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Debt and Stability

As Congress works on a package of tax cuts, it's important to think about whether our current deficit is sustainable. Now Japan is fast approaching a point where debt issues will overwhelm their financial system.Note The US is not Japan: we have a growing population, less debt, and smaller deficits. Nevertheless at some point we too will need to put our fiscal house in order.

...we don't need to run a surplus, but the current deficit isn't sustainable...

What follows uses a simple (but standard) arithmetic framework to clarify what matters. As long as debt to GDP is stable, we should be OK, because the demand for financial assets grows with the economy. In general institutional investors such as pension funds hold government bonds for good reasons, and that a particular bond has matured doesn't change that. So they want to buy new bonds to replace the old. In other words, at today's level of debt, the Treasury can "roll over" debt, issuing new bonds to replace old. There's not only no need to repay our debt, financial markets would be hard-pressed to find alternative assets if we did so. Indeed, 20 years ago, when the Clinton administration was running budget surpluses, Federal debt was declining rapidly. Tax cut proponents found Wall Street figures to wring their hands about how markets couldn't function debt was repaid.

Our economy is also growing. So even if the absolute amount of debt continues to rise, potentially debt to GDP will not. Indeed, that's what happened following WWII. By the end of the war debt surpassed GDP, but fell to just over 20% by 1974. This didn't happen because we ran budget surpluses. Quite the contrary, on average we ran small deficits after 1948. But we did grow, enough to outgrow our debt. But today we're running significant deficits and not growing.

Interest rates matter. In the 1950s and 1960s they were relatively low, so the interest the Treasury paid on our debt didn't offset growth. Today we again have low interest rates, but we also have low growth. So we need to ask whether that changes the situation.

Again, what we want to look at is whether debt is stable relative to GDP. That is, if B is the stock of bonds and Y is GDP, is B/Y growing? On its own – assuming bonds are rolled over – the stock grows with accumulated interest: Bt+1 = Bt(1 + r), where Bt is the stock of bonds at time t and r is the nominal interest rate. Similarly, GDP grows at Yt+1 = Yt(1 + g) where Y is nominal GDP and g is the nominal growth rate. Hence debt to GDP will grow at:

B(1+r)
Y(1+g)

To put this to use, we need three pieces of information: what is the level of debt, B/Y; what is the growth rate g;, and what is interest rate i. That will give us an indication of whether debt is sustainable, and if not, what level of surplus is needed to keep it within bounds.

The first is easy: Federal debt is approximately 100% of GDP, that is, debt to GDP ratio is 1.0 – convenient for arithmetic, as multiplying by 1 is easy. We then need to know the ratio (1 + r)/(1 + g). When r and g are single digits in percentage terms, as in the US, that ratio is approximately 1 + r - g. In other words, with our debt ratio of 1, B/Y will shrink as long as (1 + r - g) is less than 1. The critical issue then is the value of (r - g). If r > g then our debt level will rise, unless we run surpluses. If r < g then we can run (small) deficits indefinitely, as happened during 1949-1974, yet not see our debt level rise.


Now while it might seem that we ought to be able to earn better than the growth rate, this is fundamentally an empirical question. Thanks to the Great Inflation of the 1970s and 1980s nominal interest rates and nominal growth varied wildly. But real growth and real interest rates stay within fairly narrow bounds, except at the depths of our recent Great Recession. The graph below sets forth those data. Excluding the peak around 2009 we find that the average level of (i - g) is about -0.6%. If we include the peak, the average is roughly 0. Now as the graph below indicates, real long term bond yields fell over the past 15 years and are now on the order of 0.8%. Investors, rightly or wrongly, have not built strong growth into bond prices. So to date there's no evidence that the Fed's ongoing normalization of interest rates will raise real interest rates relative to growth. If so, we can run deficits of 0.6% of GDP forever.

To reiterate, we don't need to run a surplus. However, we do need to bring the budget close to balance. Unfortunately, our current deficit is about 3% of GDP. Now that's a vast improvement over the -10% of GDP level at the trough of the Great Recession. Employment growth and profit growth led to stronger income tax receipts, while the improved employment situation led to a drop in "safety net" expenditures. That combination lowered the deficit by a full 7% of GDP. Unfortunately we can't expect further gains, as profits are now high and (un)employment low. There is however downside potential. So we ought to count on the deficit averaging out at -3.5% of GDP, not -3.0%.

...that means we need to "enhance revenue" by 4% of GDP, not cut taxes...

That does not factor in the aging of the baby boomers, who haven't fully retired and whose healthcare expenses will continue to rise until offset by rising boomer mortality. Such retirement-related expenses will likely come to at least 1% of GDP. Hence we need a fiscal adjustment on the order of 4.0%-4.5% of GDP. Congress needs to "enhance revenue," not cut taxes.

Note: Hoshi, Takeo, and Takatoshi Ito. 2014. “Defying Gravity: Can Japanese Sovereign Debt Continue to Increase without a Crisis?” Economic Policy 29(77): 5–44.

33 thoughts on “Debt and Stability

  1. lentza20

    Why doesn't it make sense to try to run a surplus to begin decreasing the deficit? Like you said, the economy is growing and with the increase in GDP it makes it easier to pay it off as the economy grows than by taking drastic steps like taxes or tariffs? If the US wants to avoid a fate like that of Japan, shouldn't we begin trying to pay off the deficit now? Additionally, how does the retiring baby-boomer population play into the growth of GDP versus the growth of the debt? Will their retirement help the ratio, or create a larger gap? It seems to me that we are going to have to rip the bandaid off of the economic wound at some point, and begin dealing with the massive deficit, or else the economy is in trouble.

    Reply
    1. the prof

      With a growing economy we don't have to "pay off" the deficit, we merely have to keep it small. Then there's never a need to "pay down" debt. Right now however our deficit is not small. We need to reduce it, but to keep a cap on debt we don't have to run a budget surplus.

      Reply
  2. motturt20

    Does the ratio of debt to GDP qualify as something that is endogenous? Lower interest rates breed economic growth, which means that if B/Y grows in the present, than B/Y is likely to grow more in the immediate future. Or does the inflation typically brought on by prolonged low interest rates offset that expectation?

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    1. the prof

      Low interest rates make debt easier to manage. If they also spur growth, so much the better. The critical number is (i-g), so low i is good, high g is good, both together is great.

      However, holding interest rates low has side effects that we'll be discussing the remainder of the term.

      Reply
  3. Juliana Kerper

    The most viable solution seems to be for the government to raise taxes since we can't expect any further gains from growth. One possible way to do this would be to increase the sales tax gradually like we talked about in class, which wouldn't result in a recession. However, we have to wonder how feasible it is for the government to "enhance" its revenue without raising expenditures as well. I also wonder if it's still too late for US investors to build strong growth into future bond prices. Would this have an effect on the debt-to-GDP ratio, or is it already too late/our debt is already too unsustainable? I also think the possibility of future expectations of lower interest rates (following the trend of decrease in the past 25 years) could make debt more sustainable.

    Reply
    1. the prof

      Since WWII the size of government has been stable or falling at the Federal level, depending on the time period. Transfers have increased, but that's population aging, and that will ease as the baby boomers pass from the scene over the next 30 years. So there's little evidence that raising taxes will lead to higher expenditures. There is very strong evidence that creating large deficits does not lead to lower expenditures.

      I don't however follow your argument on future bond prices. IF we expect strong future growth, THEN financial assets ought to increase in value / earn a high return, which is synonymous with high long-term interest rates. But that should be neutral to debt stability, because what matters is (i-g). If both i and g increase together, then the net doesn't change.

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  4. perelk20

    To analyze the phrases "enhance revenue" vs. "cut taxes" and what they mean for the individual person in this vast system. Enhancing revenue implies an increase in taxes and government spending on stimulate the economy. Tax cuts would increase the individual's disposable income which would consequently increase investment and consumption. If we are looking at increasing GDP, enhancing revenue would be a more unilateral way to get this done. Investment and consumption are slightly harder to predict. However you could make the case that both tax cuts and "enhancing revenue" to be viable options to increase GDP.

    Reply
    1. the prof

      Boosting taxes empirically does not lead to higher expenditures. But higher taxes DECREASE disposable income. Whether investment changes depends upon the interplay of interest rates (smaller deficit = lower rates) and expectations (lower deficits are good, multiplier impact of higher taxes are bad, and then there are all the random exogenous events).

      All else equal, raising taxes initially lowers growth, but that should be a one-time effect, there's no reason that growth rates will fall permanently. In fact, under Bush Sr and esp Bill Clinton, higher taxes were associated with stronger growth.

      Cf. crowding out, which we'll discuss in class.

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  5. richardsonw20

    We do face some issues with a large amount of national debt. To try and chip away at these deficits taxes are going to have to increase in some form. No matter where the tax increases come from, there is going to be pushback from those incurring these expenses. To increase GDP, the opposite, tax cuts, seem like a better option just as Kyle has stated above. The government needs more money if it is going to try and stimulate the economy through government spending. As of September 8th, 2017 the US faces over $20 trillion in debt. Tax cuts and increases in jobs are going to be the solution to the debt crisis. While the solutions seem simple economically, the problem comes with politics. These changes will not be easy to politically enact in the near future.

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  6. mizeo20

    Japan has begun to experiment with negative interest rates to combat their slow investment and GDP growth in their state. The government is essentially saying it will cost the banks money to hold more than a certain amount of reserves and they must lend it out. Ultimately, its just a way for Japan to try to kickstart investment and see growth in their economy like they did back in the 20th century. I find it hard to believe that the Federal Reserve is raising rates but we aren't seeing any "growth in GDP.” I believe we are seeing growth in the economy. You can contribute that to unemployment being near its target rate, and growth in real purchasing power. We’re seeing higher real-estate prices country wide as well. The economy has come out of the recession and we are seeing growth across the economy. I think the federal reserve has an idea of what is going on and if they continue to raise rates they understand that they need to slow down a growing economy.

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  7. johnsonj20

    I agree with Juliana that a tax hike is the most reasonable means by which to "enhance revenue." Of course, such contractionary fiscal policy on its own would likely deter growth since disposable incomes would decrease. Thus, the government should aim for the most favorable debt-to-GDP ratio to coincide with a more balanced budget by purchasing goods or services so that the multiplier effect on growth is maximized. Transfers would be less effective at offsetting the decrease in growth caused by the tax hike because more money would leak out into savings and the multiplier effect on growth would be muted. Of course, the government would need to be wary of the danger of spending more on purchases than it collects through the tax hike. Ideally, the government would decrease debt by collecting more revenue than the expenses it incurs to purchase goods and services and increase growth through its purchases to more than offset the decline in growth from the tax hike.

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  8. mcconnellm20

    Our current deficit does not seem to be sustainable. In order to begin getting rid of such a large deficit, something is going to have to change. It makes sense that we need to increase GDP in order to cut the deficit. The government needs to increase its revenue in order to make up for the large debt, but it is interesting that taxes are not a suggested method of increasing government revenue. We do not want to fall into the trap that Japan fell into, so we should begin cutting the deficit now.

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  9. Chris Vogel

    I concur with most of my classmates above that the best way to decrease the debt-to-GDP ratio would be through an increase in taxes. Since most people have precautionary and target savings in an attempt to smooth consumption throughout their lifetime, some of the decrease in disposable income will be offset through using some of savings. Another way to decrease the multiplier effect of an increased tax, would be to have a progressive tax, in which the wealthier are taxed more. This holds true because the wealthy tend to have much more savings, and therefore, do not mind using some of their savings to smooth consumption. Since Baby-boomers are approaching retirement age, the shift in the age structure requires the government to spend more money to support these newly retired folks. All of this serves to decrease the growth rate of GDP, but by implementing the most efficient tax, the government can diminish the negative impacts on the economy. Since we are seeing diminishing returns for physical and human capital, and are in a period of slow technological advancements, it would be more efficient (for debt to GDP ratio) to raise revenue through a tax cut, rather than through the multiplier effect of increasing Government expenditure.
    https://fred.stlouisfed.org/series/RTFPNAUSA632NRUG

    Reply
  10. hermana20

    The fact that the U.S. is currently $20 trillion in debt should be measured properly by comparing the national debt to the size of the national economy. Additionally, the continuing trend of low interest rates, low inflation, and rising stock markets that have continued to break records should be taken into account when looking at the national debt, because a certain portion of the $5.2 trillion in the stock market will go to Americans, who will consume and therefore increase economic growth, while some will be taxed away. Also, when discussing the national debt, one should always evaluate the worth of the debt (i.e. how productively it was used) - if it was used to build infrastructure and provide education that leads to more economic activity then that makes sense, if not then less so. Additionally, some of the debt was added by bailing out the auto industry and building new roads and bridges which helped get us out of the recession of 2008, and employ more people, both of which are good things for the economy.

    https://www.marketwatch.com/story/trump-is-right-to-link-national-debt-to-assets-2017-10-12

    Reply
    1. the prof

      My analysis is phrased in terms of debt to GDP and deficit to GDP metrics, "real" not "nominal".

      The stock market may or may not remain high; in any case empirically the impact on consumption is quite small. But if people do sell stocks, they have to pay taxes on their profits, and so there's a bit of a boost to government revenue.

      Note that the so-called auto bailout (putting companies into bankruptcy is not a bailout!!) about broke even, and even at peak involved small amounts of money relative to the deficit, and extremely small amounts relative to Federal debt. In the end the government made money on GM, lost on Chrysler. Both had mortgage lending businesses, particularly GM – had it not been for those losses, the US government would have made a lot of money! [They made money on AIG, too, and the collapse of AIG was a much bigger event.]

      Reply
  11. hermana20

    In class we discussed how money is used in transactions, how it is a unit of account, and how it must be a store of value. We then brainstormed various forms of money such as checks, DDAs, credit cards, cash, etc. and went on to examine their liquidity (i.e. how easily they can be turned into cash, with paper money being as liquid as things get). This article explores where all of the money in the world lies and interestingly enough the vast majority of money in the world is held in the form of derivatives or contracts that derive their value from the performance of an underlying asset, index, or entity (i.e. gasoline futures rising after Hurricane Harvey when 20% of U.S. refining capacity was offline).

    https://www.marketwatch.com/story/this-is-how-much-money-exists-in-the-entire-world-in-one-chart-2015-12-18

    Reply
    1. the prof

      Ah, derivatives ... are they "money"? Used properly, they function as insurance, used improperly they're gambles (with other people's savings). Most "vanish" when they expire with the entity that wrote the insurance earning a small premium. Their value fluctuates constantly, so they're not a store of value, nor do they have standardized units so you can't keep accounts with them. Sometimes they can be sold prior to maturity, sometimes not, but they're far removed from "real" transactions, purchases of goods and services.

      Gasoline futures represent insurance, I can buy gasoline today that won't be delivered until 6 months later, and lock in the price. Much of the time the price 6 months from now won't actually be much higher or lower. If I'm running a truck fleet, though, I can lock in my costs and so can sign 6 month fixed-price contracts with my customers. Running a fleet of trucks is hard enough without having to deal with short-term price variability.

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  12. laniere20

    If the budget deficit is not sustainable, then it makes sense to either run a surplus or increase taxes. It is important the we try and reduce the budget deficit while it is at a manageable level, or things will get out of hand quickly. Unfortunately, raising taxes is not as simple as it seems.

    One thing that I am confused about is the debt to GDP ratio. Since GDP is constantly change due to the macroeconomic nature of our economy, how can we be sure that the debt to GDP ratio is accurate- shouldn't it be changing daily? Additional, instead of increasing taxes, could the government implement plans to enhance the growth of GDP so that the ratio could be lowered? I feel as though citizens would respond better to that than a direct increase in taxes.

    Reply
    1. the prof

      Debt to GDP is a backwards-looking measure. We don't know current GDP, we only know that of 2017Q2. However, the ratio won't be far off if GDP grows by 2% vs 2.5%.
      It would be nice if we could make GDP grow faster, without generating inflation. Right now, though, there is not a lot of excess labor to be employed, nor are there lots of businesses with excess capacity. So there's no low-hanging fruit, only the slow process of productivity gains.

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  13. gutierrezcuadras20

    The discussion of enhancing revenue (assuming through increase in tax rates) over cutting taxes proves highly relevant given as both houses of Congress are working to pass a tax plan. I'm confused why increasing taxes rather than cutting them proves the better option, especially if you consider the long-term and short-term implications. I would think the better option would be to try to stimulate more GDP growth through cutting taxes. If consumers had a higher disposable income, wouldn't that lead to a higher spending (even if some of the income is saved) and therefore higher GDP? Also, if investment firms had more income due to tax cuts, wouldn't that lead them to spend more on projects and therefore stimulate GDP growth?

    Reply
    1. the prof

      We've not gone through the arithmetic, but fiscal stimulus increases the deficit a lot and GDP only a little, so that doesn't in fact work, even with the multiplier factored in. And since we're near full capacity, the multiplier won't be large.

      That doesn't stop proponents of tax cuts from claiming that "dynamic scoring" results in lower taxes and higher revenue. Members of Congress are almost all lawyers, and some of them apparently have forgotten elementary school arithmetic.

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  14. williamse19

    What interests me here is the relationship between GDP and debt. We learned that government programs and transfers are positive contributors to GDP while taxes reduce it. If we wanted to improve the debt to GDP ratio, we would want to reduce the deficit without raising taxes or reducing transfers or "G". But this seems impossible. The only way in this scenario to boost GDP without creating more debt would be to increase our exports and reduce out imports... but this introduces an entirely new problem of tariffs and the inefficiencies they bring. It's truly a connected problem and one that many americans do not understand.

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  15. hartigank20

    With our current economic state including massive debt, low interest rates and low unemployment, its seems that the only way to improve our budget deficit is through increased taxes. As you said above, employment growth and profit growth lead to stronger income tax receipts and a drop in government spending on welfare programs, providing a decrease in government deficit. Today, we already have low unemployment and high profits, so these will not help with our budget deficit in the future. By increasing taxes now, we can help lower the budget deficit to prepare for the rising government spending on Social Security for the baby boomers. Can we improve our budget deficit by increasing taxes or will this hurt consumer spending and GDP by too much?

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  16. murrayc20

    The US does have issues with national debt and in order to help this, actions need to be taken. Since there aren't huge technological advancements at the moment that would dramatically increase GDP (like the assembly line in 1810s for example), it is said that an increase in taxes would have to occur to generate government funds to pay back debt. However, this would take away from consumer spending and investment, which would decrease GDP as well. What the government needs to focus on is concentrating their funds on finding jobs and cutting taxes. This would increase GDP because more people will be earning an income and therefore consumer spending would increase, and government can collect taxes from more people, with keeping taxes rates at the same level.

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  17. litvaka20

    In order to sustain the debt without attempting to run a budget surplus, it would make sense to increase taxes to “enhance revenue” for the government. The government can use these additional taxes to pay off the debt and bring the budget closer to a balance. However, cutting taxes would also spur economic growth because households would have a larger disposable income to spend in the economy, which would create further investment spending and firm output. The blog suggests that this would not be a good method to help balance the budget because profits are high and unemployment is low so this growth in disposable income may not have the desired effect of providing the government with increased revenue to help balance the budget. Therefore, increasing taxes may be an option to spur increased revenue that can assist in paying off U.S. debt and working toward a more balanced budget in order to sustain the economy.

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  18. Ellie Bradach

    It makes sense that debt does not necessarily need to be zero in order for the overall wealth and health of a nation. A budget surplus is also definitely not always needed in the fiscal policy. Government fiscal policy and revenue is important actually healthy for the economy in moderation. Because the economy is always growing, the debt can also grow. Instead of focusing on the amount of debt, the amount off debt compared to the GDP is much more efficient for navigating fiscal policy. Although many people will say that cutting taxes will help the economy, if we go off this model, that is not always the best solution.

    Reply
    1. the prof

      There's a time inconsistency, as you hint. Fiscal policy is short-term, we may want to deliberately run the occasional structural deficit. But that adds up. The economist's prescription is to then run surpluses in good times. Our political system does not seem to make that possible.

      The reality is that while the US economy is growing, the deficit is so large that debt is growing even faster. We're like the frog in a pot of water set to boil: by the time we realize it's getting really hot, we'll find it really hard to jump out of the stew we're making of ourselves.

      Hence my concern with the current tax cut maneuvering in Congress. It's irresponsible. It's also poorly timed – cutting taxes when the economy is just short of a boom is a display of willful ignorance: the multiplier effect and aggregate supply constraints are introductory topics – no need for a PhD, but there are plenty of PhD economists around. [Maybe too many: you can always find someone with a diploma on their wall to support your favorite policy. Offer fame and money and the facade of power and opportunists will find their way to you.]

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  19. bashamc20

    While growth and recovery since the Great Recession has helped lower the deficit (and the rate at which the debt has grown relative to its previous size), it seems as though this deficit rate reduction will not maintain on its upward trajectory. With this true, the U.S. government will soon be dealing with a deficit level (including the coming retirement of many baby boomers) of near 5%. In order to enhance revenue and help to lessen the damage of this, the U.S. should try to implement the fiscal policies of raising taxes and/or cutting spending. Both of these would help raise more revenue and help put the country back on track to getting increasingly close to budget surplus.

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  20. the prof

    Several of you looking at "enhancing revenue" and noted correctly that, ceteris paribus, this will slow growth. So you simultaneously proposed increasing expenditures to offset that. But in that case the deficit = (taxes - expenditures) doesn't change.

    ==> There is no painless way to trim the Federal budget deficit. <==

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  21. Mac

    In the textbook I remember reading a chapter that discussed the balance between budget deficits and surpluses. It described how neither is completely beneficial to the economy if occurring every single year. In other words, it is healthy for an economy to have an average between surpluses and deficits over the years. It also mentioned how some politicians utilize running a deficit on purpose in order to gain favor among voters to trust the politician to increase the budget revenue. I am not quite sure how that helps the politician by halting spending. But, it is clear that enhancing revenue requires raising taxes which will hurt the American people. It will not be a favorable policy among the people but it might be necessary to help correct the GDP growth.

    Reply

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