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.
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.
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.
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.
[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.
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