Yesterday was our first Tax Policy Colloquium session, and I presented my book-in-progress chapter "The Approaching Fiscal Train Wreck," available here. This piece talks about how we should measure the long-term fiscal situation in terms of the true underlying issues, which chiefly are (a) the sustainability or fiscal meltdown problem and (b) the generational issue of favoring old versus young.
Since my co-convenor David Bradford and I feel free to comment on other people's papers, we think it is only fair to bring in other people to comment on our work. My commentator was Bill Gentry of the Williams College Economics Department, an excellent public finance economist who spent some years participating in our sessions when he was at Columbia.
Bill made one really important point about how to measure fiscal problems that revises how I think about the measurement issue, although it does not affect how I think about the current situation. (Bill agrees that it does not affect how we should think about the current situation.)
I have been mainly agreeing with economists such as Lawrence Kotlikoff, Kent Smetters, and Jagadeesh Gokhale that the fiscal gap offers the best snapshot measure of our failure to establish a sustainable budget policy. Kent and Jagadeesh have written and argued that, under the inter-temporal budget constraint (known more informally as the no-free-lunch principle), the only truly sustainable policy is one with a fiscal gap of zero, i.e., where you will pay for everything.
Bill notes, however, that inter-temporal budget constraints are binding in finite scenarios, whereas the infinite horizon scenario may be the right one for the US government to use (notwithstanding grotesque misuse of this idea by the Bush Administration in its "respond to 9/11 by bombing Mexico"-style arguments for its Social Security plan).
Suppose that the US currently had a debt to GDP ratio of .5, with public debt of $5 trillion and GDP of $10 trillion. Suppose that both public debt and GDP were scheduled to rise at 2% per year, keeping the debt to GDP ratio constant at .5 forever. This would lead to a very high fiscal gap as measured in present value terms from today (indeed, an infinite fiscal gap if the discount rate were 2% or less), but seemingly to no sustainability problem.
To have a problem, therefore, we need not just a fiscal gap but an exploding debt to GDP ratio over time. No need to revise what I and others have been saying about the "approaching fiscal train wreck," since indeed that is where we are headed; debt to GDP ratios are indeed slated under the forecasts to explode. But it does suggest that we need another tool as a measurement matter, in order to have the right set of budget policy terms and tools.