Shocks and Deficits
By Arnold Kling
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.