In a major speech on April 13th laying out his blueprint for reducing America’s long-term debt burden, President Obama drew a sharp contrast between the outlook today and the much rosier one a decade ago. In 2000, he claimed, “we were prepared for the retirement of the Baby Boomers.” Yet whereas the national debt burden today, at around 65% of GDP and rising fast, is much higher than it was in 2000, the long-term fiscal path the nation was on was as unviable then as it is today. This is illustrated starkly by the figure on the left. The driver of the sharply rising debt curves was, and still is, retirees – and specifically two programs to care for them, Medicare and Social Security, as shown by the bars in the figure on the right. President Obama is surely right to draw attention to the challenge of funding retiree entitlements. He is on less firm ground, however, in suggesting that the last Democratic administration had a handle on this. 2000 was no Golden Age of preparedness for our Golden Years.

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“We’re not going to be running up the credit card anymore,” President Obama announced in introducing his 2012 budget.  That would suggest spending less.  But what is striking about the president’s actual budget math is how reliant it is on growth assumptions, rather than actual cuts in spending.  His Office of Management and Budget estimates robust growth of 4.4% in 2013 and 4.3% in 2014.  These assumptions are, however, significantly in excess of private sector “blue chip” consensus forecasts.  Private forecasts are 1.4 percentage points lower in 2013 and 1.5 percentage points lower in 2014.  If the private forecasts are used instead of the political ones, the president’s projected deficit average for 2013 to 2021 would have to be marked up from 3.3% of GDP to 4.3%.  That means about $1.75 trillion more added to the national debt.  Since 1976, the OMB has overestimated growth in the year after the budget by a substantial 0.5%.  This compares with private forecaster upside bias of only 0.1%.  In the case of the president’s budget, however, there is reason to suspect that the bias gap will actually be much larger.  This is because when the OMB and private forecasts differ widely (defined as being greater than 1.4 percentage points), the OMB’s upside bias rises to a full 1%.  In short, the president’s budget relies on rosy growth forecasts just to set the country on a path to lower but still unsustainable deficits.

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“There’s only one way to [fix America’s long-term budget problems],” said President Obama’s fiscal commission co-chair Alan Simpson. “You dig into the big four, Medicare, Medicaid, Social Security, and defense.” In shying clear of Medicare, Medicaid, and Social Security in his 2012 budget proposal, the president took a bow to the formidable political challenge posed by the first three. But what about defense, which accounts for a whopping 22% of Federal expenditures? In spite of the ups and downs in the global peace index, history suggests that cuts in nominal defense spending are just as hard to achieve. As the yellow line in the top figure shows, nominal defense spending almost never falls. Declines in defense spending as a percentage of GDP have historically been accounted for by inflation or real GDP growth – not by spending cuts. The fiscal commission’s report called for $34 billion in nominal defense cuts between 2012 and 2013, a time-period during which the president’s budget calls for increases. But even the president’s much more modest brand of fiscal discipline looks oversold. His budget projects strong economic growth in the medium term, but if private growth forecasts are more accurate he will need to do the politically impossible – actually cut nominal spending – in order to achieve the real cuts implied by his budget. Read more »

The EU-IMF Irish bailout gives Ireland a window of opportunity to solve its problems, but how large a window is it? Although the €85 billion headline number appears to be very large, at over 50% of Irish GDP, the funds must be benchmarked against what they are being earmarked for. €50 billion is tagged for public finances, which will cover two years of public debt refinancing and deficits. This provides a significant window for Ireland to achieve fiscal improvement. However, the window provided by the €35 billion tagged for banking sector recapitalization is much smaller. Over €34 billion of foreign deposits fled Irish banks in September 2010 alone. Over the past two years, Irish banks’ balance sheets have shrunk by over 9%, while their funding reliance on the European Central Bank has increased from 5% to 9% of total liabilities. This suggests that any Irish bailout plan, to be credible enough for the markets, must ensure that the Irish government ceases adding bank debt to its public debt. That will almost surely involve a restructuring – that is, a significant partial default – on the bank debt. Such a restructuring, however, will raise a slew of new bailout questions, since German, French, British and other European banks holding Irish bank debt may themselves require public assistance to remain acceptably capitalized. Read more »

On April 26th, Standard and Poor’s downgraded Greece’s credit rating, and Greek sovereign credit default swaps (CDS) climbed to 825 basis points – far higher than before the IMF and European Council of Ministers announced a support package. The Greek crisis is clearly unresolved. Some have argued that if Greece had never switched from the drachma to the euro it would have been able to pursue a fiscal policy that fit its domestic needs without depending on international capital markets. Yet Greece consistently relied on non-drachma debt issuance well before it adopted the euro in 2001. In the six years before joining the euro, only 27% of Greek debt was issued in drachma. At the end of 2000, just before Greece joined the eurozone, 79% of its outstanding debt was already denominated in euros, and a mere 8% in drachmas. Even if Greece had remained outside the eurozone, its dependence on euro borrowing would only have increased. A falling drachma would merely have brought the current crisis to a head earlier by accelerating the rise in Greece’s debt-to-GDP ratio (think Iceland). The fact that the euro is not an “optimum currency” for Greece, or any other eurozone country for that matter, is not the main problem. That problem is excessive foreign borrowing, a problem with which Greece has struggled since the early 19th century. Read more »