US Debt and Deficits Treasury Securities – a Good Investment? Kamna Gupta Tarun Bhasin Nikolai Dëus-von Homeyer

The US Federal Budget since 1990 Government spending: 1990: Federal outlays represent approximately 20% of the gross domestic product (GDP) Declining trend until the 2000, where they constituted circa 16% of GDP Government spending increased from 2000 – 2008 due to growing health care costs & the global financial crisis Nondefense discretionary spending changed dramatically compared to its average over the past 20 years Fiscal revenues: Declining fiscal revenues from 2000 until 2004, then rising until 2007, however, without exceeding the overall federal spending Government income has slumped since 2007 and constituted only 15% of GDP in 2009 (21% in 2000) Fiscal deficit: Pre 2000, Budgetary surplus: Revenues exceeding outlays by approximately 4 percentage points on average : Budgetary deficit due to growing health care costs & the global financial crisis 2009: Fiscal deficit of 10 percentage points due to bail out programs such as TARP Source: Congressional Budget Office (CBO) Chart 1: Government spending as % of GDP

CBO 20-year Forecast Extended-Baseline Scenario (EBS): Based CBO’s 10-year baseline budget projections for the next decade Extends the baseline concept beyond that 10-year window Implies that many policy adjustments that lawmakers have routinely made in the past will not occur Primary spending to grow sharply relative to its historical relationship to GDP 26% of GDP in 2009 (highest level since World War II) 20% of GDP in % of GDP in % of GDP 2035 Alternative Fiscal Scenario (AFC): Continues today’s underlying fiscal policy Deviates from CBO’s baseline even during the next 10 years as it incorporates policy changes that are expected to occur and that policymakers have regularly made in the past Primary spending to grow to its historical relationship to GDP  about 2 percentage points higher as a share of GDP than in the extended - baseline scenario throughout the projection period CBO Forecast Methodology The extended-baseline scenario implies that federal revenues will grow faster, on average, than the economy—increasing from 20 percent of GDP in fiscal year 2012 to 22 percent by But even if revenues rose to those unprecedented levels, they would not be sufficient to keep the budget in balance over the long term in that scenario. CBO Forecast Key Assumptions for Forecast Reductions in tax rates enacted in 2001 and 2003 will expire at the end of 2010 Alternative minimum tax (AMT) will not be changed, and because its parameters are not indexed to inflation like most of the tax code, its reach would expand substantially over time Revenues in extended baseline scenario would reach higher levels relative to the economy than ever recorded Ongoing increases in real (inflation-adjusted) income would push taxpayers into higher income tax brackets

Government Debt Federal Debt (% of GDP) held by the Public under Long-Term Budget Scenarios: Source: Congressional Budget Office In EBS, federal debt held by the public would stay near 60 percent of GDP during the coming decade but then would turn upward and reach 79 percent of GDP by Under AFC, the spending and revenue policies incorporated in this scenario, federal debt would surpass 100 percent of GDP in 2023 and exceed 200 percent of GDP by the late 2030s.

Assessment of the CBO Forecast Most important inputs into the CBO's forecast: Government spending for health care and social security –Health care cost to increase dramatically due to health care reform –Increasing government deficit can only be avoided if health care sector becomes more efficient, thereby reducing the relative cost – Higher social security cost can only be avoided by economic growth Tax Revenues If tax revenues higher than economic growth percentage-wise, then increasing tax rate will make economic growth come to a stop Lack in economic growth will lead to decreasing tax revenues, additionally increasing the deficit Policies that would alter future deficits: Health care: increasing costs can only be avoided by creating synergies & making the sector more efficient Social security: fewer/lower transfer payments to bring labor cost down Other government spending: public investments to be undertaken by the private sector, e.g. public private partnerships, to create synergies/efficiencies Tax revenues: tax increases would slow down economic growth, tax reductions would increase government deficit  available resources have to be used efficiently to increase productivity further, thereby stimulating economic growth Bottom-line: “It’s the economy, stupid!”

Future Outlook of US Treasury Future Deficits & Interest Rates Current forecast is to reach a 79% debt-to- GDP ratio by 2035 Current bond market is pricing some default risk in US Treasury Bonds after the Financial Crisis Risk of default will amplify in coming years if debt-to-GDP ratio increases without significant measures taken by Congress US Treasury Interest Rates will increase through 2011 as the US exits the stimulus packages enacted during the crisis. If the US continues to operate a large deficit, Treasury yields will grow due to a greater probability of default. The US will continue to honor its foreign debt even with increased debt levels. Default & Payment The recent sale of $34 billion in US Treasury’s by China signals possible loss of faith in US creditworthiness An economic collapse of the world’s currency would cause a severe disruption across world financial markets As in the case of Greece, a bail out would be instituted to prop up the market Don’t Buy