The Obama administration has recently announced several initiatives to promote US international trade. One is a National Export Initiative aimed at doubling US exports over 10 years. Another is a renewed effort to revive stalled bilateral trade agreements with Korea, Columbia, and Panama.
Economists, with relatively few exceptions, tend to favor free trade. They are at home in a world of economic models where the interests of consumers, firms, and workers are balanced against one another in a neutral, unbiased manner. Using familiar conceptual tools like producer and consumer surplus, economists tally up the net gains and losses to trade liberalization and almost always find that lifting trade restrictions benefits both importing and exporting countries.
The political game unfolds on a different playing field, for two reasons. First, although economists tend to focus on the net gains from trade, politics is very sensitive to the fact that any change in trade policy produces some losers along with the winners. Second, the political influence of winners and losers is not necessarily proportional to the magnitude of their economic gains or losses. Instead, well-organized groups, like corporations, farm groups, and unionized workers, have disproportionate political power compared to poorly organized groups like consumers and non-unionized workers.
As a case in point, consider the Korea-US Free Trade Agreement (KORUS FTA). It was originally negotiated in 2006 and signed by both governments in 2007, but it is not yet ratified. In the United States, the main opposition has come from the Big Three automakers and their unions. These control enough Democratic votes in Congress to have blocked ratification up to this point.
Ratification opponents claim that US-Korean automobile trade is inherently unfair because Korea exports 700,000 cars a year to the US, but imports more than 100 times fewer US cars. They less often emphasize the fact that KORUS FTA would lower Korean auto tariffs by more than US tariffs would be lowered, or that Korean and US automakers each produce many cars in the others' country, which do not show up in import figures, or that trade in auto parts is less unbalanced than trade in finished cars.
Will KORUS FTA be ratified? At the recent G20 summit in Canada, the presidents of the US and South Korea pledged a renewed push for ratification. A group of Republic senators has offered to help the ratification push. Still, as of mid-2010, the outcome is far from certain.
The bottom line: There is a big gap between the politics and the economics of trade liberalization. In Washington, lobbyists for corporations and unions battle one another in a zero-sum game. Consumer interests and non-unionized workers are rarely heard from. In contrast, economic analysis tells us that when the interests of all groups are taken into account, trade liberalization leads to net gains for both importing and exporting countries.
Follow this link to download a set of free, classroom-ready slides with a more detailed analysis of trade liberalization and KORUS. The slides make use of the concepts of consumer and producer surplus. Click here if you think your students would benefit from a quick tutorial on producer and consumer surplus.
Thursday, July 15, 2010
Tuesday, July 6, 2010
The Breakup of the Ruble Area (1991-1993): Lessons for the Euro
The recent problems of high-debt countries in Europe--Greece, Spain, and others--have led many observers to wonder if the euro area might break apart. Parallels have been drawn to the collapse of other fixed exchange-rate systems, ranging from the gold standard to the Argentine currency board. Less attention has been paid to what can be learned from the collapse of the 15-nation ruble area of 1991-1993.
The ruble area came into existence when the Soviet Union was dissolved at the end of 1991. The former republican branches of the Soviet state bank (Gosbank) became the central banks of the 15 newly independent states. Superficially, it looked a lot like the 17-nation euro area.
Unlike the euro area, the ruble area suffered from its birth from high inflation. The inflation arose from three main problems.
What relevance does the demise of the ruble area have for today's euro? There are two main lessons.
The first lesson is to beware free rider problems. True, the ECB has more complete control over money creation than the Central Bank of Russia had, so the euro area does not have to worry about monetary free riders. However, it does have a problem with fiscal free riders. Countries that conduct irresponsible fiscal policies, in defiance of EU rules, gain the full short-term political benefits of high spending and low taxes, while shifting at least a part of the resulting costs to their neighbors. Well-intentioned safeguards, including a supposedly strict no bail-out clause, have provided less than full protection against free riders.
The second lesson is that barriers to exit from a currency area are asymmetrical. Much has been made of the fact that countries with weak economies, like Greece, would find it hard to leave the euro. Even a parliamentary debate on exit would be likely to trigger devastating bank runs and defaults on public and private debt. (See Barry Eichengreen for a good, short presentation of this view.) However, the same barriers do not apply to countries with strong economies that want to leave a weak, inflation-plagued currency area. Estonia, Latvia, and Lithuania achieved a smooth exit from the ruble area. Introducing their national currencies quickly brought down inflation, helped stabilize financial systems, and made it easier, not harder, to attract foreign finance for public and private debt.
All this suggests a possible scenario for breakup of the euro. If a coalition of weak economies were ever to gain control of the ECB, they might be tempted to use inflationary policy to ease their debt burdens and stimulate their economies. Once that happened, stronger economies with greater aversion to inflation--Germany, in particular--might be motivated to leave the euro, and could do so without risk of bank runs or defaults.
Follow this link for more on the breakup of the ruble area and its lessons for the euro, including charts, data, and a free set of classroom-ready slides.
The ruble area came into existence when the Soviet Union was dissolved at the end of 1991. The former republican branches of the Soviet state bank (Gosbank) became the central banks of the 15 newly independent states. Superficially, it looked a lot like the 17-nation euro area.
Unlike the euro area, the ruble area suffered from its birth from high inflation. The inflation arose from three main problems.
- First, there was the legacy of perestroika. Mikhail Gorbachev's failed attempt to reform the Soviet economy led to loss of financial control and growth of nominal demand without corresponding increase of real supply. Administrative price controls led to repressed inflation, which was released in a burst when controls were lifted in January, 1992.
- Second, inflation arose from the monetization of budget deficits. With weak, corrupt, tax systems and no working financial markets to finance deficits through sales of bonds to the public, governments had no choice but to finance their spending with inflationary credits from central banks.
- Third, there was a fundamental design flaw in the ruble area that led to a free rider problem. The Central Bank of Russia claimed a monopoly on the issue of paper currency, but each of the 15 central banks of the ruble area could inflate the money supply through creation of bank credits. Each government was able to gain the full seigniorage benefit of financing its deficit through its own central bank, while spreading the resulting inflation among the whole group of 15.
What relevance does the demise of the ruble area have for today's euro? There are two main lessons.
The first lesson is to beware free rider problems. True, the ECB has more complete control over money creation than the Central Bank of Russia had, so the euro area does not have to worry about monetary free riders. However, it does have a problem with fiscal free riders. Countries that conduct irresponsible fiscal policies, in defiance of EU rules, gain the full short-term political benefits of high spending and low taxes, while shifting at least a part of the resulting costs to their neighbors. Well-intentioned safeguards, including a supposedly strict no bail-out clause, have provided less than full protection against free riders.
The second lesson is that barriers to exit from a currency area are asymmetrical. Much has been made of the fact that countries with weak economies, like Greece, would find it hard to leave the euro. Even a parliamentary debate on exit would be likely to trigger devastating bank runs and defaults on public and private debt. (See Barry Eichengreen for a good, short presentation of this view.) However, the same barriers do not apply to countries with strong economies that want to leave a weak, inflation-plagued currency area. Estonia, Latvia, and Lithuania achieved a smooth exit from the ruble area. Introducing their national currencies quickly brought down inflation, helped stabilize financial systems, and made it easier, not harder, to attract foreign finance for public and private debt.
All this suggests a possible scenario for breakup of the euro. If a coalition of weak economies were ever to gain control of the ECB, they might be tempted to use inflationary policy to ease their debt burdens and stimulate their economies. Once that happened, stronger economies with greater aversion to inflation--Germany, in particular--might be motivated to leave the euro, and could do so without risk of bank runs or defaults.
Follow this link for more on the breakup of the ruble area and its lessons for the euro, including charts, data, and a free set of classroom-ready slides.
Thursday, July 1, 2010
Budget Basics (4): Why is it So Hard to Close the Budget Gap?
Previous posts in this Budget Basics series have shown that the U.S. federal budget deficit and debt are on an unsustainable path. It is easy to say how to close the budget gap--cut spending or raise revenues. Why, then, is doing it so hard?
As a working estimate of the budget gap, we will use the cyclically adjusted primary budget deficit, which was about 7 percent of U.S. GDP in 2009. Some estimates are smaller by a percentage point or two, and some, especially those that assume delays before starting to tighten policy, are larger. It is also necessary to take into account that tightening policy too soon could slow the recovery, and make the gap larger.
Politically, the easiest promise to make is to eliminate waste, fraud, and abuse. Often such political rhetoric is vague about just what programs should be targeted. The first place many people look for wasteful programs is in nondefense discretionary spending, but that part of the budget is surprisingly small, only 19 percent of all federal spending in the 2010 federal budget, or just 4.7 percent of GDP. Adding defense gives total discretionary spending of about 9 percent of GDP. At least a few areas of spending, like federal courts, U.S. embassies abroad, and operations of the Treasury would have to be protected in any program of cuts. It follows, as a matter of simple arithmetic, that any attempt to eliminate the budget gap through cuts in discretionary spending alone would have to cut defense spending by more than half, and eliminate most nonessential departments--HUD, agriculture, commerce, NASA, EPA and many others--entirely.
Long-term projections show that growth of entitlement spending is more important than discretionary spending in explaining growth of the budget gap in coming decades. To some extent, this is due to aging of the US population. The other big factor is excess growth of medical costs, which have been growing at a rate about 2.5 percent faster than the general price level. Bringing the growth of medical costs down to the rate of increase of other prices could by itself eliminate most of the budget gap. However, doing so would be politically difficult. Many cost-cutting proposals, ranging from malpractice reform to a public insurance option to removing tax preferences for employer-paid health plans were considered, but rejected, during the recent health care debate in Congress.
The budget gap could also be closed by raising revenues, but there are constraints here, as well, as shown in recent research by the Urban Institute-Brookings Institution Tax Policy Center. It would be difficult to close the gap simply by raising tax rates within the existing income tax system--essentially impossible if rates were raised only for higher tax brackets. Closing tax loopholes and preferences could make a substantial contribution, up to 5 percent of GDP. However, many tax preferences serve public policy purposes, so that eliminating them would have opportunity costs. New taxes like a VAT could also raise much of the revenue needed to close the gap, but there seems to be solid political resistance to a VAT for the time being.
The bottom line: Simple arithmetic suggests that no single approach can close the budget gap. A combination of spending cuts and revenue increases will be needed. However, it must be kept in mind that every line in the federal budget has its political supporters--otherwise it would not be there in the first place. Eliminating the budget gap and restoring fiscal sustainability will be very hard work.
Follow this link to download a free, classroom-ready set of slides that present graphs and tables showing options for closing the budget gap. Three earlier posts in this Budget Basics series appeared on this blog during June, 2010.
As a working estimate of the budget gap, we will use the cyclically adjusted primary budget deficit, which was about 7 percent of U.S. GDP in 2009. Some estimates are smaller by a percentage point or two, and some, especially those that assume delays before starting to tighten policy, are larger. It is also necessary to take into account that tightening policy too soon could slow the recovery, and make the gap larger.
Politically, the easiest promise to make is to eliminate waste, fraud, and abuse. Often such political rhetoric is vague about just what programs should be targeted. The first place many people look for wasteful programs is in nondefense discretionary spending, but that part of the budget is surprisingly small, only 19 percent of all federal spending in the 2010 federal budget, or just 4.7 percent of GDP. Adding defense gives total discretionary spending of about 9 percent of GDP. At least a few areas of spending, like federal courts, U.S. embassies abroad, and operations of the Treasury would have to be protected in any program of cuts. It follows, as a matter of simple arithmetic, that any attempt to eliminate the budget gap through cuts in discretionary spending alone would have to cut defense spending by more than half, and eliminate most nonessential departments--HUD, agriculture, commerce, NASA, EPA and many others--entirely.
Long-term projections show that growth of entitlement spending is more important than discretionary spending in explaining growth of the budget gap in coming decades. To some extent, this is due to aging of the US population. The other big factor is excess growth of medical costs, which have been growing at a rate about 2.5 percent faster than the general price level. Bringing the growth of medical costs down to the rate of increase of other prices could by itself eliminate most of the budget gap. However, doing so would be politically difficult. Many cost-cutting proposals, ranging from malpractice reform to a public insurance option to removing tax preferences for employer-paid health plans were considered, but rejected, during the recent health care debate in Congress.
The budget gap could also be closed by raising revenues, but there are constraints here, as well, as shown in recent research by the Urban Institute-Brookings Institution Tax Policy Center. It would be difficult to close the gap simply by raising tax rates within the existing income tax system--essentially impossible if rates were raised only for higher tax brackets. Closing tax loopholes and preferences could make a substantial contribution, up to 5 percent of GDP. However, many tax preferences serve public policy purposes, so that eliminating them would have opportunity costs. New taxes like a VAT could also raise much of the revenue needed to close the gap, but there seems to be solid political resistance to a VAT for the time being.
The bottom line: Simple arithmetic suggests that no single approach can close the budget gap. A combination of spending cuts and revenue increases will be needed. However, it must be kept in mind that every line in the federal budget has its political supporters--otherwise it would not be there in the first place. Eliminating the budget gap and restoring fiscal sustainability will be very hard work.
Follow this link to download a free, classroom-ready set of slides that present graphs and tables showing options for closing the budget gap. Three earlier posts in this Budget Basics series appeared on this blog during June, 2010.
Thursday, June 24, 2010
Estonia Joins the Euro: What Can We Learn?
The economic news has been full of talk about a crisis in the euro area. Some observers are even taking bets on who will leave the euro first--Germany or Greece? Yet, in the middle of this crisis, Estonia has applied to join the euro area as its 17th member, and has been accepted, effective January 1, 2011. Why does the Estonian government think this is a good idea? What can we learn?
Start with the context. When Estonia achieved independence from the Soviet Union in 1991, it inherited the unstable Soviet ruble as its currency, and along with it, inflation of more than 1000 percent. To end the hyperinflation, in 1992 it introduced its own currency, the kroon, and pegged it firmly to the German mark using a currency board. When the euro was introduced, the peg moved from the mark to the euro. The currency board was highly successful in ending hyperinflation and restoring growth. It also helped Estonia shift its trade quickly from East to West. Today, more than 75% of its trade is with EU members.
After accession to the EU in 2004, Estonia began to see some of the drawbacks of a fixed currency. Under the currency board, it could not use interest rates or exchange rates to offset the inflationary pressures of financial inflows and a housing bubble. Similarly, when the financial crisis hit, Estonia could not use depreciation to soften the shock. Like its Baltic neighbors Latvia and Lithuania, Estonia went from boom to bust. In contrast, floating-rate countries like Poland and the Czech Republic were much less affected by the crisis. (See this previous post for more details about the impact of the crisis on fixed and floating-rate countries.)
A final lesson that can be drawn from Estonia's experience is the importance of sound fiscal policy to countries that choose a fixed exchange rate or membership in a currency block. Going into the crisis, Estonia had a solid budget surplus and the smallest debt-to-GDP ratio in the EU. In contrast to Greece, which entered the crisis in the worst fiscal position of all EU members, Estonia had much more room to maneuver. Yes, like Greece, it was forced to make some budget adjustments during the crisis, but the cuts were merely painful, not catastrophic. It appears that 2010 will see the beginning of economic recovery in Estonia, whereas Greece faces several more years of austerity and is still not certain to avoid default.
The bottom line: There are both pros and cons to fixed exchange rates and common currencies, but a small country like Estonia, with sound fiscal policy and strong trade ties to its currency partners, has the best chance that the advantages will outweigh the drawbacks.
Follow this linkhttp://www.archive.org/download/P100620Estonia/P100620Estonia.ppt to download a free set of classroom-ready slides with charts, data, and lessons to be learned from Estonia's accession to the euro.
Start with the context. When Estonia achieved independence from the Soviet Union in 1991, it inherited the unstable Soviet ruble as its currency, and along with it, inflation of more than 1000 percent. To end the hyperinflation, in 1992 it introduced its own currency, the kroon, and pegged it firmly to the German mark using a currency board. When the euro was introduced, the peg moved from the mark to the euro. The currency board was highly successful in ending hyperinflation and restoring growth. It also helped Estonia shift its trade quickly from East to West. Today, more than 75% of its trade is with EU members.
After accession to the EU in 2004, Estonia began to see some of the drawbacks of a fixed currency. Under the currency board, it could not use interest rates or exchange rates to offset the inflationary pressures of financial inflows and a housing bubble. Similarly, when the financial crisis hit, Estonia could not use depreciation to soften the shock. Like its Baltic neighbors Latvia and Lithuania, Estonia went from boom to bust. In contrast, floating-rate countries like Poland and the Czech Republic were much less affected by the crisis. (See this previous post for more details about the impact of the crisis on fixed and floating-rate countries.)
A final lesson that can be drawn from Estonia's experience is the importance of sound fiscal policy to countries that choose a fixed exchange rate or membership in a currency block. Going into the crisis, Estonia had a solid budget surplus and the smallest debt-to-GDP ratio in the EU. In contrast to Greece, which entered the crisis in the worst fiscal position of all EU members, Estonia had much more room to maneuver. Yes, like Greece, it was forced to make some budget adjustments during the crisis, but the cuts were merely painful, not catastrophic. It appears that 2010 will see the beginning of economic recovery in Estonia, whereas Greece faces several more years of austerity and is still not certain to avoid default.
The bottom line: There are both pros and cons to fixed exchange rates and common currencies, but a small country like Estonia, with sound fiscal policy and strong trade ties to its currency partners, has the best chance that the advantages will outweigh the drawbacks.
Follow this linkhttp://www.archive.org/download/P100620Estonia/P100620Estonia.ppt to download a free set of classroom-ready slides with charts, data, and lessons to be learned from Estonia's accession to the euro.
Sunday, June 20, 2010
Budget Basics (3): The Long Term, Demographics, and Entitlements
Even while the debate continues over short-term fiscal stimulus vs. austerity, it is important to look further into the future. Projections reaching 30 to 50 years into the future show that the U.S. federal debt is clearly on an unsustainable path, even given the most optimistic assumptions about legislation, demographics, and interest rates. More realistic assumptions show the debt exploding to unsustainable levels in little more than 20 years. (See the second post in this Budget Basics theories for a discussion of the meaning of debt sustainability).
According to the Congressional Budget Office (CBO), increases in entitlements, including Medicare, Medicaid, and Social Security, will be the big drivers of increases in future debts and deficits. Entitlement spending is projected to increase so rapidly that it will swamp an expected gradual increase in revenues as a percentage of GDP.
In the first 20 years, aging of the population will be the biggest force behind the growth of entitlement spending. After that, excess growth of medical costs are the culprit. The health care legislation passed earlier this year will supposedly make a small start toward controlling medical costs, but not enough to change the long-term budget picture. All really major cost-cutting proposals proved too controversial for inclusion in the bill. If Congress waits 20 years before revisiting health care (as happened between the Clinton and Obama initiatives), the debt will have already exploded.
The really frightening thing about the CBO budget projections are the estimates of the cost of delaying fiscal consolidation. If fiscal consolidation were to begin as the current business cycle moves into expansion, an adjustment of about 8 percent of GDP (spending cuts, revenue increases, or a mix of the two) would be required to ensure sustainability. If adjustment is instead delayed until 2030, the needed correction balloons to 12 percent of GDP.
The bottom line, according to the CBO: "The choice facing policymakers is not whether to address rising deficits and debt but when and how to do so. . . . The longer that policy action on the budget is put off, the more costly and difficult it will be."
Click here to download a free set of classroom-ready slides discussing long-term projections of the U.S. federal debt.
According to the Congressional Budget Office (CBO), increases in entitlements, including Medicare, Medicaid, and Social Security, will be the big drivers of increases in future debts and deficits. Entitlement spending is projected to increase so rapidly that it will swamp an expected gradual increase in revenues as a percentage of GDP.
In the first 20 years, aging of the population will be the biggest force behind the growth of entitlement spending. After that, excess growth of medical costs are the culprit. The health care legislation passed earlier this year will supposedly make a small start toward controlling medical costs, but not enough to change the long-term budget picture. All really major cost-cutting proposals proved too controversial for inclusion in the bill. If Congress waits 20 years before revisiting health care (as happened between the Clinton and Obama initiatives), the debt will have already exploded.
The really frightening thing about the CBO budget projections are the estimates of the cost of delaying fiscal consolidation. If fiscal consolidation were to begin as the current business cycle moves into expansion, an adjustment of about 8 percent of GDP (spending cuts, revenue increases, or a mix of the two) would be required to ensure sustainability. If adjustment is instead delayed until 2030, the needed correction balloons to 12 percent of GDP.
The bottom line, according to the CBO: "The choice facing policymakers is not whether to address rising deficits and debt but when and how to do so. . . . The longer that policy action on the budget is put off, the more costly and difficult it will be."
Click here to download a free set of classroom-ready slides discussing long-term projections of the U.S. federal debt.
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.
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.
Thursday, June 10, 2010
Budget Basics (1): What is the Cyclically Adjusted Deficit and Why Should We Care?
A furious debate over the federal budget deficit is underway in Congress, in the press, and in the blogosphere. Is the deficit a dire threat that we need to attack with immediate austerity measures? Should we instead focus on more stimulus to create jobs, in the expectation that the deficit will take care of itself as the economy expands?
The answer to these questions depends part on how much of the deficit is caused by the recession. If most of the deficit is cyclical, we can hope that more stimulus spending now will actually shrink the deficit. If it is mostly caused by runaway spending or reckless tax cuts, it would make more sense to do something about the deficit right away.
The CBO has addressed this issue with new estimates of the cyclically adjusted budget deficit--deficit as it would look when the effects of the business cycle are stripped away. These estimates show that automatic stabilizers contributed about 1.9 percentage points of the record 9.3 percent federal deficit in 2009. The CBO numbers also show the deficit shrinking to a relatively comfortable 2.6% of GDP by 2014, when it expects the economy to be at or close to potential real output.
At first glance, these numbers are reassuring. They lend support to the argument for more stimulus and a faster return to potential real GDP, with the deficit taking care of itself. But, unfortunately, we cannot simply take the CBO projections at face value.
First of all, they are only estimates. To estimate the adjusted budget deficit, the CBO must first estimate the output gap. An interesting recent study from the Federal Reserve shows that different methods of measuring the output gap can vary by as much as 2% of GDP. So, not only can we not be sure how fast the economy will approach potential real output, we don't really know exactly where the potential is.
An even more serious problem lies in the well-known fact that the CBO, by law, makes its projections on an assumption that existing legislation will remain unchanged. Its recent rosy projections of the deficit are largely due to the assumption that the Bush tax cuts will be allowed to fully expire (even though neither Democrats nor Republicans want that to happen), and that there will be no further adjustments of the alternative minimum tax (even though Congress has repeatedly adjusted it in the past). If we strip out these assumptions, the chances that the deficit will shrink to a sustainable level by 2014 look much slimmer.
Follow this link to download a free set of slides for use in your economics course. The slides discuss the cyclically adjusted budget deficit, automatic stabilizers, the output gap, and related concepts and include relevant charts and definitions of terms. Additional posts in this Budget Basics series are planned for the near future.
The answer to these questions depends part on how much of the deficit is caused by the recession. If most of the deficit is cyclical, we can hope that more stimulus spending now will actually shrink the deficit. If it is mostly caused by runaway spending or reckless tax cuts, it would make more sense to do something about the deficit right away.
The CBO has addressed this issue with new estimates of the cyclically adjusted budget deficit--deficit as it would look when the effects of the business cycle are stripped away. These estimates show that automatic stabilizers contributed about 1.9 percentage points of the record 9.3 percent federal deficit in 2009. The CBO numbers also show the deficit shrinking to a relatively comfortable 2.6% of GDP by 2014, when it expects the economy to be at or close to potential real output.
At first glance, these numbers are reassuring. They lend support to the argument for more stimulus and a faster return to potential real GDP, with the deficit taking care of itself. But, unfortunately, we cannot simply take the CBO projections at face value.
First of all, they are only estimates. To estimate the adjusted budget deficit, the CBO must first estimate the output gap. An interesting recent study from the Federal Reserve shows that different methods of measuring the output gap can vary by as much as 2% of GDP. So, not only can we not be sure how fast the economy will approach potential real output, we don't really know exactly where the potential is.
An even more serious problem lies in the well-known fact that the CBO, by law, makes its projections on an assumption that existing legislation will remain unchanged. Its recent rosy projections of the deficit are largely due to the assumption that the Bush tax cuts will be allowed to fully expire (even though neither Democrats nor Republicans want that to happen), and that there will be no further adjustments of the alternative minimum tax (even though Congress has repeatedly adjusted it in the past). If we strip out these assumptions, the chances that the deficit will shrink to a sustainable level by 2014 look much slimmer.
Follow this link to download a free set of slides for use in your economics course. The slides discuss the cyclically adjusted budget deficit, automatic stabilizers, the output gap, and related concepts and include relevant charts and definitions of terms. Additional posts in this Budget Basics series are planned for the near future.
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