Gross Federal Government Debt

0.10.10.10.10.20.30.30.30.30.30.30.30.30.30.30.30.30.30.30.30.30.30.30.30.30.30.30.40.40.40.40.40.50.50.50.6

0.70.80.80.91.01.1

1.41.61.82.12.3

2.62.93.23.64.04.44.6

4.95.25.4

5.55.65.65.86.26.8

7.47.9

8.59.0

10.0

12.9

14.514.8

16.0

16.8

17.417.918.418.919.420.020.5

21.1

21.7

0.3

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40 44 48 52 56 60 64 68 72 76 80 84 88 92 96 00 04 08 12 16 20

$ T

rill

on

s

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130%

Per

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Dollar Amount Percent of GDPSource: Office of Management and Budget

$84 Trillion Implicit (unfunded) liabilities

2012:Gross Debt = $16 TrillionDebt-to-GDP = 103%

Federal Government DebtHeld by Public

0.00.00.10.10.20.20.20.20.20.20.20.20.20.20.20.20.20.20.20.20.20.20.30.30.30.30.30.30.30.30.30.30.30.30.40.50.5

0.60.60.70.80.9

1.11.31.51.7

1.92.12.22.42.73.03.2

3.43.63.73.83.73.63.43.33.5

3.94.34.64.8

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8.59.0

10.1

11.2

11.912.412.813.213.513.814.114.514.915.3

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40 44 48 52 56 60 64 68 72 76 80 84 88 92 96 00 04 08 12 16 20

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ion

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Dollar AmountPercent of GDP> 90% => 1% GDP Loss

Source: Congressional Budget Office, http://www.cbo.gov/doc.cfm?index=10014

2012:Public Debt = $11.2 TrillionPublic-Debt-to-GDP = 72.5%

Employment-to-Population Vs Debt-to-GDP

55

56

57

58

59

60

61

62

63

64

65

80 81 82 83 84 85 86 87 88 89 90 91 92 93 94 95 96 97 98 99 00 01 02 03 04 05 06 07 08 09 10 11 12 13

(Perc

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t)

25

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45

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55

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75

RecessionEmployment-to-Population (LHS)Employment Ratio Target = 62.5%Debt-to-GDP (RHS)

Source: Department of Labor.

The level of the employment ratio determines direction of debt ratio:•Employment-to-Population > 63% => Debt-to-GDP•Employment-to-Population = 62-63% => stable Debt-to-GDP•Employment-to-Population < 62% => Debt-to-GDP

Unemployment Rate Vs Budget Deficit-to-GDP

-4

-3

-2

-1

0

1

2

3

4

5

6

7

8

9

10

11

12

90 91 92 93 94 95 96 97 98 99 00 01 02 03 04 05 06 07 08 09 10 11 12 13 14

(P

ercen

t)

-4

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-2

-1

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8

9

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12

Recession Unemployment RateDeficit-to-GDP 3% Sustaintable Deficit Target

5% Unemployment Target

Automatic Stabilizers: government spending and tax rules that counteract the business cycle

Low Unemployment Scenario => high tax revenues and low transfer payments => low deficit & contractionary fiscal policy.High Unemployment Scenario => low tax revenues and high transfer payments => high deficit & expansionary fiscal policy.

In the short run, the deficit ratio is determined by the unemployment rate. When the unemployment rate exceeds 6%, the deficit ratio rises above the 3% sustainable target. If unemployment falls below 6% the deficit ratio falls below 3%. This will bring down the Debt-to-GDP ratio.In the long run, the unemployment rate is influenced be the nation’s debt-to-GDP ratio.

Options to Reduce Public Deficits to 3% of GDP by 2014Persistent deficits lead to:

Rising interest rates which crowds out private spending

Future tax uncertainty which reduces business/consumer confidence/spending

Spending Options: $ bn

Raise Social Security retirement age to 70 (eligibility of 67 by 2027 currently) 4

Change benefit inflation index to one less upwardly biased 10

Reduce starting Social Security benefit for most workers 7

(initial benefit indexed to wages for low income, inflation for others)

Raise Medicare age to 67 from 65 3

Convert Medicaid share to block grants (to reduce distorted state cost incentives) 47

Reduce Medicaid share to wealthy states (eliminate 50% floor on federal share) 22

Reduce highway funding and farm assistance 8

Total: $101

Options to Reduce Public Deficits to 3% of GDP by 2014

Eliminate Tax Deductions for:

Employer-provided health insurance (to reduce Cadillac plans and spending) 215

Mortgage interest (to reduce excessive borrowing and leverage) 147

State & local taxes 65

Capital gain on homes (to reduce distorted incentives and behavior) 60

Property tax 33

Municipal-bond interest 32

Total: $552

Options to Reduce Public Deficits to 3% of GDP by 2014

Other tax options:

Implement 5% VAT (Value Added Tax at each stage of production) 324

Cap employer health-insurance deduction to average premium 70

Raise federal fuel tax by 50 cents a gallon to 68 cents 62

Carbon-emissions tax (or Cap-and-Trade system)

National sales tax (to reduce dependence on income tax which penalizes work and investment)

The U.S. tax system needs less complexity, more bias towards taxing consumption and elimination of loopholes to broaden income-tax base which will allow for the lowering of tax rates.

Employment Cost Index(Most Comprehensive Measure of Labor Costs)

Web address: www.stats.bls.gov/news.release/eci.toc.htmAnnual revisions with release of first quarter data which can go back several years.

The employment cost index (ECI) is an early warning system for rising inflation which can push interest rates higher and stock prices lower. ECI is the best harbinger of pricing pressures and is a forerunner of inflation.

Labor costs typically make up 70% of a firm’s operating costs. Employment costs = wages/salaries and fringe benefits.

Rising compensation costs can result in various responses by firms:Raise retail prices => inflation.Absorb expense and maintain prices => falling profits => falling stock prices.Increase capital investment to raise productivity and reduce workforce.Reallocating production facilities by decreasing domestic production and increasing foreign production => increasing unemployment and

unemployment insurance costs => increasing government spending and deficits.

Wage-price spiral (a vicious cycle the Federal Reserve will try to stop) labor expenses => retail prices => workers demand for wages/salaries => retail prices (self-perpetuating inflation escalation)

Every quarter the BLS surveys 8,500 private and 800 public sectors (local and state only) on labor cost issues. Survey is done for the pay period that includes the 12th day of March, June, September, December.

Wage and salary data include bonuses, incentive pay, commissions, and cost of living adjustments.Benefits data include insurance benefits, retirement savings benefits, paid vacations, sick leave, holidays, premium pay for overtime, shift

differentials, social security, Medicare, federal-and state mandated social insurance programs.Data is converted to index where June 1989 = 100

Labor Costs relative to ProductivityIf annual compensation costs are rising (tight labor markets) faster than annual changes in non-farm productivity (falling marginal product of labor),

then economy may be facing inflationary pressures.Strong productivity growth => profits => wages and salaries.

The monthly Employment Report’s average hourly earnings (AHE) is another good indicator of wage inflation. But AHE covers only workers who receive hourly pay (not salaries) and does not include benefits, whereas the ECI covers both hourly and salaried workers.

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Market Analysis:Bonds: Unexpected big ECI without big in productivity => (P/P)E

t+1=> DBonds => iBonds

=> fed funds rate by Fed to stop wage-price spiral

Stocks: Unexpected big ECI without big in productivity and economy operating above potential => business costs => profits => PStocks

Dollar: Unexpected big ECI without big in productivity and economy operating above potential => interest rates => capital inflows => increase value of dollar.But an ECI => U.S. export competitiveness => exports/ imports=> trade deficit => exchange rate.

Employment Cost Index(% change from quarter one year ago)

Civilian Workers

0

1

2

3

4

5

6

7

8

9

10

83Q1 85Q1 87Q1 89Q1 91Q1 93Q1 95Q1 97Q1 99Q1 01Q1 03Q1 05Q1 07Q1 09Q1 11Q1 13Q10

1

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Recession Total Compensation

Wages & Salaries Benefit Costs

Source: http://w w w .bls.gov/new s.release/eci.nr0.htm

Federal Government Surplus/Deficit(Billions of Dollars)

-74-79-128

-208-185-221

-150-155-153

-221-269-290

-255-203

-164-107

-22

69126

236

128

-158

-378-413

-318

-248

-161

-459

-1,400

-1,294-1,296

-1,079

-585

-345

-269-302

-220-196-258-280-279

-339

-212

-$1,500

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$0

$250

$500

80 82 84 86 88 90 92 94 96 98 00 02 04 06 08 10 12 14 16 18 20 22

Source: Congressional Budget Office.

•Bank stock purchases (TARP)•Stimulus plan•Mortgage bailout plan•Income-support programs•Recession-induced falling revenues

Fiscal Austerity Versus Economic GrowthQuestion: Should government cut spending and raise taxes in the short run to reduce our deficit-to-GDP

ratio or should we wait and allow economic growth to reduce the ratio in the long run.

Short-term fiscal austerity can be self-defeating:• This paradox can be explained with the “Fallacy of Composition”: What is true for an individual in not always

true for the whole.

• Recall the economic principle - one person’s spending is another person’s income.

Micro levelWhen a household reduces their current spending, they can use the funds to pay down their debt (deleverage). Assume

a household income is not affected by their spending.

Household Budget Constraint

Income + Change Debt = Taxes + Debt Interest + Consumption + Savings

Macro level When a government reduces their spending, household incomes drop which reduces tax revenues and increases

transfer payments (unemployment insurance, food stamps, medicaid). This could increase the nation’s deficit .

Government Budget Constraint

Tax Revenue + Change Debt = Government Spending + Transfer Payments

The Political DecisionShort-Run Economic Growth versus Long-Run Fiscal Sustainability

Two Goals:

1. Avoid a recession in the near term

2. Achieve fiscal sustainability in the long run

Fiscal Sustainability• Constant Debt-to-GDP ratio

• Achieved when the national debt grows in line with GDP

• Keep the Debt-to-GDP ratio below 90% to avoid triggering a financial crisis.

• Keep deficits below 3% of GDP. Given the expected pace of GDP growth, that will stabilize the debt-to-GDP ratio.

• Unemployment must be below 6% to see the deficit-to-GDP ratio below 3% and therefore a stable and falling Debt-to-GDP ratio.