1. Source: Office of Management and Budget $84 Trillion Implicit (unfunded) liabilities 2012: Gross Debt = $16 Trillion Debt-to-GDP = 103%

2. Source: Congressional Budget Office, http://www.cbo.gov/doc.cfm?index=10014 2012: Public Debt = $11.2 Trillion Public-Debt-to-GDP = 72.5%

3. The level of the employment ratio determines direction of debt ratio: Employment-to-Population > 63% =>  Debt-to-GDP Employment-to-Population = 62-63% => stable Debt-to-GDP Employment-to-Population  Debt-to-GDP

4. Automatic Stabilizers: government spending and tax rules that counteract the business cycle Low Unemployment Scenario => high tax revenues and low transfer payments => low deficit & contractionary fiscal policy. High Unemployment Scenario => low tax revenues and high transfer payments => high deficit & expansionary fiscal policy. In the short run, the deficit ratio is determined by the unemployment rate. When the unemployment rate exceeds 6%, the deficit ratio rises above the 3% sustainable target. If unemployment falls below 6% the deficit ratio falls below 3%. This will bring down the Debt-to-GDP ratio. In the long run, the unemployment rate is influenced be the nation’s debt-to-GDP ratio.

5. Options to Reduce Public Deficits to 3% of GDP by 2014 Persistent deficits lead to: Rising interest rates which crowds out private spending Future tax uncertainty which reduces business/consumer confidence/spending Spending Options:$ bn Raise Social Security retirement age to 70 (eligibility of 67 by 2027 currently) 4 Change benefit inflation index to one less upwardly biased 10 Reduce starting Social Security benefit for most workers 7 (initial benefit indexed to wages for low income, inflation for others) Raise Medicare age to 67 from 65 3 Convert Medicaid share to block grants (to reduce distorted state cost incentives) 47 Reduce Medicaid share to wealthy states (eliminate 50% floor on federal share) 22 Reduce highway funding and farm assistance 8 Total: $101

6. Options to Reduce Public Deficits to 3% of GDP by 2014 Eliminate Tax Deductions for: Employer-provided health insurance (to reduce Cadillac plans and spending)215 Mortgage interest (to reduce excessive borrowing and leverage)147 State & local taxes 65 Capital gain on homes (to reduce distorted incentives and behavior) 60 Property tax 33 Municipal-bond interest 32 Total:$552

7. Options to Reduce Public Deficits to 3% of GDP by 2014 Other tax options: Implement 5% VAT (Value Added Tax at each stage of production)324 Cap employer health-insurance deduction to average premium 70 Raise federal fuel tax by 50 cents a gallon to 68 cents 62 Carbon-emissions tax (or Cap-and-Trade system) National sales tax (to reduce dependence on income tax which penalizes work and investment) The U.S. tax system needs less complexity, more bias towards taxing consumption and elimination of loopholes to broaden income-tax base which will allow for the lowering of tax rates.

8. Employment Cost Index (Most Comprehensive Measure of Labor Costs) Web address: www.stats.bls.gov/news.release/eci.toc.htm Annual revisions with release of first quarter data which can go back several years. The employment cost index (ECI) is an early warning system for rising inflation which can push interest rates higher and stock prices lower. ECI is the best harbinger of pricing pressures and is a forerunner of inflation. Labor costs typically make up 70% of a firm’s operating costs. Employment costs = wages/salaries and fringe benefits. Rising compensation costs can result in various responses by firms: Raise retail prices => inflation. Absorb expense and maintain prices => falling profits => falling stock prices. Increase capital investment to raise productivity and reduce workforce. Reallocating production facilities by decreasing domestic production and increasing foreign production => increasing unemployment and unemployment insurance costs => increasing government spending and deficits. Wage-price spiral (a vicious cycle the Federal Reserve will try to stop)  labor expenses =>  retail prices =>  workers demand for wages/salaries =>  retail prices (self-perpetuating inflation escalation) Every quarter the BLS surveys 8,500 private and 800 public sectors (local and state only) on labor cost issues. Survey is done for the pay period that includes the 12 th day of March, June, September, December. Wage and salary data include bonuses, incentive pay, commissions, and cost of living adjustments. Benefits data include insurance benefits, retirement savings benefits, paid vacations, sick leave, holidays, premium pay for overtime, shift differentials, social security, Medicare, federal-and state mandated social insurance programs. Data is converted to index where June 1989 = 100 Labor Costs relative to Productivity If annual compensation costs are rising (tight labor markets) faster than annual changes in non-farm productivity (falling marginal product of labor), then economy may be facing inflationary pressures. Strong productivity growth =>  profits =>  wages and salaries. The monthly Employment Report’s average hourly earnings (AHE) is another good indicator of wage inflation. But AHE covers only workers who receive hourly pay (not salaries) and does not include benefits, whereas the ECI covers both hourly and salaried workers. ------------------------------------------------------------------------------------------------------------------------------------------------------------------ Market Analysis: Bonds: Unexpected big  ECI without big  in productivity =>  (  P/P) E t+1 =>  D Bonds =>  i Bonds =>  fed funds rate by Fed to stop wage-price spiral Stocks: Unexpected big  ECI without big  in productivity and economy operating above potential =>  business costs =>  profits =>  P Stocks Dollar: Unexpected big  ECI without big  in productivity and economy operating above potential =>  interest rates => capital inflows => increase value of dollar. But an  ECI =>  U.S. export competitiveness =>  exports/  imports=>  trade deficit =>  exchange rate.

10. Bank stock purchases (TARP) Stimulus plan Mortgage bailout plan Income-support programs Recession-induced falling revenues

11. Fiscal Austerity Versus Economic Growth Question: Should government cut spending and raise taxes in the short run to reduce our deficit-to-GDP ratio or should we wait and allow economic growth to reduce the ratio in the long run. Short-term fiscal austerity can be self-defeating: This paradox can be explained with the “Fallacy of Composition”: What is true for an individual in not always true for the whole. Recall the economic principle - one person’s spending is another person’s income. Micro level When a household reduces their current spending, they can use the funds to pay down their debt (deleverage). Assume a household income is not affected by their spending. Household Budget Constraint Income + Change Debt = Taxes + Debt Interest + Consumption + Savings Macro level When a government reduces their spending, household incomes drop which reduces tax revenues and increases transfer payments (unemployment insurance, food stamps, medicaid). This could increase the nation’s deficit. Government Budget Constraint Tax Revenue + Change Debt = Government Spending + Transfer Payments

12. The Political Decision Short-Run Economic Growth versus Long-Run Fiscal Sustainability Two Goals: 1.Avoid a recession in the near term 2.Achieve fiscal sustainability in the long run Fiscal Sustainability Constant Debt-to-GDP ratio Achieved when the national debt grows in line with GDP Keep the Debt-to-GDP ratio below 90% to avoid triggering a financial crisis. Keep deficits below 3% of GDP. Given the expected pace of GDP growth, that will stabilize the debt-to-GDP ratio. Unemployment must be below 6% to see the deficit-to-GDP ratio below 3% and therefore a stable and falling Debt-to-GDP ratio.