How Much Public Debt?: The Sky is the Limit and Why Not?

How much public debt a nation can withstand? In my previous blog (April 21, 2010), I discussed the fiscal deficit and its projected path over the next 10 years. The concern there had to do not solely with its size in relation to GDP but also in relation to the “expected growth” in federal spending with the full implementation of the Health Care Reform Act of 2010.

Economists are in the habit of making “prescriptions” for the economy by setting dosage levels that when exceeded, the patient’s health (in this case the economy) will falter if not die (become bankrupt). Those targets are neither pulled out of thin air nor set in stone. Moreover, one “target” does not fit all. Two such doses or “targets” are prescribed for world economies: one target for the deficit; the other for public debt.
Setting target levels does not mean strict adherence to these levels, except in such cases where it is mandated by some super national authority. For example, the admission to the European Union (EU) requires adherence to the union rules, two of which are the ratio of deficit to GDP and the second is a debt to GDP ratio (The Maastricht criteria are: The budget deficit must not exceed 3 percent of GDP and public debt not to exceed 60 percent or declining towards 60 percent. As I will discuss later on the first one is much more critical for admission than the second. Other countries (i.e. the US) may aim for the deficit or debt target but there is no mandate that requires the federal government to adhere to the target levels. Many state governments in the US however, cannot run deficits as their constitutions mandate a balanced budget. Before addressing the “economies” of deficit or debt targets, a bit of US history of deficits and debt along with some theorizing may be useful.
The Record:
In the US, talking about the fiscal deficit or the public debt makes news, good and bad. But the deficit and the debt numbers by themselves tell us nothing about budget issues or the fundamentals that shape their levels as well as their trends. Let me explain.
The fiscal deficit is a “byproduct” of fiscal actions reflecting both the “ideology” of successive administration as well as the historical path of the federal budget. As discussed in the earlier blog, the discretionary deficit reflects the decision of the “current administration” about its fiscal program—level of spending on federal programs and level of taxes on the national income.
To talk about the deficit and debt one needs to start with the federal budget. In democratic societies, the government is a political institution to which the public has assigned the task and the power of defining and protecting their property rights and, when necessary for the enhancement of the general welfare (i.e. the health care reform), the redistribution of these property rights. Since the government possesses no resources of its own, it must acquire them from private owners through taxes and by borrowing (debt). But how far can the government tax and borrow from the public? Put in another way what size should the federal budget be?
Back at the time of Adam Smith, the role of government was well defined and quite limited in scope; people then did not worry much about the size of the government. Two hundreds or so years later, the size of the budget, the budget programs, taxes, deficits and debts are issues that concern all societies and people of various persuasion.

One needs not go back to the days of Adam Smith to show the dramatic path the federal budget followed. It suffices to point out that its growth has been quite impressive—in 1794, for example, the federal government spent about $7 million; in 2009 federal spending reached $3,518 billion. Relative to GDP ($310 million in 1794), the ratio of spending to GDP was 2 percent; the corresponding figure for 2009 is 24.7 percent. Well! Going that far back is not very meaningful—nothing stays the same and no one (except maybe the Tea Party) would want to return to those days.[1]
So let us look at the numbers by five years interval over the past 59 years 1950-2009. From the data (Table 1) we discern the following: A critical imbalance between spending and receipts beginning in 1975 (except for a short span of time during the Clinton period), with receipts falling below their levels of the 1960’s. Note that in the 1960’s we had almost a balance budget followed by small deficits, except during the Reagan years (1981-89) where tax cuts coupled with an increase in defense spending produced an unprecedented level of deficits to GDP (5.1 percent) in the year 1985. After 1985, the deficit number was in the “tolerant” threshold of 3 percent. Today (2009) the deficit is blown off the chart at the unprecedented level of 9.9 percent of GDP.

But look closely at what is deriving this “out of experience” record. Budget receipts to GDP ratio between 2000 and 2009 are below their levels 50 years ago, (14.7 percent in 2009 compared to 17.8 percent in 1960) and a spending /GDP ratio in 2009 of 24.6 percent, only 2 percentage points above their level of 22.8 percent recorded during the Reagan years. The culprit then is not that spending is out of control, although this may be true, but that the government budget receipts have not kept up with the growth of spending. Both sides of the coin paint the deficit picture. To attack the deficit, one needs to change the fundamental thinking about its source. It is not uncommon to hear critics of the budget posture pointing to the growth of spending but few dare to point out the erosion in budget revenues. The conventional wisdom (proven again and again) is that it is easy to point out to a “runaway spending” than to point out the shortfall in budget receipts. Most of us feel the pinch of taxes, and only a few recognize the value of public spending. But to be serious about closing the budget gap, both sides of the equation have to adjust for it to come to a state of balance. This is easier said than done.
What about the debt? As shown in the table, the debt/GDP ratio over the period 1960-1990 oscillated between 30 percent and 55 percent, a level that did not depart much of what conventional (economics) wisdom suggests, around 60 percent. Once again we have an “out of experience” level of debt, a level equals to 83.3 percent in 2009. The values of these two indicators (deficit and debt) for 2009, where the trend continues bode ill for the growth of the American economy.
Why deficit and debt matter?
Recall that the debt evolves through deficits. Borrowing domestically (debt in the hands of the public) or from foreign countries (external debt) is not without cost. Borrowing entails interest payments on the debt which must be financed through budget receipts. An ever rising debt service requirements impairs the government’s ability to meet its budget spending and/or absorbs private income through taxation which would adversely affect private consumption and investment. A preponderance of evidence also shows that budget deficits raise interest rates and causes the inflation rate to rise by fueling inflation expectations. In short, a rising deficit and debt have repercussions over the short and the long run.
The ratios of 3 percent for the budget deficit to GDP and 60 percent of the public debt to GDP have been advocated for advanced economies and, in some instances, have been adhered to. When these indicators are discarded financial crisis occur and defaults are not far behind (experience of New York City in the 1970’s but one example).[2] A great deal can be said about the links between domestic debt and external debt. A most insightful account of debt crises domestic and external is given in a recent volume (2009), This Time is Different: Eight Centuries of Financial Folly by Carmen M. Reinhart and Kenneth S. Rogoff (Princeton University Press). Not only does the volume provide a historical account of crises arising from both domestic debt and external debt but also provide the theoretical underpinning of debt crisis.[3] Policy makers may do well to take their diagnoses to heart so that they may hit on the right prescription.

[1] For historical statistics see: http://usgornementspending,com/federal_debt_chart.html, Budget data and GDP data are also reported in the National Income and Product Accounts

[2]See Attiat F. Ott (1975), “The New York Financial Crisis: Can the Trend be Reversed? American Enterprise Institute (November), Washington, D.C.
[3] Concern today is voiced for the debt problem facing Greece, Spain and Portugal. The debt crisis may spillover affecting both the US and emerging economies.

The Fiscal Deficit…Is As Far As The Eye Can See

For quite some time I thought about venting my frustration about what is written about the soaring fiscal deficit. Not that it is beyond the “norm”, if there is such a thing of what a “responsible” fiscal stand dictates but because of the latest claim as to why the budget deficit and hence the federal debt is soaring, uncontrollable, unsustainable or downright un-American.
What prompted me to get on with it and write this blog is an article about the deficit which appeared in the New England Journal of Medicine (April 1, 2010): “The Specter of Financial Armageddon-Health Care and Federal Debt in the United States” by Michael E. Chernew, Ph. D., Katherine Baicker, Ph.D. and John Hsu, M.D., M.B.A, M.S.C.E. All of the authors, one way or another, are involved in health care policy and/or health economics (see NJM p.1168 for affiliation). The authors’ main thesis is that the health care reform goals (which became law on March 21, 2010), although “laudable”, will have dire consequences in that spending on health care will “add substantially to our structural spending and thus necessitate more draconian fiscal austerity elsewhere” (NJM p. 1168).
Before going further, let me first congratulate the authors for explaining to the journal’s audience (after all not all readers of the NJM are likely to be versed in the field of public economics), that the term deficit and hence the size of the deficit is linked to the state of the economy. In other words, “not all deficits are equals”. The total deficit consists of two parts: autonomous and induced. Autonomous means discretionary while induced is not. When the government makes a decision to purchase an item (expenditure), just like you and I, it needs revenue to meet the purchase. If there is no revenue, it borrows the money and hence the deficit. This deficit was labeled “structural deficit”. The other component, the “induced” reflects what is happening in the economy. Just like the individual seller, when the economy falters and people lose their jobs, their purchases of certain goods are curtailed or eliminated, and hence the seller’s income falls not because of his own actions (i.e. he decided not to sell), but because the economic condition has worsened. The same with government revenues: when economic conditions falter, the Treasury tax collection falls, government spending on income support such as unemployment compensation rises and the deficit materializes. After the economy rebounds, the opposite takes place. In short, this part of the deficit is “induced” and not at the discretion of the government. Since the rise and fall in economic activity is labeled “the business cycle”, this deficit component was called the “cyclical” deficit.
There is not much policy makers can do about the cyclical deficit (at least in the short run) and should not be of concern. Obviously, if the business cycle can be “eliminated” this component will disappear and all we have is the discretionary deficit. I prefer the discretionary term rather than the structural term as it conveys the willful act of the public sector.
Having decomposed the deficit into its two components, any discussion about its rise or fall has to be clear about which deficit we are talking about and here lie the thesis of the NJM’s article. Since Health Care Reform entails discretionary federal spending, unless it is financed dollar for dollar by new federal receipts, or through reallocation of federal spending (cuts in other federal programs), no matter how you slice it the discretionary deficit will increase. This is true now as it has always been.
The history of federal deficits, which I will explore in a later piece, will convey this simple story. The budget process (where the determination of expenditures, revenues and the discretionary deficit take place) is invariant to the expenditure program initiated (whether that may be health care, defense spending, social security and so on), or taxes raised or lowered.
To form an opinion about the predicted dire consequences of the Health Care Reform on the deficit and whether “draconian” fiscal measures may have to be used to address them, a look at the actual and projected federal deficits may be enlightening if not useful. With respect to the public debt, its path follows the path of deficits since budget short falls have to be funded by issuing new debt which adds to the stock of the public debt in the hands of the public. A government that balances its budget will have no need to add to the stock of debt. The debt (a stock accumulation of flows of deficits) as a ratio of GDP (a flow) is a useful indicator of the capacity of the economy to sustain indebtedness.
Why accumulate deficits and debt?
There is an economic theory of deficits backed up by research suggesting that politicians behave strategically (Persson and Svensson (1989) and Alesina and Tabellini (1990)). The essence of this proposition is that the deficit and debt issues are used strategically by the current government to influence the fiscal decisions of those who will succeed them. In other words a Republican government may accumulate debt during its tenure to force its successor (presumably a democratic government) to curtail federal spending or raise federal taxes.
Getting back to Chernew et al’s article in the NJM (April 1, 2010), there is a need to examine the link between federal health care spending and the budget deficit, a link which is of great concern to the authors.
The authors provide data (obtained from a letter written by the director of the Congressional Budget Office to Senator Inouye, March 5, 2010) which purports to show that federal health care spending which amounted to 5 percent of the GDP and 20 percent of the federal outlays in 2009 is forecast to reach 12 percent of the GDP by 2050—a 41 year stretch.
The authors do not elaborate on whether or not this growth reflects the full implementation of the Health Care Reform Act neither do they inform the reader about the underlying reasons for the growth in health care spending, one of which is the aging of the population. A better indicator would be the growth of federal spending on health care per capita as compared to the growth rate of per capita GDP.
Even assuming that the only concern is with the growth rate, then one can translate the figure (7 percent increase from 5 percent to 12 percent) into an annual growth rate over the 41 year period. This growth rate is equal to 2 percent per year, not much if GDP is to grow at an annual growth rate of 3 percent which (hopefully) is achievable over the business cycle.
Calculation of growth rates aside, the concern should be over the “planning cycle” of the federal budget which is 10 years. The Congressional Budget Office (CBO, January 2010) provides projections of budget outlays, revenues and deficits over the period 2010-2020. It is perhaps useful to divide the period into two sub-periods 2010-2014 and 2015-2020. In the first sub-period, some but not all of the provisions of the Health Care Reform Act will be implemented. The second sub-period, 2015-2020, is the period where the full provisions of the reform would have been implemented. So let us look at the numbers (These are CBO’s projections based on the President’s Budget of 2009). The year 2009 is taken as the reference point.

What these numbers tell us and why the budget path matters.
Let us first look at the first period 2010-2014. Two numbers—deficits and debt—are of significance no matter what one’s political persuasion—fiscal conservative or fiscal liberal. CBO has been labeled as “bipartisan”. By that it meant that those who “crunch up” the numbers are professional (mostly economists) who do not inject their political views into the projection. That does not necessarily means that the actual numbers will exactly match projected numbers but this is the “best” given the uncertainty of the path of the economy. With this caveat one ought to take the projection in “the spirit” they are given. Now, what we have in the first period (2010-2014) is a steady decline in the deficit path from 10.3 percent of the GDP in 2010 to 4.1 percent of the GDP in 2014. This is a remarkable achievement indeed. Now comes the “horrifying” story of deficits for the period 2015-2020 and hence the overly pessimistic forecasts of what await us (expressed in Chernew’s article as well as by others) if these projected deficits turned out to be actual deficits.
The projected outlook shows a rise in the ratio of deficit to GDP from 4.1 percent in 2014 to 5.6 percent in 2020, an increase of 1.5 percent of GDP over a 5 year period. But then recall that in 2009 the actual deficit GDP ratio was 9.9 percent and the projection for 2010 is 10.3 percent. Remember what is being said earlier—the total deficit reflects both induced (discretionary budget action) and autonomous (reflecting the state of the economy) deficits. Given that we are in a “recession”, the economy’s lower path impacts the total deficit because of the fall in the level of economic activity and the rise in spending on transfer payments (for example unemployment insurance and stimulus packages).
The projection beyond 2010 clearly assumes a rebound in the level of economic activity and hence one would expect lower deficits to GDP ratios beyond 2010. Why then the deficit/GDP ratios are projected to rise in the 2015-2020 period?
The story lies in the projected path of spending and revenues. In the first period, revenues are projected to grow by 9 percent annual growth rate while spending growth is projected to grow at an annual rate of 2 percent. In the second period, revenues is projected to grow at 4 percent annual rate while spending growth is projected at 3.9 percent annual growth rate. The projection hence assumes an “increase” in the annual growth rate of spending in the second period by 2.7 percent (from 2 percent annual growth rate in the first period) while revenue growth falls from an annual rate of 9 percent in the first period to 3.9 percent annual growth rate. The increase in the annual growth rate of spending beyond 2014 is understandable as the growth must reflect the spending impact of the Health Care Reform Act. As to revenue projections many underlying assumptions may have to account for this such as the assumption about the state of the economy, a discretionary tax cut, or both perhaps enacted in the period. These assumptions should give the reader “food for thought”.
If our economic theory of deficits is correct, then the current administration in increasing, over its tenure, the growth path of the deficit will “tie” the hands of the next administration, especially if the new administration was “fiscally conservative”. By tying its hands it is meant that neither new spending initiatives can be undertaken nor “tax cuts” would be effected.
What about the public (or national) debt?
The projected debt numbers from 2015-2020 are “staggering” but what those numbers mean? And should they give up a pose? Because of the complexity of this issue, I will defer the answers to a follow up blog.
Where do the Health Care spending figures in all of this?
There are many sources which give projected levels of Health Care spending. According to the National Health Expenditure Projections, total National Health Care spending was to exceed $2.5 trillion in 2009 which put it at 17.6 percent of the GDP (see also Economic Report of the President, February 2010). CBO projections put the trend upward so that by 2020 National Health Care expenditures would be around 20 percent of GDP. The corresponding GDP figures for these two years are $14.3 trillion in 2009 and $22.4 trillion in 2020, an annual growth rate of GDP of 4.2 percent. Translating the growth rate of National Health Care spending into “levels” we get spending level for the year 2020 of $4.48 trillion—an annual growth rate of health care spending between 2009 and 2020 of 5.4 percent which (if the projection holds) mean a 1.2 percent difference in the projected annual growth rates of health care spending and GDP. This clearly suggests a shift in the spending growth in favor of health at the expense of other type of spending.
What about public sector (government) spending on health care (the culprit in all the debates on health care)? It is interesting if not “funny” that National Health Expenditure Projections (released by the Center for Medicare or Medicaid services) project health care spending to “decelerate” to 3.9 percent in 2010. CMS attributes this slowdown to a “deceleration in Medicare spending growth (1.5 percent in 2010 compared to 8.1 percent in 2009).” If this trend continues, then it would provide a cushion against the anticipated rise in health care spending under the Health Care Reform Act.
Obviously more can be said about these projections. This task has to wait until projected numbers are on a more solid footing as projected growth rates of health care spending impact the federal deficits and these in turn impact the projected path of the federal debt. These issues will be dealt with in my next blog. For now, a quotation from “Government by Red Ink” by Nobel Laureate James M. Buchanan, Professor Charles K. Rowley and Robert Tollison gives us food for thought:

“Many and varied are the perspectives on budget deficits offered by those who analyze them from a reformist standpoint. Some look for a return to the Victorian Prudent house hold ethic…others look for the election to office of the more responsible, less myopic politicians”
(In Deficits, 1986, p,3).