"The current fiscal path of the federal government is unsustainable." This sentence begins any discussion about the future of US fiscal policy and CBO uses it a lot. But when they go into detail about the increased possibility of a fiscal crisis related to our rising fiscal debt picture, it's bound to raise some eyebrows on Capitol Hill - not to mention sending shivers down some spines on both sides of the aisle.

We'd like to think that we were the inspiration for this more detailed brief. After all, we did write a paper talking about the increased risk of a debt crisis if US fiscal conditions were left on auto pilot. We looked at different possibilities of how a fiscal crisis could play out in the US, based on real-life points of vulnerability in the US economy. The paper (and others - by Len Burman and Fred Bergsten) was discussed by an impressive group of experts (including CBO Director Elmendorf) at a CRFB event.

CBO doesn't go into specific scenarios as we did. But it puts us all on notice that there's a new kid on the block: as we think about negative consequences from our rising fiscal debt, add the increased chance of a fiscal crisis to our tried and true standard list of worries (eg, the crowding out of investment, the crowding out of fiscal priorities, the need to raise taxes and/or cut spending simply to keep up with debt service on existing debt; and the lack of flexibility when faced with a new or unexpected problem domestically or internationally.)

What makes normal tough fiscal situations turn into crises? Sometimes, tough debt situations can be managed, but, under certain conditions, CBO writes, an already daunting fiscal management challenge can suddenly turn to a crisis. A country with low domestic savings like the United States is particularly vulnerable - even if its "safe haven" status has allowed it to more freely issue debt under altogether different circumstances. Another cautionary note for the United States, countries already in recession are also quite vulnerable, particularly if new borrowing requirements pop up unexpectedly and investors lose confidence.     

While the lessons of fiscal crises elsewhere do not "necessarily" apply to the United States, CBO notes that their main elements can be instructive. First, the situation can deteriorate very rapidly. In Ireland and Greece, changes in interest rates happened quickly. Two years ago, interest rates on their ten year bonds were less than a percentage point higher than Germany's. Right now, the spread is at about three percentage points for Ireland and eight percentage points for Greece. In both countries, they had to undertake austerity measures, despite adverse economic conditions. In Argentina's case, the early 2000s recession exacerbated their fiscal situation, and due to their past history of defaulting on debt, interest rates quickly spiraled out of control until Argentina simply ceased to pay its creditors. It has had trouble borrowing since then.

In all three of these cases, fiscal crisis resulted in part from recessions that significantly raised each country's debt burden. Plus, there were other factors making each country highly vulnerable to a collapse in confidence under certain circumstances.  In Ireland's case, the country's rapid growth path had been based on high leverage. In Greece, growth was also deficit financed, plus extremely high unfunded liabilities were hidden and announced in a fiscal information shock. Greece's fiscal credibility (and also, by the way, the eurozone's) was undermined. In these cases, to sustain financing at a reasonable interest rate cost, governments were forced to tighten fiscal policy during a recession, setting off the growth-deficit spiral.

The timing of fiscal crises underscores the importance of prudent fiscal policy during good times. The possible aftermath in the US of a sudden fiscal crisis is not pretty: restructuring of debt, inflationary monetary policy (to remedy the crisis), and drastic fiscal austerity. All of these options would be extremely painful and the first two would severely hamper the ability of the federal government to borrow in the future.

The bottom line is: why take the chance that we can muddle through? CBO has given us a warning:  it is better to put our fiscal house back in order on our own terms rather than to be forced by our creditors to take a hachet to our standard of living. We still have a window of opportunity to get it right.

If You Can’t Stand the Heat… – Washington has been experiencing a heat wave, but it can’t all be blamed on the friction between the two parties. Before members of the House can escape at the end of the week for a long break, they must complete work on the war supplemental that has bounced around more than a beach ball. The Senate will stay an extra week before its month-long recess and will try to complete a small business measure amid votes on the Elena Kagan nomination to the Supreme Court, campaign finance reform, and energy legislation.

War Supplemental a Hot Potato – A measure to fund operations in Iraq and Afghanistan has gone back and forth between the two chambers as $23 billion in domestic spending added by the House has made it too hot to handle for the Senate. On Thursday the Senate sent back the version it originally passed without spending for domestic items like aid for teachers and summer jobs after a test vote on the House version came well short of the votes needed. The House wants to send a bill to the president this week so that funding for the troops is not affected. The likeliest outcome is for the House to adopt the Senate version and try later to attach the domestic funding to other legislation.

Trying to Keep the Small Business Fires Burning – The Senate is moving slowly on legislation to aid small businesses. Leaders agreed to drop a $30 billion lending program that some criticized as TARP junior only to have an amendment reinstating the fund get 60 votes to end a filibuster. Some senators are also pushing a divisive amendment reinstating the estate tax at lower levels. Leaders still need to reach agreement to bring the bill to a final vote.

Heat Turning Up for Tax Cuts – The issue of what to do about tax cuts set to expire at the end of the year is getting more attention as the expiration date draws near. The Senate Finance Committee recently convened a hearing on the topic and members held a private meeting last week, with the possibility of a committee mark-up before the recess. President Obama has recommended permanently extending the tax cuts for families making under $250,000 a year, but not all lawmakers are on board. The idea of extending the tax cuts for two years is gaining traction. It could have the affect of aiding the recovery in the short run and providing a space for much-needed fundamental tax reform to be considered. The House has said it will let the Senate go first on this difficult issue. Some have suggested that the costs of extending the tax cuts should not have to be offset. CRFB countered this argument in a blog post last week.

Social Security a Hot Topic – In advance of its 75th anniversary next month and a report expected soon from those overseeing the program that will highlight the need to shore up the finances of Social Security, possible reform is being discussed. Leaders from both parties in the House separately broached the idea recently of making adjustments to improve its long-term solvency. The idea of raising the retirement age is being discussed as a part of reform. This comes as more Americans doubt that Social Security will be there for them. A recent USA Today/Gallup poll indicates that a majority of non-retirees don’t think they will get benefits when they retire. The proportion is much higher among younger workers.

Four Congressmen Seek to REDUCE the Budget Heat – Last week four legislators introduced a package of legislation to reduce the national deficit by more than $70 billion over the next decade. The four bills, collectively known as the REDUCE Acts, cover defense, agriculture, the treasury, and energy.

Voters Cold to Congress – According to the latest Gallup poll, only 17 percent of voters have confidence in Congress, an all-time low. This comes as lawmakers have been unable to adopt a basic budget blueprint or to address long-term debt.

Mid-Session Review Released – The White House released its Mid-Session Review on Friday. It showed slight improvement for the  deficit outlook this year, but a dreary picture in the longer term. See here and here for initial analysis from CRFB and check back soon for a more in-depth examination.

In an op-ed for the Wall Street Journal this Wednesday, Martin Feldstein discusses the pivotal role of tax expenditures in increasing the federal deficit and how they should be considered, perhaps even more than direct spending cuts, in reducing the deficit as well. Tax expenditures are the special tax breaks that indirectly subsidize spending on education, healthcare, and other programs and, accordingly, cause the government to lose substantial amounts of revenue—this year, about $1 trillion.

Feldstein notes that despite Obama’s call to freeze nondefense discretionary spending, he has also advocated substantial increases in some of the most politically popular tax expenditures on the books today, which could dramatically undermine if not negate entirely any plans for deficit reduction. To date, Feldstein notes, neither Democrats nor Republicans have given significant attention to the large revenue drain caused by tax expenditures—but, he argues, eliminating some of the biggest tax expenditures would increase revenues and economic efficiency, while not increasing marginal tax rates at all. Total tax expenditures today form 6.4 percent of GDP, and while they shouldn’t be completely cut, they could be significantly (as was done under Reagan in 1986 with a combined tax break). Feldstein states that cutting them 2 percent would reduce the national debt by 18 percent in 2020, or some $4 trillion.

Tax expenditures are indeed an oft-overlooked yet very promising method of effectively cutting spending that we all must consider, especially at a time when deficit reduction is a more pressing issue than ever before.

At a time when Social Security is increasingly getting lawmakers' attention for the possibility of reform, raising the retirement age is starting to emerge as one of the more palatable options. Coincidentally, the Urban Institute held an event on it recently at the exact same time the Senate held a hearing about older Americans' participation in the labor force. The two issues are very much intertwined and many other issues also combine to raise questions about how we balance retirement security, health security, labor force participation, and fiscal sustainability in an effective way.

The normal retirement age (NRA) currently sits at 66, having been bumped up from 65 gradually. It is scheduled to increase again starting in 2017, increasing two months each year until it reaches 67 in 2022. There has been talk of further increasing the retirement age to 68 or even 70, justified by the fact that life expectancy has increased significantly since Social Security was enacted 75 years ago.

The benefits of raising the retirement age obviously come through the most in the fiscal equation. While retirement age increases are generally thought of as benefit reductions on the individual level, they improve both sides on a macro level. By encouraging people to work longer, the worker-to-beneficiary ratio increases, having the effect of both increasing payroll tax revenues and reducing the benefits paid out. It is one of the few options talked about that works on both sides of the fiscal equation.

Additionally, there are some economic benefits. Encouraging longer labor force participation obviously increases the labor supply over the long-run. It can also increase the wealth of older workers and consequently increase their savings. In the long-run, both of these effects--bigger labor force and higher savings--will lead to higher economic growth. Also, working longer will mean that retirees will have fewer years to rely on their own wealth, a particular concern for those at the lower end of the income distribution.

However, much concern about increasing the NRA comes from a distributional perspective. A common argument against retirement age increases is that it is a regressive policy since longevity increases have accrued to top earners more than to low earners. One measure used by EPI's Monique Morrissey at the Urban Institute event shows that since 1982, male life expectancy at age 65 has increased by five years for the top half of earners, while it has only increased by one year for the bottom half.

Other concerns stem from the ability of workers to be able to keep working into their mid- to late-sixties. The Urban Institute event focused heavily on the vulnerability of older workers to "health shocks" and how the Social Security disability insurance program (SSDI) might not be well equipped to handle a larger number of these cases. Many workers who are unable to work at their jobs in their later years don't qualify for SSDI because they are not strictly disabled, but rather have physically strenuous jobs. Many of the event participants also argued that those who do qualify for SSDI do not get benefits that adequately replace the income and wealth lost due to disability. Those who oppose increasing the retirement age say that these problems are made worse if people have to work into their late sixties to receive full Social Security benefits. Also, these issues are distributional in nature, since low earners are more likely to have strenuous jobs, more likely to have "health shocks", and less likely to have the wealth to weather a disability.

These concerns certainly are not unfounded and could be addressed in the context of a Social Security reform plan that raises the NRA. The Brookings Institution's Gary Burtless, who supports raising the retirement age, suggested liberalizing eligibility for SSDI to allow people with physically strenuous jobs to qualify. An expansion of SSDI is one way to deal with the health concerns of an increased NRA. An option to address the distributional concerns would be to modify benefits for low-income earners to offset the effects of a higher retirement age. This could be done, for example, by instituting a minimum Social Security benefit (one of the illustrative options in our budget simulator) or by modifying the PIA formula favorably for low earners (either by increasing the first PIA factor modestly or increasing the first bend point). These "sweeteners" could help bring together lawmakers to enact a plan that balances the concerns of income security and fiscal sustainability.

There have been a lot of numbers thrown around with regards budget resolutions, deeming resolutions, and discretionary spending limits. To keep it simple, we've put the numbers for a bunch of different proposals below (hat tip to our colleague Jason Delisle with the Federal Education Budget Project at the New America Foundation for putting together these numbers).

^{*To compare on an apples-to-apples basis, war spending was removed and Pell grants were added to the discretionary category in the President's budget. The actual budget removes Pell grants from discretionary and puts them in mandatory.}

^{Note: House Blue Dog numbers aren't here because they haven't provided complete numbers for discretionary spending.}

Notice how with the exception of Sessions-McCaskill, all these resolutions represent increases from the FY 2011 levels in the 2010 budget resolution. And at a time when lawmakers are trying to claim the mantle of "fiscal responsibility."

The Senate essentially voted to pass an extension of unemployment benefits yesterday, invoking cloture on the measure with the requisite sixty votes. The bill would extend unemployment benefits through the end of November, ensuring that we won't need to witness constant bickering over the extension as we did this past spring. The $34 billion price tag had previously held up its passage, as lawmakers refused to offset the cost (we have been calling for them to do so). The bill itself is the final version of what was originally a nearly $200 billion dollar bill, but as passage grew tougher, the bill was whittled down. COBRA subsidies, tax extenders, and aid to states for Medicaid were all dropped from the bill and the doc fix was passed separately. It's telling that the Senate chose to jettison other priorities rather than simply pay for them.

Once the bill passes the Senate, it will go back to the House, where it will likely be approved quickly and then sent up to the White House for signing. We will post this new bill on Stimulus.org as soon as it is officially passed. The current average weekly unemployment benefit is about $307 and the maximum number of weeks for collecting unemployment benefits is 99.

In other stimulus news, the small business bill--one that combines a $30 billion small business lending fund to community banks and targeted small business tax breaks--is being held up over Republican concerns that the lending fund would be another TARP. Sen. Kent Conrad (D-ND) said that dropping the fund altogether was a possibility. This bill--having already passed in the House--is actually deficit neutral over ten years, offsetting its costs by closing some tax loopholes. 

Remember you can follow all of the unemployment benefit extensions since the 2009 stimulus on Stimulus.org. So far there have been four unemployment benefit extensions (this one will make five) since ARRA, at a gross cost of $35.6 billion and a net cost of $33 billion, since one of the extensions was offset. You can also track all other government actions undertaken in the last three years to support the economy at Stimulus.org.

Ben Bernanke, the Chairman of the Federal Reserve, will present his twice-yearly testimony to Congress tomorrow (the Senate) and then again on Thursday (the House), accompanied by the always must-read semi-annul monetary policy report by the Fed Board. The big questions this time (and somehow there are always big questions when the Chairman speaks to Congress) are:

1. Whether we should be concerned about an economic slowdown and inflation coming in below the Fed’s lower target;
2. Whether in present circumstances, the Fed’s present monetary policy stance and plans for an exit strategy from its extraordinary stimulus measures are still appropriate.

We’ll also watch for any statements by the Chairman on our fiscal challenges. Chairman Bernanke and other Fed officials have placed considerable emphasis on getting our fiscal house in order sooner rather than later, to take heat off the Fed. It is still early days, but concern has already started to surface that politicians, who might ultimately be unable to take the tough decisions needed to get our fiscal house in order, might then turn to the Fed to get them off the hook by monetizing our huge debt. We could pay a dear price through inflation.

Stay tuned to this space tomorrow.

Larry Summers, the Administration's top economist (and former CRFB board member), has an op-ed in the Financial Times today, looking at why the current debate in Congress muddies the fiscal waters.

In his op-ed, he suggests a more comprehensive way of thinking about our real fiscal choices: our challenges are not a matter of a simple choice between "jobs" and "deficits"; and supporting recovery in the short-term yet calling for deficit reduction in the medium- and long-run is an appropriate rather than a "mixed" message about fiscal responsibility. 

In his view, while budget deficits are unproductive, if not harmful, during economic expansions, right now with interest rates close to zero and the unemployment rate at 9.5%, expansionary fiscal policy can have a powerful, positive effect on the economy. Also, since it boosts economic growth, it will help with reducing deficits in the medium-term.

However, in his view (and ours), there is most certainly a cost. Running budget deficits (especially high budget deficits) will have a cost to the economy--and the taxpayer--through the debt channel.  Budget deficits if not offset translate into debt accumulation. And our debt has to be paid for somehow, somewhere, sometime, managed normally through interest payments on debt held. And there are many ways in which our budget deficits are financed:  foreigners might buy more debt (or not), our domestic bond vigilantes might buy more debt (or not). To keep buyers coming to the Treasury auction table, higher interest rates might be needed, especially if the private economy looks more appealing as the economy runs closer to the full employment of people, buildings, and machines. Our government might be tempted to inflate some of the debt away--which doesn't work for long, by the way. In this process, other government priorities might be crowded out. None of these situations can be sustained for long and we don't want to go there.

So how do we avoid the costs of higher debt?  In other words, what do we do to balance our short-term needs with our need to get the budget on a sustainable track? Dr. Summers points out that deficit reduction is important when the economy is on stronger footing, and it can have positive effects on the economy:

There is a very strong presumption that there are likely to be beneficial effects from the expectation that budget deficits will be reduced after an economy has recovered and is no longer demand-constrained. Not least of these are increased confidence and reduced capital costs that encourage investment, even before the deficit is reduced. Such impacts are likely to be particularly important when prospective deficits are large and raise substantial questions about sustainability or even creditworthiness.

This statement re-affirms his membership in the Announcement Effect Club and brings us to an important point. We can't have significant medium-term deficit reduction without relatively strong economic growth, and considering our future fiscal situation, we can't have robust economic growth in the long-term without deficit reduction. By announcing a deficit reduction plan now that will take effect when the economy recovers, we can increase short term economic growth, and this increased growth will further cut into our deficit. We have expanded on this point in the past.

Alan Blinder, in an op-ed in The Wall Street Journal, suggests stimulating the economy in a deficit-neutral way by letting the upper-income tax cuts expire and using the money saved over the next two years to finance further stimulus efforts. Citing multiplier calculations by Mark Zandi, Blinder estimates that "trading" upper-income tax cuts for unemployment benefits would add $100 billion to aggregate demand and one million jobs to the economy over the next two years. Even if the numbers are high, he says, the stimulative effects of unemployment benefits would certainly be higher than those of the tax cuts, since high earners save much more of their income than unemployed workers.

Summers gives the Administration credit for making recommendations to put the U.S. on a more sustainable fiscal path in the medium-term. The policies he cites are the three year freeze on non-security discretionary spending, the expiration of upper income tax cuts, the health care law, and the formation of the fiscal commission. While these are positive steps, there is still much more to be done, especially since the President's 2011 budget would put public debt at 90 percent by 2020. The freeze is good, but it should be expanded to all discretionary spending and actual cuts should be considered. The expiration of the upper income tax cuts translates as "extending the tax cuts for everyone making under $250,000 at a staggering cost"; instead the costs should be offset. Limiting the roughly $1 trillion in individual and corporate tax expenditures would be one good approach. The jury is still out on the health care law over the longer-term (see our analysis here), though it seems that if Congress sticks to their guns, it will have quite a positive effect over the long term (though much more will still need to be done). Finally, while its work could prove to be extraordinary useful for America's fiscal future, it is far from clear whether the fiscal commission will even be able to agree on recommendations to reduce medium-term and long-term deficits -- although we certainly do hope they will succeed. It would help if the President was doing more to elevate the importance of the Commission's work.

We think that Summers has it right in terms of the timing of fiscal policy. There are certainly differences in opinion over the right mix of stimulus and deficit reduction, but it is clear that we can't get our deficits under control by mid-decade with weak growth and we won't be able to have strong growth later on if our debt is rising rapidly. The announcement effect of a deficit reduction plan takes advantage of this feedback starting this year. The Administration, and the Congress for that matter, should get working on a plan that would truly put the country on a fiscally sustainable path. Everything should be on the table and everyone should be at the table.

CRFB board member Eugene Steuerle joined the Announcement Effect Club in a post on the Urban Institute's website. In the post, he talked about the need to separate the difference between our short-term deficits and our medium-term structural deficits. First, the main quote:

Finally, there's a bonus in handling the first, short-term problem by starting to solve the second, long-term problem immediately: it gives greater assurance to the markets that countries are going to get their fiscal houses in order. Many solutions to long-term fiscal problems—such as reducing powerful incentives to retire—could also be designed to boost recovery.

As he points out, there's no need to wait to develop a plan, since there obviously can be a lag between when a policy is enacted and a policy is implemented. Because of this lag, he says, "The economics always [say] we should adopt and maintain good long-term budget policy as soon as possible, even when we disagree on the timing of short-term stimulus." Since a medium-term deficit reduction plan would have little, if any, contractionary effect in the short term, enacting one now makes economic sense, especially since a credible plan would reduce upward pressure that fears of excessive debt could have on long-term interest rates.