Economic Disruption and U.S. Federal Budget Deficits: History, Outlook, Options by Robert M. Coen Emeritus Professor of Economics Northwestern University Web page: Shirley Ryan Learning for Life Lectures October 27, 2010

Chronology of Disruption : Unprecedented mortgage debt accumulation Home prices skyrocket, peak in 2006, plummet 12/2007: Housing-led recession begins 02/2008: Bush signs $168b stimulus bill 03/2008: Bear Stearns collapses Fed aids primary market dealers 09/2008: Lehman bankruptcy $85b credit line to AIG Fannie Mae, Freddie Mac rescued 10/2008: Fed rescues commercial paper market $700b TARP enacted : Fed cuts funds rate from 5.25% to ~0 02/2009: Obama signs $787b stimulus bill

Growth of Debt by Sector Percent of GDP 2000Q4 2007Q4 Change Total Households Mortgages Businesses Federal Govt State-local Govts Source: Federal Reserve, Flow of Funds

Consequences for Federal Deficit and Debt Tax receipts fall sharply -- income/output down, rate cuts Unemployment benefit payments rise sharply Unemployment rate stubbornly high – housing frictions Deficit reaches record levels Additional borrowing to fund capital infusions to business Federal debt approaches record levels

Sources of Deficit Increase in Current Recession 2007Q4 2009Q3 Change Receipts 2, , Personal taxes 1, Corp profits taxes Indirect taxes Soc ins taxes Other Expenditures 2, , Goods and services Transfers 1, , Aid to states Interest Other Deficit , ,080.0 % of GDP

Source: Federal Reserve, Flow of Funds

Future Outlook CBO: Baseline Federal Budget Projection Total deficit $3,202 $6,246 ($ billions) Deficit/GDP (Percent) Debt/GDP (Percent) Source: CBO, The Budget and Economic Outlook: An Update, August 2010

Future Outlook CBO: Effects of Alternative Policies on Deficit (Billions of dollars) Baseline deficit $3,202 $6,246 Troop cut by 30,000 by ,508 Freeze discretionary spending ,650 Extend expiring Bush tax cuts +1,215 +3,312 Extend other expiring tax cuts +1,192 +2,800 Index AMT for inflation Interactions of above Deficit with all of above +5, ,728 Source: CBO, The Budget and Economic Outlook: An Update, August 2010

Future Outlook CBO: Baseline and Alternative Projections Total deficit ($bil) Baseline 3,202 6,246 Alternative 5,347 10,728 Deficit/GDP (%) Baseline Alternative Debt/GDP (%) Baseline Alternative* * Author’s estimate

Markets Not Spooked by Outlook Interest rates not spiking Dollar not plummeting Inflation dormant Why? Debt/GDP high, but not excessive Federal interest payments modest relative to tax revenue Strong demand for US dollar and public debt Confidence in US problem-solving

Total Public Debt as Percent of GDP, 2008 France 68 Germany 64 Japan 173 Sweden 37 UK 52 US 61 Source: CIA World Fact Book

What Is Responsible Public Debt/Budget Policy? Mistaken analogies to private debt Domestic public debt both liability and asset We owe it to ourselves Government immortal Government has power to tax Balance the budget? Balance current budget, borrow for capital expenditures? Balance the budget over business cycle? Keep debt/GDP ratio at “safe” level? Prospects for Expenditure Cuts and Tax Increases

Key Comparative Ratios, 2006 TaxesIncome taxConsumption to GDP to total tax* to GDP France Germany Japan Sweden UK US * Excluding property and social insurance taxes Source: OECD

How to Burden Future Generations Bequeath less capital Bequeath a less educated, less healthy workforce Bequeath less scientific, engineering, and managerial knowledge Bequeath fewer natural resources Accumulate foreign debt to finance current consumption or unprofitable investment