory for the debt-to-GDP ratio) and credible means for achieving them. President Obama outlined some steps in this direction in his budget, but I believe they fall far short of what is required. Under his official budget the debt would grow faster than the economy in every single year. That’s unacceptable.

The President has proposed that a fiscal commission be tasked with stabilizing the debt-to-GDP in 2015 and beyond. That proposal is worth serious consideration. However, I believe any commission should have a more ambitious goal–e.g., reducing the debt-to-GDP ratio to 60% by the end of the budget window. In addition, I wonder whether a commission created by executive order will have sufficient political legitimacy and power to have much effect.

4. A credible plan to reduce future deficits would help keep long-term interest rates low, thus strengthening the current recovery.

5. In the long-term, bringing our deficits under control will require both spending restraint and increased revenues. Spending restraint should receive greater emphasis both because spending is the primary driver of our long-run budget imbalances and because higher government spending may slow economic growth. Given the government’s existing commitments, however, it is unlikely that spending restraint alone can put our nation on a sustainable fiscal trajectory. As policymakers consider how to finance a larger government, they should therefore give special attention to making our tax system more efficient. That means thinking about ways to tax consumption rather than income, ways to broaden the tax base rather than increase rates, and, ways to tax undesirable things like pollution rather than desirable things like working, saving, and investing.

The Problem with Tax Expenditures

Last week, Len Burman published a provocative op-ed suggesting that President’s Obama idea of freezing non-security discretionary spending amounts to “chump change” and that if he wants to make real budget improvements the President should propose to freeze tax expenditures (i.e., all the various preferences in our famously complex tax code). By Len’s calculations, such a freeze would increase tax revenues by $3.5 trillion over the budget window, 14 times as much as the $250 billion in spending reductions from the narrow spending freeze.

Over at the National Journal, John Maggs interviewed Len about his proposal and then asked various experts for their reactions.  Here’s what I wrote:

Len is right to focus attention on tax expenditures. They involve big money, distort our conception of the size of government, often disproportionately favor the affluent, and receive too little oversight.

He’s also right that they deserve special attention when Congress decides that it wants to increase tax revenues. As Len says in the interview: “Cutting tax expenditures is a much better way to do this than raising marginal tax rates since the former tends to improve economic efficiency by reducing economic distortions — for example, among different kinds of investments — while the latter increases the economic cost of taxation.”

Of course, there are some complications. In addition to the obvious political challenges, tax expenditure cutters face another problem: agreeing on what provisions should actually be characterized as tax expenditures. One could, of course, just use whatever definitions the Treasury and the Joint Committee on Taxation use. But analysts do not agree on which provisions are really spending programs in disguise.

Some cases are easy. Tax credits for using ethanol-blended motor fuels are clearly spending programs run through the tax code. But then there are items like the 15% tax rate on capital gains and dividends. That rate is scored as a tax expenditure in the current system because 15% is lower than the rates on ordinary income. It wouldn’t be viewed as a tax expenditure, however, by analysts who believe that a consumption tax, rather than an income tax, should be the lodestar for judging tax policies. My point is not to take sides on that issue, but just to point out that there is sincere debate about which items labeled as tax expenditures should be viewed as hidden spending programs and which as good tax policy.

In response to one question, Len raises the idea of subjecting all tax expenditures to annual reauthorization as one way to rein them in. I appreciate the desire for greater oversight, but I find this idea worrisome. We are already cursed with a tax system in which an enormous number of provisions are scheduled to expire. That creates needless uncertainty, placing a real burden on businesses and families and often undermining the very intent of the tax provisions. As a case in point, consider the research and experimentation tax credit, which Congress extends every year or two. That’s absurd. If the credit is good policy, it should be enacted on a permanent (or, at least, prolonged) basis so that it provides a clear signal to firms that engage in R&E. Conversely, if it’s bad policy, we should kill it. Revisiting it every year will just enrich lobbyists, distract legislators from more important issues, and weaken any incentives it might create.

I expect that the same holds true for many other tax expenditures. Some deserve to be enacted for prolonged periods to accomplish their goals. Some deserve annual review. And many deserve to be killed.

The Debt Limit is a Tax on the Majority

Today the Senate voted 60-39 to increase the federal debt limit from $12.4 trillion to $14.3 trillion. No one is happy that we need to borrow another $1.9 trillion in the next year or two, but the alternative–default–is unthinkable. So let’s hope that the House follows suit when it votes next week.

As expected, today’s vote was entirely party line: 60 Democrats (including the two Independents who caucus with them) voted yea, while 39 Republicans voted nay; one R didn’t vote.

You might be tempted to look at these results and try to read into them some larger ideas about fiscal politics. Perhaps Democrats all voted to increase the debt limit because they are big spenders? Perhaps Republicans will recklessly risk default in their anti-government zeal?

I will leave to you, dear reader, to decide whether such claims have any merit. But please understand that the debt limit vote tells us absolutely nothing about them.

With rare exceptions, votes to increase the debt limit do not involve any real substance. Defaulting remains unthinkable, so the debt limit has to go up. The horse-trading before the final vote may have plenty of substance–this round included a welcome amendment bringing back statutory PAYGO rules as well as an almost-successful effort to create a budget commission–but the final vote is pure politics. The Senate has to deliver a debt limit increase. And that means that the Senate majority has to deliver the votes.

As a matter of politics, then, debt limit votes are a tax on the majority. The majority has to take the hit for increasing the limit, while the minority gets a free ride.

To test this view, I looked at Senate votes on the last five stand-alone increases in the debt limit (three other increases were part of the housing, TARP, and stimulus bills that passed in 2008 and 2009). The chart above shows the fraction of senators in each party who voted to increase the limit.

The results are striking: Back in 2004 and 2006, the Republicans (in red, but do I really need to say that?) controlled the Senate and thus bore the political tax of increasing the debt limit. In those two votes, the Rs accounted for 102 of 104 yeas. In 2009 and 2010, the situation was reversed, as the majority Democrats (yes, in blue) bore the political burden. In those two votes, the Ds (including the Is) accounted for 119 of 120 yeas.

And then there’s 2007, when the two parties shared the burden of boosting the debt ceiling. What explains that rare outburst of bipartisanship? Divided government. In 2007, President Bush had to work with a Democratic Congress to get the debt limit passed. With divided government, the pain had to be shared. In the other four years, however, the President was the same party as the Senate majority.

Bottom line: Sometimes it hurts to be in charge.

For a good summary of past debt limit increases, see this CRS report. For information on Senate votes, start here.

Wondering who the three aisle-crossers were? In 2004, Democrats John Breaux and Zell Miller voted yea. In 2009, Republican George Voinovich voted yea.

Deficits As Far as the Eye Can See

Today the Congressional Budget Office released its much-anticipated projections for the budget. As usual, the headline figure is CBO’s estimate of the budget deficit, now projected to be $1.35 trillion for the fiscal year, about 9.2% of GDP.

That’s slightly better than last year–when $1.4 trillion deficits amounted to 9.9% of GDP–but is still the second-worst since World War II. And, as CBO notes, new legislation could easily lift the 2010 figure higher. For example, Congress will likely consider further extensions to unemployment benefits and more war spending, not to mention a possible jobs bill.

CBO also projected deficits for the next decade. They are large and persistent:

The blue line shows CBO’s official budget baseline. That baseline shows persistent deficits over the next decade. They fall below 3% of GDP by 2014 and then increase somewhat in later years. I would characterize that trajectory as unwelcome but not a crisis.

It’s also completely unrealistic given Washington’s current policy predilections.

The official baseline is built upon two key assumptions: that existing laws execute exactly as written and that discretionary spending increases with inflation in future years. Those assumptions make sense for constructing a baseline that will be used to score the budget impacts of new legislation. But, as CBO itself notes, they are unrealistic if your goal to make predictions of where current policy is leading:

  • Under current tax law, a remarkable number of tax reductions will expire in the near future. These include the 2001 and 2003 tax cuts (EGTRRA and JGTRRA, often known as the Bush tax cuts), the annual patch to the dreaded alternative minimum tax (which prevent the AMT from hitting more and more families), the Making Work Pay tax credit (enacted as part of the stimulus), expanded net operating loss carrybacks (enacted as part of another, smaller stimulus bill in the summer), and a panoply of other, smaller provisions (e.g., the research and experimentation tax credit). It is unthinkable that Washington will allow all these to expire.
  • In recent years, discretionary spending has grown faster than inflation. As yet, there is no reason to believe that will stop.
  • On the other hand, the current baseline assumes that spending on the wars in Afghanistan and Iraq will continue at their 2009 pace, adjusted for inflation, over the next decade. One hopes that assumption is unrealistically high.

To help outside analysts construct alternative baselines that better show existing policy, rather than existing law, CBO provides estimates for several policy alternatives. Analysts differ on which of these alternatives they use to build a policy alternative (and, given more time, they may also use other estimates).

As rough justice I made the following assumptions for the chart above: (1) that regular discretionary spending grows at the same pace as nominal GDP in coming years (closer to recent history than the baseline assumption of growth with inflation), (2) that spending on the wars in Iraq and Afghanistan moderates somewhat in coming years (CBO’s 60,000 troop scenario), (3) that the 2001 and 2003 tax cuts are permanently extended, and (4) that the AMT is indexed for inflation.

Under these assumptions, the budget picture is much scarier: deficits never get lower than 5.5% of GDP and they are 7.5% by 2020.

Bottom line: Current policy is unsustainable.

Note: You should view my adjusted baseline as a quick-and-dirty, back-of-the-envelope of existing policy. For example, it doesn’t include any adjustments for other expiring tax provisions (which are substantial) or the infamous Medicare doctor payment problem; if you made adjustments for those, the deficit outlook would look worse. On the other hand, many political leaders, including President Obama, want to scale back the 2001 and 2003 tax cuts; if you did that, the deficit outlook would look better.

Joining the “Announcement Effect Club”

Inspired by the popularity of Greg Mankiw’s Pigou Club, which favors using taxes (or auctioned permits) to address pollution problems, the Committee for a Responsible Federal Budget has created its own: the “Announcement Effect Club.”

To become a member, you need to endorse the idea that it would help the U.S. economy if our elected leaders could develop a credible plan to bring our deficits and skyrocketing debt under control. In CRFB’s phrasing:

While aggressive debt reduction in the short term might imperil the fragile recovery, the announcement of future deficit reduction can actually strengthen it.

I’m happy to be a member (based on this post last October).

Key Readings on America’s Fiscal Plight

It remains to be seen whether our elected leaders have much enthusiasm for dealing with America’s troubling fiscal trajectory. But the policy commentariat has embraced the issue with relish.

If you have a few hours (or days) to ponder these issues, let me recommend the following:

  • Train Wreck: A Conference on America’s Looming Fiscal Crisis, held last Friday at the USC Law School. Conference papers addressed a host of issues, including the need to pay attention to tax expenditures, the burden of state pensions, the potential for catastrophic budget failure, and the arithmetic impossibility of solving our budget woes by raising income taxes on the highest earners. I had an unusual role in the conference, presenting a paper by Joyce Manchester and Jonathan Schwabish of the Congressional Budget Office about the role of health spending in our long-term budget challenges. I didn’t play any role in preparing the paper, but was happy to present the findings when neither of the authors could attend. My presentation is near the end of the afternoon session (video here). Bottom line? Our fiscal trajectory is unsustainable thanks to population aging and rising health spending.
  • Choosing the Nation’s Fiscal Future, released last week by the National Research Council and the National Academy of Public Administration. Weighing in at a hefty 360 pages (including appendices), this report provides a comprehensive overview of our budget challenges. More important, it then lays out strategies for addressing them. And it makes very clear the most important decisions we face: how big a government do we want and how should it balance the interests of older and younger generations?
  • Red Ink Rising: A Call to Action to Stem the Mounting Federal Debt, released last month by the Pew-Peterson Commission on Budget Reform. This report  reviews our fiscal prospects and makes six big picture recommendations: (1) Commit immediately to stabilize the debt at 60 percent of GDP by 2018; (2) Develop a specific and credible debt stabilization package in 2010; (3) Begin to phase in policy changes in 2012; (4) Review progress annually and implement an enforcement regime to stay on track; (5) Stabilize the debt by 2018; and (6) Continue to reduce the debt as a share of the economy over the longer term. This framework strikes me as reasonable, although one can always debate the exact numbers (e.g., would 60% in 2018 be that much better than 60% in 2020?).
  • The Right Target: Stabilize the Federal Debt, released last week by the Center on Budget and Policy Priorities. Another excellent overview of the budget challenge, this report agrees with the Pew-Peterson report in many qualitative ways, but disagrees on tempo: “Pew-Peterson Commission endorses sounds ideas but overly ambitious target.” The authors would like to see deficits reduced to 3% of GDP or lower by 2019. (A goal that OMB Director Peter Orszag has also mentioned.)
  • A Path to Balance: A Strategy for Realigning the Federal Budget, released last month by the Center for American Progress. This report takes a slightly different approach from the others, focusing on achieving primary budget balance (i.e., balancing revenues with spending excluding interest payments) rather than a debt-to-GDP target. Those concepts are closely related in analytic terms (each of the reports explains why), but as Stan Collender over at Capital Gains and Games notes, the concept of achieving primary budget balance may be a better talking point than stabilizing the debt-to-GDP ratio. Because CAP has close ties to the Obama Administration, Stan also suggests that its budget thoughts may offer a “sneak peek” about what to expect in the President’s upcoming budget.

Treasury is Issuing More TIPS

As noted by the Wall Street Journal this morning (“U.S., in Nod to Creditors, Is Adding TIPS Issues“), Treasury is issuing more Treasury Inflation-Protected Securities (TIPS). Today’s auction involves $10 billion 10-year notes; one estimate suggest that total TIPS issuance this year will be $80-85 billion. Still small compared to our nation’s overall borrowing needs (somewhere in the $1 trillion range, not including rolling over existing debt), but a real boost to the TIPS world.

As I discussed in two earlier posts (here and here), many observers have recommended that Treasury increase TIPS issuance. The WSJ piece emphasizes one particular set of advocates: our creditors who are beginning to worry about inflation:

TIPS, which account for less than 10% of the $7 trillion Treasury market, offer investors a way to hedge against inflation as their value rises along with the increase in consumer prices. The fixed returns on nominal Treasurys, in contrast, can be eroded over time by inflation, which especially affects long-term bonds.

The small size of the market for inflation-protected securities means many large investors who want to be able to sell easily still prefer other ways to hedge against inflation risk, such as commodities.

But in the past year, China and other large foreign investors have become vocal about their concerns that the large U.S. fiscal deficits and the Federal Reserve’s ultra-loose monetary policy will lead to a spike in inflation. That would hurt the value of their large holdings of nominal Treasurys.

U.S. officials reassured China in late July that the Treasury remained committed to its TIPS program and would take investors’ views into account when drawing up its issuance plans. That pledge was seen as a commitment to increasing TIPS sales.

Will Rising Government Debt Hurt Growth?

Every January America’s economists gather for their annual conference. There are far more papers than one could ever read (or want to read), so you need a strategy to choose the most important.

In recent years, your optimal strategy should have included the papers by Carmen Reinhart and Ken Rogoff (see, e.g., this prescient paper from 2008). And so it is again in 2010.

This year’s installment is a paper that examines how government debt levels relate to economic growth and inflation. Their key finding? High levels of government debt have a substantial economic cost. In developed economies, that cost is weak economic growth. In emerging economies, that cost is weak economic growth and high inflation.

The growth findings are nicely illustrated in the following table from their paper:

Developed economies that have high levels of government debt (90% of GDP or more) have much lower rates of economic growth; for example, their median rate of growth has been a mere 1.6%, much less than the 3 to 4% growth of countries with lower debt levels. The same pattern holds for emerging economies, as well. (The third panel shows that high levels of public and private external debt also reduce growth, but the sample there includes only emerging economies.)

As R&R note, these results are particularly important today given the rapid growth in government debts around the world. In the United States, for example, debt will probably end the year around 60% of GDP, with no sign of stopping. The good news is that we are still relatively far from the 90% level that R&R identify as problematic. The bad news is that current policies will get us close to that level in less than a decade. For example, the Peterson-Pew Commission on Budget Reform recently projected that current policies would lift the debt-to-GDP ratio to 85% by 2018.

That’s too close for comfort.

What’s the United States Worth? $1.4 Quadrillion

Happy 2010, everyone. To kick off the new year, I am in Atlanta at the annual meeting of the American Economic Association. As Paul Kedrosky notes, there are lots of sessions on the financial crisis and its aftermath. Perhaps not surprisingly, many presentations have a pessimistic tone. But there are pockets of optimism, including Robert Shiller’s luncheon speech about the potential benefits of continued financial innovation.

One of Shiller’s ideas is that the federal government should issue a new kind of security that would pay quarterly dividends based on the nation’s gross domestic product (GDP). More specifically, each security would entitle its owner to one-trillionth of America’s gross domestic product (GDP). These “Trills” would be perpetual, like common stock in a private company, and would be backed by the government’s full faith and credit.

I will leave to others to argue the pros and cons of Trills. What caught my attention was Shiller’s estimate of how much they would be worth. With GDP around $14 trillion, each Trill would pay about $14 in annual dividends this year. That dividend would then increase (or, of course, decrease) as the economy grows (or contracts) in the future.

How much you would be willing to pay for a Trill? In principle, that should depend on your expectations of future GDP growth and your choice of what discount rate to apply to cash flows that track GDP. Oh, and if you worry about the U.S. government defaulting (still a very low risk), you might include a discount for that as well.

Shiller’s own answer is $1,400. In other words, he thinks Trills would be priced with a yield of about 1%. Trill owners would be willing to accept that low yield because they would expect future economic growth to boost dividends–and, therefore, Trill values–in the future.

That figure feels a bit high to me, but not unreasonable. For example, you could justify a $1,400 per Trill valuation if you believe that nominal GDP growth will be 4 percent and that an appropriate discount rate would be 5 percent.

If you take Shiller’s estimate seriously, it is just a short step to placing a value on the U.S. economy as a whole. If one trillionth of the economy is worth $1,400, then the entire economy would be worth $1.4 quadrillion.