Having found the time to read the Auerbach-Gale fiscal gap paper more carefully than when I recently posted about it, the following points seem especially pertinent:
(1) We have a really huge fiscal sustainability problem that the financial crisis has made significantly worse, but that the stimulus legislation, if its provisions generally expire in a couple of years as expected, affects only slightly. In my recent article about the fiscal gap, what I considered the most reasonable projections (in terms of projected current policy for future years) from the perspective of mid-2008 placed it at $103 trillion, whereas a similar Auerbach-Gale estimate now places it at $118 trillion. This may not be entirely apples to apples, however. Current stimulus initiatives are trivial compared to this if they are indeed temporary.
(2) Paul Krugman and his acolytes like to say that we don’t really have a budget crisis, but rather a healthcare crisis. My common response has been – why would it be just one or the other, when clearly it’s both? The twin crises relate to each other like overlapping circles in a Venn diagram. Medicare, Medicaid, and other healthcare subsidies fit into both, but each also has lots of independent elements (e.g., Social Security and unsustainable tax cuts for the fiscal crisis, employer-provided plans’ long-term feasibility for the healthcare crisis). Against this background, Auerbach and Gale note that the Bush-era tax and spending changes added about as much to the fiscal gap as everything attributed to healthcare does. (This may involve counting Medicare prescription drugs towards both, as it was a Bush-era policy change.)
(3) Deficit accounting for TARP and other Fed or Treasury interventions presents an interesting topic that perhaps has received too little attention. Two alternative methods, as always when we are thinking about deficit accounting versus true long-term accounting, are cash flow on the one hand and economic accrual on the other. The Fed’s activities appear to be getting accounted for on the basis of whichever is lower as between the two. TARP is being accounted for on a present value basis, with only the present value subsidy being added to the deficit. This led to $461 billion of TARP outlays as being scored at only $184 billion, reflecting the present value of expected future recoveries. Fair enough, but the Fed has also extended more than $1 trillion in financial support to banks, corporations, etc., scored at zero on the view that these are just loans, but in fact exposing the Federal government to significant downside risks that presumably have a present value (these are not arm’s length commercial loans) and yet that are ignored for deficit measurement purposes.
(4) It’s stunning to read in Auerbach-Gale that the market for 5-year senior U.S. Treasury bonds is now, for the first time in known history, pricing in a non-trivial default risk. They estimate the market’s perceived default risk for Treasury bonds – within the next 5 years, mind you – at about 6 percent. This estimate admittedly reflects disputable assumptions, e.g., about the percentage recovery people expect in the event of a Treasury default. Arguably, the true figure is either higher or lower. But the world is changing faster than we thought if the prospect of a U.S. Treasury default is already starting to affect world financial markets.
At this point, nasty world capital market events such as a run on the dollar can no longer reasonably be considered impossible even within the relatively short term.