Drowning in debt: the long-term cost of the crisis
Only World Wars One and Two, and the American Civil War, caused larger deteriorations in the budget. Bank rescues, stimulus and tax cuts will bequeath a massive legacy of government debt, on course to reach a level not seen since 1947.
Stabilising government finances will require deep cuts in spending and sharp tax rises in the years ahead.
The need to refund the huge stock of maturing debt and issue new securities to cover deficits will also make it hard for the Federal Reserve to raise interest rates in a timely manner once the crisis has passed. Officials will face a protracted conflict between raising rates to head off inflation and keeping them low to stabilise the government debt market and contain government borrowing costs.
LESSONS FROM THE WAR
All the challenges now facing the Fed, Congress and President Barack Obama were prefigured by President Franklin Roosevelt in his annual budget message to Congress in January 1942, when the president outlined the enduring financial consequences of mobilising the government and the nation to fight a “total war”. Click here for pdf.
Roosevelt promised to finance as much as possible of the cost through increased taxes. But the president recognised as much as two-thirds of the burden would have to be met by borrowing on an unprecedented scale.
He warned federal debt would rise from $43 billion in 1940 to 110 billion in 1943. In fact it rose six-fold from $43 billion in 1940 to peak at $269 billion in 1946. He also warned taxpayers would still be paying for the conflict long after the fighting was over: “an increase in interest requirements will prevent us for some time after the war from lowering taxes to the extent otherwise possible”.
How the government handled the challenge provides useful lessons for policymakers handling the legacy of debt from the current crisis.
The attached chartbook puts the bank rescues and fiscal stimulus in context. It shows the government’s annual borrowing, debt stock and interest payments since the 1930s, together with projections based on the budget plan submitted to Congress by the Obama administration and evaluated by the non-partisan Congressional Budget Office (CBO).
The budget deterioration between 2007 (when the government was running a deficit of 2.4 percent of GDP) and 2009 (when the deficit is forecast to hit 13.1 percent of GDP) is only half the size of the deterioration between 1940 (1.6 percent deficit) and 1942 (21.8 percent deficit) but far greater than anything experienced in peacetime.
Crucially however, wartime deficits were quickly reversed. The deficit shrank from 23 percent of GDP in 1945 to 2.8 percent of GDP in 1946, and by 1947 the federal government was actually running a small surplus of 1.7 percent of GDP. By reducing borrowing requirements and even running surpluses the Roosevelt and Truman administrations helped limit the build up in debt and maintain confidence in the government bond market.
In contrast, the Obama budget plan assumes the government will still be running deficits throughout the forecast horizon. The president’s outline has no plan to stabilise the long-term financing requirement, let alone run surpluses to pay down debt. Projected deficits in 2011 (6.4 percent of GDP), 2013 (4.1 percent of GDP) and 2019 (5.7 percent of GDP) are all much larger than before the crisis began and the budget position will be deteriorating again.
By failing to give investors a credible horizon for stabilising then reducing borrowing, the administration may struggle to place the securities it needs and risks triggering a sharp rise in yields once the immediate crisis has passed.
The Treasury is already running into resistance. Almost all the new debt issued so far has been short term (maturing in less than two years). The government has found it impossible to place longer-dated notes and bonds at acceptable yields; most medium and long-term securities have in effect been bought by the Federal Reserve (“monetised”) under the quantitative easing programme.
The Roosevelt-Truman administrations were able to turn deficits into surpluses because the wartime emergency was accompanied by a massive expansion in the tax base — and many of those taxes were maintained at or near emergency levels for several years after the conflict ended. The war was accompanied by a massive increase in “tax effort” (tax collections rose much faster than GDP as a whole).
In fact, the federal government was able to fund about a third of the cost of the war effort ($90 billion per year by 1944) through increased taxation ($32 billion) with remainder raised by borrowing ($62 billion). Once the fighting ended, extra revenues could be used to fund an expansion of social programmes as well as reducing government borrowing needs.
The problem with the Obama outline is that it is not accompanied by any increase in “tax effort” and fails to identify new sources of funding to rebalance the budget in the longer term. Officials argue that dealing with the crisis is a one-off expense which should be funded by borrowing rather than (deferred) tax rises. But the CBO projections show much of the deterioration is in fact structural and will not be reversed by current tax and spending policies.
The president’s budget will still require massive tax increases, spending cuts or some mixture of the two to bring the budget back to a more stable trajectory. It is silent on where these will be found. But the scale is reasonably clear. Even after current emergency programmes expire, the government will need to find tax rises or spending cuts amounting to around 2-3 percent of GDP by 2015-2019, which would represent one of the largest fiscal “consolidations” on record.
The debt build up will not be costless. Even assuming the government can hold costs to low levels, interest payments are set to climb from $237 billion per year in 2007 (1.7 percent of GDP) to $733 billion per year in 2019 (3.8 percent of GDP).
Interest payments were already the sixth-largest item in federal spending in 2007, absorbing 9 percent of all outlays. By 2019, interest payments will have risen to 11 percent and become the third or fourth-largest item. If debt cannot be stabilised, or borrowing costs rise, there is a real risk that rising interest charges will start to crowd out the money available for other programmes.
This will also create a severe problem for monetary policy. As in the late 1940s, the Federal Reserve will come under intense pressure to keep rates low and stable to avoid destabilising the bond market and triggering a damaging rise in yields that would drive up the borrowing burden significantly.
The Fed’s role as the government’s debt manager (assumed during the war and again during the recent crisis through the quantitative easing programme) will make it hard to raise rates.
After the war ended in 1945, the Fed found itself trapped, obliged to continue supporting the government bond market throughout the rest of the decade to avoid a damaging escalation of yields. Support was not withdrawn until the Fed-Treasury Accord in 1951 and not fully until 1953.
For all their promises that liquidity will be reduced and interest rates normalised in a timely fashion this time around, the debt overhang inherited from the crisis will pose the same dilemmas, and Fed officials will struggle to control liquidity and raise rates in a bond market characterised by massive (over-) supply.