Wednesday, June 16, 2010

Budget Basics (2): Debt Dynamics, the Primary Deficit, and Sustainability

The debate over U.S. fiscal policy is as much about the debt as it is about the deficit. The federal debt grew significantly during the early 2000s, and has risen even more sharply since the onset of the financial crisis. In 2009, it reached a post-World War II high of 53 percent of GDP, and it is expected to continue growing at least over the next 10 years.

The growth path of the debt depends on several factors. Political decisions on discretionary spending and taxes play a role, of course. So do demographic changes, which influence entitlement spending. Less well understood, there is an inherent debt arithmetic that determines the long-term economic consequences of whatever political decisions are made in the short term. This arithmetic, and the resulting debt dynamics, are the focus of this second part of the Budget Basics series.

A good starting point for understanding debt dynamics is provided by a simple formula that gives the equilibrium value of the debt. Suppose the federal deficit as a percent of GDP, the rate of real growth, and the rate of inflation are constant over time. If so, the equilibrium value of the debt will be equal to the deficit ratio divided by the sum of real growth plus inflation (that is, by the rate of nominal GDP growth).

For example, suppose we were to start from the 2009 U.S. debt ratio of 53 percent and hold the deficit constant at its 2009 cyclically adjusted value of about 6.5 percent of GDP. (See Part 1 of this series for a discussion of the cyclically adjusted deficit.) Assume 3 percent real growth and 2 percent inflation. In that case, the debt would grow to an equilibrium ratio of 130 percent of GDP over the next half-century or so.

At first glance, it seems comforting to think that even with a relatively large 6.5 percent deficit, there need not be a debt crisis--only a gradual approach to a sustainable equilibrium debt. However, there is an unpleasant assumption hidden in the equilibrium debt formula. Although it assumes a constant ratio of the total deficit to GDP, it requires big changes in the structure of the budget. Over time, as the debt approaches equilibrium, rising interest expense must squeeze out program spending on things like roads, defense, schools, and social security, or instead, there must be a steady increase in taxes, or some mix of the two.

In this sense, the equilibrium debt formula hides as much as it reveals. To get a clearer picture, we need to look at a different number--the primary budget balance. The primary balance is the deficit or surplus excluding interest expense. In order to hold the debt to a sustainable equilibrium in the long run, the primary balance must be held at or close to zero. If a primary surplus is achieved, the debt will decrease over time, as it did briefly during the 1990s in the United States. However, if the primary balance remains substantially in deficit for a prolonged period, the debt explodes, leading to a crisis of like that of Russia (1998), Argentina (2001), or Greece (2010). Such a crisis leaves the government with a choice among three very unpleasant alternatives: Outright default, indirect default via inflation, or painful austerity measures forced at a moment when the economy is already in recession.

Right now, the United States has a very large primary deficit. Adjusted for cyclical effects, the primary deficit was more than 7 percent of GDP in 2009. That was the second-largest in the OECD. It was larger even than such acknowedged fiscal basket-cases as Greece, Spain, or Japan, and was exceeded only by Ireland. This large cyclically adjusted primary deficit is the best single indicator of the fiscal policy adjustment that the U.S. government needs to make if it is to avoid a future debt crisis.

None of this means that there must be a "rush to austerity," an immediate closing of the budget gap while the recovery is still fragile. Because of a flexible exchange rate and an ability to borrow at low interest rates, the United States has more room to maneuver in the short term than a Greece or a Latvia. However, there is no escaping the need to make sufficient policy changes to close the primary budget gap over the medium term, say, by the time the economy approaches its next business cycle peak, which presumably will come less than a decade from now. If the necessary chages are not made, there will be trouble, for sure. It's a matter of simple budget arithmetic.

Follow this link to download a free set of classroom-ready slides with detailed data, charts, and analysis on the subject of debt dynamics and sustainability. Watch for further posts in this Budget Basics series, coming soon.


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