Deficit Issue Going Away???


An optimists view of the deficit

On the deficit, from Jed Graham at investors.com:

Here’s a pretty important fact that virtually everyone in Washington seems oblivious to: The federal deficit has never fallen as fast as it’s falling now without a coincident recession.
To be specific, CBO expects the deficit to shrink from 8.7% of GDP in fiscal 2011 to 5.3% in fiscal 2013 if the sequester takes effect and to 5.5% if it doesn’t. Either way, the two-year deficit reduction — equal to 3.4% of the economy if automatic budget cuts are triggered and 3.2% if not — would stand far above any other fiscal tightening since World War II.
Until the aftermath of the Great Recession, there were only three such periods in which the deficit shrank by a cumulative 2% of GDP or more. The 1960-61 and 1969-70 episodes both helped bring about a recession.

This fits with the graph I posted last week:
US Federal Government Budget Surplus DeficitClick on graph for larger image.
This graph shows the actual (purple) budget deficit each year as a percent of GDP, and an estimate for the next ten years based on estimates from the Congressional Budget Office (CBO).

Wednesday: Retail Sales
Bill McBride
Wed, 13 Feb 2013 01:44:00 GMT

This is shared to a degree by a scholar at the American Enterprise Institute, John Makin.  He however seems strangely concerned that circumstances don’t suggest we have anything close to current deficit crisis.  The article is here.

This is a very readable guide to understand what drives a deficit crisis.  One needs to keep the share of the debt (not the deficit) of the GDP stable.  Basically there are three things that do affect this:

1. How fast is your economy growing;

2. How much does it cost to borrow;

3. What is the size of deficit as a share of the economy

How does this work?

D1/G1=D2/G2 with G2 = G1 X (1+R)  or

D1/G1 = D2/(G1  X  (1+R)) or

D1 =D2/(1+R) => D2 = D1 X (1+R)

Equation (1) D2=D1 X (1+R1)

D = Government Debt

G=Gross Domestic Product

R=Economic Growth Percent

So the above means that Debt can grow at the same rate as the economy.  This implies that in a growing economy you wouldn’t necessarily expect or need for deficits to be zero even in the long run.

Debt in the following year will grow due to interest on the current debt I1 (the interest rate) and primary deficit or the gap in taxes T1 and spending S1.

This summarized as:

D2 = (S1-T1) + I1  X  D1

T=Taxes

S=Spending other than on debt payments

So that with equation (1) implies:

D1 X (1+R1)=(S1-T1) +(1+ I1) X D1

So assuming the economic growth are not under our control but taxes T and spending are:  what deficit or S greater than T is sustainable?

D1 X (1+R1)-(1+I) X D1=S1-T1

D1 X (R1-I1)=S1-T1

So as economic growth is larger and interest rates are lower, a larger deficit is sustainable in the sense of keeping the ratio of government debt constant relative to the size of the overall economy. 

The US is awash in cash looking for a home.  This has kept our interest rates low supported a larger deficit that remains affordable.

What’s the Downside?

All this seems to lead to a what me worry view of the deficit.  Why not?

The main issue I think is that interest rates are volatile and may move in an unexpected way.  Some of this is brought to light by looking at some date.

Let consider Spain in Makin’s analysis:

Spain experienced a sharp jump in interest costs after the 2008 financial crisis, despite a relatively low debt-to-GDP ratio of just over 40 percent. (See figure 2.) Spain’s 1999 entry into the eurozone permitted it to borrow at much lower interest rates while experiencing fast growth during the decade from 1997 to 2007. The Spanish government and Spanish borrowers responded with a surge in borrowing that drove up debt, but growth remained high relative to GDP. This is illustrated in figure 3, which shows a decade-long period of high growth relative to borrowing costs that ended in 2007. When the eurozone crisis hit in late 2009 after Greece revealed its previously unreported disastrous government finances, interest rates on most bonds of highly indebted European countries, including Spain, jumped.

Spain like much of Southern Europe is a cautionary tale about how the variable in the ability to borrow can go from extremely good to very bad in a decade.

Another example is Italy:

 

 

A nation may enjoy relatively large governmental programs paid for by a deficit IF it can maintain low borrowing costs.  This made clear by the examples of the US but more so Japan and other nations:

Note that the Japan currently has the second highest debt to GDP ratio in world, and yet no reports of a Japanese debt crisis.  Why is that?

Again the size of growth versus interest rates is the key.

Here’s a comparison of this metric for the countries we’ve been discussing including the infamous Greek economy:

Japan thought it has a high debt to GDP ratio benefits from low borrowing costs relative to its economic growth and so does the US.

What about our equation?  The current debt is about $16,000,000,000,0000

plugging in the 2% for R1-I1 then the sustainable debt is:

$320,000,000,000 or well below the expected $845,000,000,0000.

Perhaps that explains this:

Graph of Federal Debt: Total Public Debt as Percent of Gross Domestic Product

Our deficit may be on glide path down, but it’s still pretty scary.

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One response to “Deficit Issue Going Away???

  1. Pingback: Is the US at a Tipping Point? | Brucetheeconomist's Blog

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