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When Debt Flies Off the Charts

Thursday, July 15, 2010

Under one realistic future scenario, the nation’s debt becomes so large that Congressional Budget Office models break down.

At a time when Paul Krugman and other Keynesians are arguing against austerity measures and in favor of more stimulus money, it is worth asking how bad the country’s financial situation is. The answer, unfortunately, is: really bad.

The chart below examines the Congressional Budget Office’s (CBO’s) most recent Long-Term Budget Outlook projections for the next 25 years of federal debt held by the public.  Projections are shown under the CBO baseline, alternative scenario, and the alternative scenario incorporating crowding-out effects (data from this most-likely scenario are only given through 2027 because at this gargantuan level of debt CBO models simply break down).

Even under the extremely unrealistic best-case scenario, debt continues to grow faster than the economy, increasing from around 60 percent of gross domestic product in 2010 to 80 percent of GDP in 2035.

 deRugy 7.14.10

The CBO baseline uses spending and revenue provisions as they exist under current law. Under this scenario, the Bush tax cuts are allowed to expire, the alternative minimum tax remains un-indexed to inflation, and revenue and spending in the healthcare bill occur as planned (note that these promises have already begun to be broken—projected cuts in Medicare reimbursement have been put off three times already this year). Even CBO finds this scenario highly unlikely.

This is why the scenario in black projects what CBO deems more likely. In the world of the alternative scenario, widely expected policy changes occur. These include:

•    A gradual increase in the reimbursement rates of Medicare physicians

•    Elimination of pay-as-you-go rules that control spending

•    Congress protects middle-class families from the alternative minimum tax.

As you can see, things look bad in this case. But when the dynamic effects of government debt on the economy are incorporated, things look even worse. When government borrows money, there is less money available for the private sector to invest in capital; this results in decreased economic output in the long run. Economists refer to this effect as crowding out. The red line shown above captures the most likely projection of debt as a percentage of GDP, incorporating crowding-out effects.

In the real world—where politicians are subject to political pressure, investors must compete with the government for capital, and citizens watch their government for cues before spending and investing—debt held by the public as a percentage of GDP skyrockets to 188 percent of GDP by 2027. From there, no one, not even CBO, can pretend to know where the economy will go.

Veronique de Rugy is a senior research fellow at The Mercatus Center at George Mason University.

FURTHER READING: de Rugy also says “It Depends on What the Definition of ‘Austerity’ Is” when it comes to federal deficits. In addition, she shows our “In-the-Red State” and details “Athens on the Potomac.” AEI’s Michael Barone says “Obama Economy Sends Americans to their Mattresses” and Kevin Hassett suggests “Ask George W. Bush How to Avert a Double Dip.

Image by Darren Wamboldt/Bergman Group.

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