Monday, February 15, 2010

What do we mean by sustainable debt? 

Greg Mankiw provides an answer in yesterday's NYTimes, and suggests the Obama Administration comes up short of its advertised goal:
From 2005 to 2007, before the recession and financial crisis, the federal government ran budget deficits, but they averaged less than 2 percent of gross domestic product. Because this borrowing was moderate in magnitude and the economy was growing at about its normal rate, the federal debt held by the public fell from 36.8 percent of gross domestic product at the end of the 2004 fiscal year to 36.2 percent three years later.

That is, despite substantial wartime spending during this period, budget deficits were small enough to keep the debt-to-G.D.P. ratio under control.

The troubling feature of Mr. Obama�s budget is that it fails to return the federal government to manageable budget deficits, even as the wars wind down and the economy recovers from the recession. According to the administration�s own numbers, the budget deficit under the president�s proposed policies will never fall below 3.6 percent of G.D.P. By 2020, the end of the planning horizon, it will be 4.2 percent and rising.

As a result, the government�s debts will grow faster than the economy. The administration projects that the debt-to-G.D.P. ratio will rise in each of the next 10 years. By 2020, the government�s debts will equal 77.2 percent of G.D.P.
And that's using the more favorable growth and spending assumptions in the Administration's budget. If you use CBO, the story gets worse. This is why the figures Menzie Chinn shows only take us so far: One can easily imagine a case where cyclical adjustment in a recession causes a temporary rise in the debt-to-GDP ratio without a concern about sustainability, if in the long run we stabilize and eventually reduce that ratio.

Debt market participants are forward looking. What they concern themselves with is that the debt they are buying are not part of a Ponzi scheme. To make a long story short (the long, mathematical story is here if you're curious), your country must be expected to run budget surpluses some time in the future to pay off the current debt. There's discounting involved of course, but most important is the difference between your country's real interest rate and the rate of growth of real GDP. (One of the remarkable lessons of the theory is that you can't inflate your way out of the problem, as long as we assume nominal interest rates fully adjust to higher money growth rates being used to pay off the debt. Read around the math of that last link for more.)

What matters most then are either policies that bring down the primary deficit, those that maintain our credit such that real interest rates are reduced, and those that increase the growth rate of GDP. At present the primary deficit -- the deficit less interest payments on the debt -- doesn't stabilize. It's not necessarily the bomb that Ed is talking about; this debt is a very slow rotting of the nation's economic health, taking a couple of decades to become apparent. It's worth remembering in this story that while the government may show you the debt "held by the public", the bonds in the trust funds are being held in trust for the public. Interest on those bonds in the trust funds are meant to pay for future benefits for Social Security, Medicare, railroad pensions, etc. At present all we have is the past good credit of the US and a promise by the Obama Administration to get serious ... by forming a committee to tell us how to get serious.