Why Our Current Budget Situation Is a Crisis
Tuesday, May 4, 2010
There is no precedent for reducing the ratio of debt to GDP by simply growing our way out of it.
At the end of World War II, the United States had a federal debt of more than 100 percent of gross domestic product (GDP). In fiscal year 2009, federal debt was 53 percent of GDP, and the Congressional Budget Office (CBO) projects it will rise to at least 90 percent of GDP by 2020 and continue rising thereafter, unless either policy changes or investors lose confidence in American fiscal policy and refuse to extend further credit.
Given that the United States recovered from its WWII debt burden, could we recover again? I think it helps to analyze how the debt evolved over the past several decades, in order to see what lessons history might teach us.
Suppose that you have a credit card with an outstanding balance too large for you to repay this month. The balance on that credit line evolves based on interest charged on the outstanding balance as well as the difference between the payments you send the credit card company and your new purchases using the credit card. Similarly, we can consider the government's debt evolving based on interest expense as well as the difference between purchases and receipts.
The difference between receipts and purchases, not including interest expense, is known as the primary surplus. The primary surplus is one component of the federal debt’s evolution.
By 2020, the ratio of debt to GDP is projected to be at least 90 percent. From there on, it is forecast to rise further, as entitlement spending rises due to demographic shifts and increasing healthcare spending.
With your credit line, the bank might worry about how the interest rate compares with the rate at which your income is growing. If the interest rate is 10 percent per year but your income grows at 20 percent per year, then your ability to repay a given outstanding balance will be improving. On the other hand, if the interest rate is higher than your rate of income growth, then your ability to repay the outstanding balance will be deteriorating.
The analogy with the federal debt is to compare the interest rate to the growth rate of federal tax revenue. More often, however, economists compare the interest rate to the growth rate of total spending in the economy, or GDP. Implicit in this comparison is the assumption that tax revenues will grow at the same rate as GDP.
When the government runs a primary surplus, that causes the ratio of debt to GDP to fall. In addition, when GDP grows faster than the interest rate, that causes the ratio of debt to GDP to fall. Conversely, a primary deficit or GDP growth that is slower than the interest rate causes the ratio of debt to GDP to rise.
Below is a table that summarizes these factors in five-year periods, beginning in 1950. By that point, the ratio of debt to GDP had fallen to 79 percent, thanks to a large surplus in 1948 and also to a GDP surge in 1948 and 1949.
Table Source: Tables B-78 and B-81 of the Economic Report of the President, 2010, and author's calculations. The interest rate is calculated as the ratio of interest expense in the period to the outstanding debt at the end of the previous period.
The first chapter of the history runs from 1950 through 1969. I call these the Surplus Years. At the time, the official data showed deficits. One reason was that only under President Johnson did the government adopt the “unified budget” that included Social Security receipts and outlays. Because until very recently Social Security ran surpluses, the “unified budget” shows more fiscal strength than was initially reported in the 1950s and early 1960s. In addition, we are looking at the primary surplus, which excludes interest payments. Adding in interest expense would move some of the individual years into deficit, but it would not erase the overall surpluses in the five-year totals.
In addition to the primary surpluses, the Surplus Years saw GDP growth in excess of the interest rate by a substantial amount. As a result of these factors, at the end of the Surplus Years the ratio of debt to GDP had plummeted to 29 percent from 79 percent.
If the interest rate is higher than your rate of income growth, then your ability to repay the outstanding balance will be deteriorating.
The second chapter runs from 1970 through 1979. I call this the Inflation Shock, because inflation rose much faster than investors had anticipated. Although the performance of the economy was weak, the unexpected inflation kept nominal GDP growth high relative to interest rates. Bondholders' losses were the government's gain, so that even though the primary budget swung into deficit, the ratio of debt to GDP edged down further, to less than 26 percent.
The third chapter runs from 1980 through 1994. I call this the era of Bond Market Vigilantes, a term coined by Federal Reserve-watching economist Edward Yardeni, who used it to describe the way that investors raised interest rates at the slightest whiff of inflation. Having been burned by the Inflation Shock, bond investors were wary, and interest rates soared well above GDP growth rates. Even when the large primary deficits of the early Reagan years moderated, the Bond Market Vigilantes caused the ratio of debt to GDP to continue to rise, to just over 49 percent.
The fourth chapter runs from 1995 through 2004. I call this the Clinton Boom. The primary surpluses were huge, and the Bond Market Vigilantes relaxed, so that the ratio of debt to GDP fell below 37 percent.
The final chapter goes from 2005-2009. I call this BushObamanation, because the allocation of blame between the two presidents cannot be settled objectively. I am not prepared to draw any particular line between what President Obama inherited and what he initiated. I leave that to the reader. The end result is that in the last two years the economy was weak, the primary deficit soared, and the ratio of debt to GDP climbed to 53 percent.
The swing in the primary deficit in the past two years has been sharp. In fiscal year 2007, the federal government actually ran a primary surplus of $76 billion, and the ratio of debt to GDP fell to 36.2 percent. This changed to a deficit of $206 billion in 2008 and a deficit of $1,226 billion in 2009.
The years with the largest increases in the ratio of debt to GDP since WWII are:
This staggering rise in the ratio of debt to GDP reflects both the steepness of the recession and the nature of the policy response. Again, I leave it to the reader to apportion responsibility.
Going forward, the CBO foresees that debt rising relative to GDP will continue. By 2020, they project the ratio of debt to GDP to be at least 90 percent. From there on, the CBO projects it will rise further, as entitlement spending rises due to demographic shifts and increasing healthcare spending.
The Lessons of History
One point that stands out is that the years of dramatic reductions in the ratio of debt to GDP were years in which the United States ran primary surpluses. The only other chapter in history where the debt to GDP was reduced was the Inflation Shock. Even then, it was not reduced by much, and this chapter was followed by the Bond Market Vigilantes chapter, in which investors punished the government for its prior inflationary transgressions.
In short, there is no precedent for reducing the ratio of debt to GDP by simply growing our way out of it. Instead, policy choices must be made in order to restore a primary surplus.
In fact, looking at the deficit as a percent of GDP may understate the difficulty of the policy choices. Americans pay more in taxes to state and local authorities than do the residents of many other nations. As a result, the share of GDP available to be taxed by the federal government is not as high as elsewhere.
In any event, in a non-recessionary economy, the federal government's ratio of revenue to GDP is generally around 20 percent. While a $1 trillion primary deficit represents less than 7 percent of GDP, it represents about 30 percent of full-employment revenues. Eliminating a primary deficit of that magnitude will not be easy, particularly when the major expenditure components are entitlements, which are under pressure to expand rather than contract.
I do not think it is overstating things to describe our current budget situation as a crisis.
Arnold Kling was an economist on the staff of the board of governors of the Federal Reserve System and was a senior economist at Freddie Mac. He is a member of the Mercatus Center financial markets working group and co-hosts EconLog, a popular economics blog. He is the author, along with THE AMERICAN editor-in-chief Nick Schulz, of From Poverty to Prosperity: Intangible Assets, Hidden Liabilities, and the Lasting Triumph over Scarcity.
FURTHER READING: Kling’s other articles for THE AMERICAN include “Not Your Grandfather’s (Or Keynes’s) Economy,” “Regulation and the Financial Crisis: Myths and Realities,” and “The Problem with the Biggest Tax Break in America.” Kling and Nick Schulz have also questioned “Is Mandated Health Insurance Constitutional?” explained how government policies are “Planning the Next Bubble,” and discussed why “Individual Health Savings Accounts Are Better.”
Image by Rob Green/Bergman Group.