Arnold Kling  

Shocks and Deficits

PRINT
The Optimal Capital Gains Tax ... Jeff Tucker on Intellectual Pr...

Alan Blinder writes,


The CBO projects federal spending on all purposes other than health care and interest to be roughly stable as a share of GDP from 2015 to 2035, and then to drift lower. So no, America, we don't have a generalized overspending problem for the long run. We have a humongous health-care problem.

But the CBO does not have a clean forecasting record. The WSJ blog reports,

A new paper by the Federal Reserve Bank of St. Louis argues the Congressional Budget Office has for some time consistently underestimated how much the government would need to borrow.

I have not yet read the paper, but I have a hypothesis about why deficits are underestimated. Baseline scenarios tend to assume no shocks. But shocks tend to occur, and when they do, they raise the deficit. The government provides a lot of financial insurance, which means that taxpayers are "short volatility." Whenever the economy veers from a smooth growth path, the deficit goes up "unexpectedly."

One shock that would be really devastating now would be a rise in interest rates. In addition to raising the interest cost of outstanding government debt, a sudden rise in interest rates would cause huge losses in the government-owned portfolio of mortgage-backed securities. If you are holding securities that are backed by mortgages with interest rates of 5 percent or less, and the interest rate you have to pay suddenly goes up to 7 or 8 percent, you are in a world of hurt. Also, because of FDIC insurance, the taxpayers ultimately are liable for the interest-rate risk on mortgages held by banks. See Pinto and Wallison, The Hidden Cost of Free Money.

Have a nice day.


Comments and Sharing


CATEGORIES: Fiscal Policy



COMMENTS (8 to date)
Daniel Kuehn writes:

re: "Also, because of FDIC insurance, the taxpayers ultimately are liable for the interest-rate risk on mortgages held by banks."

This is only true if the banks actually go under, right? It's not exactly true to say that we're liable for the interest rate risk. We're only liable if that interest rate risk causes a bank failure.

And, of course, taking on liability for that PARTICULAR risk reduces other risks we could be faced with, which is the whole reason we have an FDIC.

Nick Rowe writes:

"But shocks tend to occur, and when they do, they raise the deficit."

This assumes that shocks are bad news, and never good news. But that might be correct. Plucking/PSST.

Steve Roth writes:

"raising the interest cost of *outstanding* government debt"

Am I profoundly misunderstanding something here? Excepting TIPS, outstanding government bonds are fixed-rate; they'll pay the rate set at issue through maturity. Don't you mean newly-issued/rolled-over debt?

But yes you're right: if interest rates are higher than GDP growth, long-term, (government) debt spirals.

If the reverse, the reverse. But that's "financial repression"! (Of creditors.)

The first is, just as validly, financial repression of debtors.

And as soon as you start talking about "repression," we've exited the economic realm and entered the moral/political.

Yancey Ward writes:

Steve Roth,

Financial repression is defined as interest rates lower than inflation rate, not GDP growth rate (at least the real rate). I have no real moral objection to this until it involves capital controls and gains taxes of inflation gains on real assets- then it is real repression in every sense of the word. To take the other side of the debtors- they are not repressed until they aren't allowed to default in bankruptcy. So, I would argue that student debts on government guaranteed loans are repression in every sense of the word, but other debts in the US are not.

Arnold Kling writes:

Nick,
I am not just thinking of shocks to GDP. I am thinking of shocks to interest rates, for example. Even when shocks are symmetric, the government loses from volatility, because it tends to be writing insurance that pays out for any shock in any direction.

Jeremy, Alabama writes:

CBO rules are gamed to underestimate borrowing. Gaming the other way, to overestimate borrowing, would cause politicians to be unnecessarily restricted in their spending. Since politicians control the CBO's rules, the rules necessarily underestimate.

Floccina writes:

Logic would say that as we get richer there is less need for programs for the poor to keep up with gdp. The same might go for schooling, defense and law enforcement, of course defense depends on the threats.

Noah Yetter writes:
The CBO projects federal spending on all purposes other than health care and interest to be roughly stable as a share of GDP from 2015 to 2035, and then to drift lower. So no, America, we don't have a generalized overspending problem for the long run. We have a humongous health-care problem.
This seems to me a rather curious way of framing the issue.

The fact that health care and/or interest are the spending categories that are growing does not tell us anything about what kind of problem we have with spending in general. That, in fact, is an easy question to answer, just look at the size of the deficit. It's huge. That means we have a generalized spending problem. The fact that health care spending is growing faster than e.g. defense spending doesn't mean that defense spending isn't a major problem (it is).

Comments for this entry have been closed
Return to top