What Happens When The US Can Borrow No More?

In a previous post, I noted that the US can handle a debt load up to about $20 Trillion, even in the absence of rapid economic growth. Unfortunately, we appear to be rapidly headed past that figure, with the White House’s official projection showing that total debt will pass $20 Trillion by 2016 [1], and will rise above $25 Trillion by the end of the decade!

The growth of the federal debt is thus unsustainable, as even politicians now acknowledge. Eventually, bond markets will be unable to consume the volume of debt that America needs to issue in order to continue spending. What happens at that point, when the US can no longer borrow to fund current spending?

Here are the options for 2015, using the assumption that real GDP growth and inflation will both average 2% through 2015, with a resulting budget deficit of $1,014 Billion [2]:

  1. Cut Spending: Spending cuts of $475B will be needed to reduce the budget deficit below 3% in 2015. A 3% budget deficit is generally viewed as sustainable by economists [3]. Budget cuts this size would necessarily have to include cuts to Defense, Medicare, or Social Security, as they together make up 2/3 of the Federal budget.
  2. Raise Taxes: As with spending cuts, $475B in taxes would be needed to drop the deficit below 3% in 2015. Taxes would have to be raised to 21% of GDP to close the gap, the highest total tax burden since at least 1975.
  3. Monetize Debt: Since the start of financial crisis, the Federal Reserve has been purchasing US treasuries in order to keep interest rates down and to inject cash into the economy. The Fed could also bail out government finances by buying the $475B in excess Treasury issuance in 2015, but this is the equivalent of printing money. Such an approach will create inflation, and is unsustainable in the long term.

The federal government is likely to attempt a combination of all three approaches in order to minimize the pain on any one interest group. Inflation will likely rise above its recent norm of 2% as the Federal Reserve quietly injects money into the economy. The federal government’s total tax burden will likely rise to at least 20% of GDP, and spending cuts in the hundreds of billions will be required. The sacred cows of Medicare, Defense, and Social Security will be cut, since there’s little to cut outside these programs. The future looks increasingly to hold higher taxes and less government services, a penance decades in the making.

[1] See table S-14 for the OMB’s debt projections.

[2] The OMB uses rosy economic growth projections (table S-13) of over 4% for most of the years between now and 2015. I use a more conservative 2% for real economic growth and 2% for inflation, for 4% total nominal GDP growth (vs. 5.6% used by the OMB). Using 4%, I estimate GDP at $18 Trillion in 2015, whereas the OMB projects $19.4 Trillion. My lower GDP estimate also lowers projected government revenue proportionally, so that my budget deficit estimate for 2015 is $1014 Billion (versus $752 Billion OMB estimate).

[3] Why is a 3% budget deficit acceptable? Long term real economic growth in the US is around 3.75%, so a 3% budget deficit will over time cause the overall debt to grow more slowly than the economy. As the debt-to-GDP ratio shrinks, interest payments on the debt become easier and easier to pay via the growing tax base.

How to Balance the Federal Budget

Can the US federal budget be balanced? It is obviously physically possible to balance the budget by either lowering spending, raising taxes, or a bit of both. But can the budget be balanced in a manner that is fiscally prudent while maintaining adequate funding for government’s most important operations?

I have attempted to balance the 2008 budget below while obeying the following constraints:

  1. No tax increases
  2. No spending shifts between departments, only spending cuts
  3. All spending, including entitlements spending, is fair game

The actual federal deficit for 2008 was $459 Billion, which forms the goal for the cost cutting exercise outlined in the table below [1].

Category 2008 Spending ($Billions) Proposed Cuts Proposed Spending
Defense 612 Cut by $150 Billion, maintaining US defense spending at a level that exceeds the entire World excluding NATO. [2] 462
Social Security 612 Phase out social security benefits for upper income seniors, cutting roughly $110 Billion annually. [3] 500
Medicare + Medicaid 587 Introduce 20% coinsurance for medical spending above $40,000 per year for Medicare and Medicaid recipients, saving $110 Billion. End Medicare Advantage subsidies, saving $17 Billion. [4] 460
Non-defense Discretionary 508 Make an across-the-board 9% cut in non-defense discretionary spending, saving $46 Billion. [5] 462
Other Mandatory Programs [5] 411 End agricultural commodity subsidies and crop insurance subsidies, saving $15 Billion. Modify student loan programs to cut out private middlemen, saving $9 Billion. [6] 387
Interest Payments 253 This cannot be cut without a US government default. 253
Totals 2,983 459 2523

As the table shows, the US federal budget cannot be balanced without deep cuts in Medicare/Medicaid, Social Security, and the Department of Defense. Roughly 60% of the budget is allocated to these major programs, making a balanced budget impossible without reductions here.

A rationale for each major budget cut is provided in the footnotes below. I invite readers to share their balanced budgets as well, or to suggest changes in the cuts that I’ve suggested. Just make sure that the numbers add up, as cutting $459 Billion from the federal budget is harder than it looks!

[1] The core budget data for the table comes from Table S-3 of the US Budget Summary Tables. The 2010 budget document is used, as actual spending for 2008 is not available in earlier versions. The 2009 fiscal year data is incomplete, and also has significant one-time items like TARP and Stimulus package spending, so I chose to focus on the finalized 2008 numbers instead.

[2] The US defense budget represents almost 50% of the entire world’s defense spending, leaving ample room for cuts without jeopardizing US security. Over time the US defense apparatus has become particularly bloated, and cuts may actually improve the DoD’s efficiency over time. It’s worth noting that the US won the Cold War with much lower defense budgets than today.

[3] Social Security was enacted to ensure that American seniors did not starve in their last years, but later grew into a mandatory retirement program. Cutting Social Security payments to upper income seniors would bring the program closer to its original goal. There are 5 million senior households with income greater than $50,000, and they represent the top 20% of all seniors in income terms. These seniors likely draw maximum social security benefits, around 30k annually if there is slightly more than one senior per household on average.  Phasing out these benefits for the wealthiest 20% of seniors would save around $110 Billion. Gross benefits reductions would be around $150 Billion (5 million * 30,000), with an offsetting loss of tax revenue from the reduction in benefits.

[4] Along with defense spending, Medicare and Medicaid are the fastest growing parts of the federal budget.  Since government resources are limited, government benefits must also be limited. Medicare and Medicaid spending can be contained by requiring individuals to pay 20% of their own health care bills beyond $40,000 per year. This change would affect only 5% of Medicare recipients, but would yield huge savings as many patients would decline expensive treatments once cost became a consideration. 32% of all Medicare spending occurs above the $40,000 line; if requiring coinsurance cut this in half, roughly $110 Billion would be saved. This analysis assumes that the breakdown in Medicaid spending is similar to that of Medicare.  An additional $17 Billion annually could be saved by ending subsidies to Medicare Advantage, which is part of current health care reform proposals under debate.

[5] Non-defense discretionary spending includes almost all other federal departments. A 10% across-the-board cut would force all departments to shrink and increase efficiency. Alternately, targeted cuts could be used to shrink certain programs, but these cuts would still have to total $51 Billion annually. Health care cost growth could be reined in through heavy cuts at the NIH, which heavily subsidizes health care and pharmaceutical research. Cutting NIH’s $30 Billion budget in half would enable other departments to get by with a 6% cut instead. One more alternative would involve eliminating Congressional earmarks, which would reduce spending by $20 Billion.

[6] Other Mandatory Programs includes federal funding for food stamps, unemployment insurance, farm subsidies, student loans, veterans’ benefits, and other miscellaneous programs written into law with automatic spending formulas. Farm subsidies in particular deserve heavy cuts, as they distort the economy while worsening Americans’ health. Eliminating commodity crop payment programs and crop insurance subsidies would save $15 Billion annually (see page 4). An additional $9 Billion in savings is possible through the removal of middlemen in federally-backed student loans. Since the federal government assumes all risk on these loans, there’s no reason to compensate private banks to issue the loans.