1. Economic Disruption and U.S. Federal Budget Deficits: History, Outlook, Options by Robert M. Coen Emeritus Professor of Economics Northwestern University Web page: http://faculty.wcas.northwestern.edu/~rcoen Shirley Ryan Learning for Life Lectures October 27, 2010

2. Chronology of Disruption 2001-07: 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 2007-08: Fed cuts funds rate from 5.25% to ~0 02/2009: Obama signs $787b stimulus bill

3. Growth of Debt by Sector Percent of GDP 2000Q4 2007Q4 Change Total 179 222 +43 Households 69 97 +28 Mortgages 47 74 +27 Businesses 65 74 +9 Federal Govt 33 36 +3 State-local Govts 12 15 +3 Source: Federal Reserve, Flow of Funds

6. 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

7. Sources of Deficit Increase in Current Recession 2007Q4 2009Q3 Change Receipts 2,666.1 2,176.3 -489.8 Personal taxes 1,196.4 827.0 -369.4 Corp profits taxes 296.2 127.7 -168.5 Indirect taxes 94.2 97.0 +2.8 Soc ins taxes 957.8 953.5 -4.3 Other 121.5 171.0 +49.5 Expenditures 2,942.8 3,532.9 +590.1 Goods and services 870.4 999.7 +129.3 Transfers 1,289.2 1,637.6 +348.4 Aid to states 381.9 490.9 +109.0 Interest 304.7 273.8 -30.9 Other 96.5 131.0 +34.5 Deficit 276.7 1,356.7 +1,080.0 % of GDP 1.9 9.6

9. Source: Federal Reserve, Flow of Funds

10. Future Outlook CBO: Baseline Federal Budget Projection 2011-152011-20 Total deficit $3,202 $6,246 ($ billions) 201120152020 Deficit/GDP 7.0 2.7 3.0 (Percent) Debt/GDP66.167.369.4 (Percent) Source: CBO, The Budget and Economic Outlook: An Update, August 2010

11. Future Outlook CBO: Effects of Alternative Policies on Deficit (Billions of dollars) 2011-152011-20 Baseline deficit $3,202 $6,246 Troop cut by 30,000 by 2013 -458 -1,508 Freeze discretionary spending -303 -1,650 Extend expiring Bush tax cuts +1,215 +3,312 Extend other expiring tax cuts +1,192 +2,800 Index AMT for inflation +247 +720 Interactions of above +252 +808 Deficit with all of above +5,347 +10,728 Source: CBO, The Budget and Economic Outlook: An Update, August 2010

12. Future Outlook CBO: Baseline and Alternative Projections Total deficit ($bil)2011-152011-20 Baseline 3,202 6,246 Alternative 5,347 10,728 Deficit/GDP (%)201120152020 Baseline 7.0 2.7 3.0 Alternative 9.5 5.1 5.1 Debt/GDP (%)201120152020 Baseline 66.1 67.3 69.4 Alternative* 68.6 79.8 91.0 * Author’s estimate

13. 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

15. 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

16. 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

19. Key Comparative Ratios, 2006 TaxesIncome taxConsumption to GDP to total tax* to GDP France 44 49 55 Germany 36 52 57 Japan 28 66 56 Sweden 49 60 46 UK 37 58 62 US 28 74 70 * Excluding property and social insurance taxes Source: OECD

20. 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