Business Insider

Peter Crabb: Without entitlement reform, the economy will suffer

They are calling our bluff! The bond market will soon force the government’s hand to do something about a growing government budget deficit.

A sell-off in the long-term bond market started early this year, raising the yield on 10-year U.S Treasury debt from just over 2 percent to near 4 percent. During this time interest rates in the short-term bond market remained low. The two-year U.S. Treasury note stayed just under 1 percent.

All that changed this past week. The president said he was “not satisfied” with how fast money from the stimulus plan was getting out and into the economy. But this call for quicker action was met by a sharp rise in the two-year U.S. Treasury note yield to near 1.4 percent.

There is little argument that our propensity to borrow and spend at the national level cannot go on forever. But little opposition was put forth when the federal government passed new legislation last fall and earlier this year with the hope of mitigating the economic downturn.

Why no real opposition? The economic stimulus package is not the true source of the problem. In a report for The New York Times this week, David Leonhardt describes “two basic truths” about federal government deficit: The president’s recent proposals account for very little of deficit, but Mr. Obama also has no “realistic plan” to do anything about it. Mr. Leonhardt correctly notes there is no current plan to reform the real problem: entitlement programs.

The deficit issue over the long run can only be addressed by reforming our long-run budget commitments. The Congressional Budget Office reported in May that the outlook for deficit is “unsustainable and, if it is not resolved, will undermine economic growth.”

The CBO also reviews the receipts and outlays for the federal government each month. In its most recent review on June 4, the CBO found that most of the growth in federal spending over the previous year is attributable to increased Medicaid expenditures. Medicaid spending is rising at a 21 percent annual rate.

The recent bond market actions suggest reform of these programs and others will need to come sooner than later.

The cost of financing our debt is rising because foreigners have slowed their purchases. The Federal Reserve has somewhat replaced these buyers in the market, increasing its balance sheet and the money supply, but this raises inflation expectations.

The U.S. federal deficit has long been financed by foreign purchases of Treasury bonds, particularly Asian countries. This has mitigated the crowding-out affect I discussed a few weeks back.

Asian countries have long provided funds to the U.S. credit market, and interest rates are lower than they would be otherwise. The foreign purchases have increased the supply of credit, partially offsetting the increase in the demand for credit from U.S. Treasury borrowing.

Because we continuously run trade deficits, importing more than we export, foreigners have accumulated U.S. dollars and purchased U.S. assets. Larger trade deficits have always been associated with larger fiscal deficits. When the U.S. runs large government deficits, foreigners spend more on U.S. government securities, bonds, and less on U.S.-produced goods and services, our exports — further increasing the trade deficit.

Today, the trade deficit is declining along with the global decline in economic activity. The monthly U.S. trade deficit at this time last year was over $60 billion. The most recent monthly report shows only $28 billion. Foreigners will be buying fewer and fewer Treasury bonds, raising interest rates and slowing growth.

We used to be able to rely on other countries to finance our national debts, but no more. Trying to replace these players at the table by printing more money will not work. Inflation will rise, offsetting the necessary economic growth.

Without reform of Medicaid, Social Security, and the other nondiscretionary federal spending programs, the U.S. deficit will hold us back. We need to play our cards right.

Since 2000, Peter R. Crabb has been a professor of finance and economics at Northwest Nazarene University in Nampa. He earned his doctorate in international and financial economics from the University of Oregon.