Recent Forecasts of Government Debt
The Office of Management and Budget has recently released its new forecasts. The 2009 federal budget deficit is now anticipated to be 11.2 percent of GDP, by far the largest value of the postwar period. Forecasts for the longer horizon are even more alarming, with the deficit expected to be consistently around 4 percent of GDP over the next decade. Congressional Budget Office forecasts tell a similar story.
As a result of the large projected budget deficits, the expected path of the government debt has been revised upward substantially. The federal debt held by the public is now expected to reach 76.5 percent of GDP by 2019. Again, one needs to go back to the years immediately following World War II to see levels of government debt so high.
To investigate what drives these forecasts, we look at the composition of revenues and expenditures. On the revenue side, projections are mainly driven by the forecasts of economic activity. Revenues from most types of taxes are anticipated to be below trend in the near term and then to gradually return to their trend values as the economy recovers. Keep in mind, however, that there is some uncertainty about these trend values, given the uncertainty about the long-run growth rate of the economy over the next decade.
On the expenditure side, the long-run decrease of defense spending relative to GDP is more than compensated for by the long-run increase in the entitlement programs, Medicare and Medicaid in particular, and of interest payments. Due to increases in the average age of the population and in health care costs, spending for Medicare and Medicaid is expected to reach 5.9 percent of GDP by 2019. Interest payments will reach 3.4 percent of GDP by 2019, accounting for about 85 percent of the projected deficit.
The scenario depicted in these forecasts poses tighter constraints on the fiscal authority. On one hand, because the recovery has just begun and may be still vulnerable to adverse shocks, the fiscal authority would rather avoid a sudden reversal of its current expansionary stance.
On the other hand, there is an evident need to decrease the long-run budget deficit. Levels of government debt as high as the ones forecasted by the OMB have several adverse consequences. First, without a correction on the spending side, more tax revenue will need to be raised, with the consequence of subjecting the economy to greater tax-associated inefficiencies. The risk of default may also increase, leading to higher risk premiums, higher interest payments, and a greater cost to be sustained in the future to address the fiscal imbalance. In addition, a sustained demand for funds by the government sector will likely put upward pressure on future real interest rates, with adverse consequences for private investment and growth. The increase in domestic interest rates will likely attract further financial flows from countries with higher saving rates, which may lead to a dollar appreciation and a worsening of our current account deficit.