Sunday, May 29, 2011

Should We Panic Over the Level of Federal Debt?

Glenn Hubbard thinks our Federal debt problem is worse than it was at the end of World War II:

The US has addressed debt burdens before. Between the end of the second world war and 1960, the nation cut its debt-to-gross domestic product ratio in half from 109 per cent to 46 per cent through economic growth and avoiding additional debt accumulation. The US debt problem is now more difficult. Since 2008, the ratio of federal debt held by the public to GDP has risen from 40 per cent on its way to over 90 per cent by 2020, an alarming increase outside of major wartime experience. Today’s problem is not a past war, but ever-rising future debt burdens unless we take action.

Our chart shows the federal debt held by the public (DHP) to GDP ratio as well as total Federal Debt (TD) relative to GDP from 1939 to 2011 (projected) as reported in table B.79 of the Economic Report of the President 2010. Note that this 90% projection for DHP/GDP in 2020 is not as high as the ratio for 1945 but it is entirely possibly that TD/GDP will reach 120%.

Why would the Federal debt problem be more difficult now or even in 2020? This topic has received substantial attention of late – with a couple of mentions to Paul Krugman and the CBPP . Paul talks about debt arithmetic, which is reminiscent of Sargent and Wallace’s Unpleasant Monetarist Arithmetic . Let’s pessimistically assume that by 2020 we have a steady state real interest rate equal to 4% and real growth equal to 3%. If we could obtain a non-interest surplus to GDP ratio equal to or greater than 1.2%, then we could avoid a debt explosion and in fact might even see the debt ratio decline over time.

Glenn argued that we enjoyed a reduction in the debt ratio from 1945 to 1960, which is true. In fact, the debt ratio continued to decline during the 1960’s and 1970’s despite the Vietnam War spending and the various recessions we had during the Nixon, Ford, and Carter Administrations.

The CBPP chart shows that the explosion in the public debt ratio discussed by Glenn Hubbard comes from three primary sources: (1) the Bush tax cuts (I don’t exactly recall Glenn objecting to these when he worked for the Bush Administration); the two wars started at a similar time; and (3) the recession and fiscal policy moves designed to limit the recession. Robert Barro back in 1979 noted that the US economy often saw jumps in the debt to GDP ratio as the result of major wars and recessions but for its history up to then, long-term fiscal policy tended to retire this debt over time. Ah but this was another example of the Cheshire Cat in economics – as soon as an economist documents this tendency for long-term fiscal responsibility, we get the Reagan tax cuts which were not accompanied by meaningful spending cuts. So the debt ratio rose dramatically until the fiscal discipline movements of the 1990’s – which were in part defense spending cuts and largely tax increases – began to show up in a debt ratio that began to decline. At least until we had the fiscal irresponsibility of the Administration that Glenn Hubbard served.

We should, however, mention the elephant in the room which is the projected increase in Federal spending on health care. The Administration that Glenn Hubbard served made the problem worse as it added a prescription drug benefit without adding any revenues to pay for it. The current Administration managed to pass health care reforms that would tend to limit this growth in spending but with no support from the Republican Party. And yet it is this same Republican Party that not only refuses to consider any revenue increasing measures but wants to cut taxes even more.

We should close with admonition that fiscal discipline during a weak economy does not necessarily improve the situation with a hat tip to Brad DeLong .


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