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Economics for your Classroom from Ed Dolan’s Econ Blog Is Government Debt Out of Control? A Tutorial on Debt Dynamics and Sustainability Posted November 30, 2015

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Economics for your Classroom from Ed Dolan’s Econ Blog Is Government Debt Out of Control? A Tutorial on Debt Dynamics and Sustainability Posted November 30, 2015 Terms of Use: These slides are provided under Creative Commons License Attribution—Share Alike 3.0 . You are free to use these slides as a resource for your economics classes together with whatever textbook you are using. If you like the slides, you may also want to take a look at my textbook, Introduction to Economics, from BVT Publishing.


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Is the Debt Out of Control? Many people fear that government debt is growing out of control in a way that threatens America’s future Is that fear realistic? This tutorial explains what determines how fast the debt grows and whether its growth is sustainable NJ Gov Chris Christie: “Are you concerned like I am that the debt and deficits of Washington, D.C., are endangering America's future?” Fla. Sen. Marco Rubio: “The time to act is now. The time to turn the page is now. If we don't act now, we are going to be the first generation in American history that leaves our children worse off than ourselves.” Fmr. Ark. Gov Mike Huckabee: “I do not want to walk my five grandkids through the charred remains of a once great country called America and say, ‘Here you go, $20 trillion dollars of debt. Good luck making something out of this mess’ ” —all quotes from Republican presidential debate, Oct. 29, 2015 http://www.cnbc.com/2015/10/29/cnbc-full-transcript-cnbcs-your-money-your-vote-the-republican-presidential-debate-part-2.html November 30, 2015 Ed Dolan’s Econ Blog


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First: What to Measure? To determine whether the debt is too large or growing too fast, we need to measure two things: The debt ratio: The size of the government debt as a share of GDP. (A larger economy can support a proportionately larger debt) The net debt, also called debt held by the public. (Debt owed by one government agency to another is just a bookkeeping entry that creates no net burden on the economy) November 30, 2015 Ed Dolan’s Econ Blog US federal debt, 2015: Gross debt = $18.4 trillion Net debt = $13.4 trillion Debt ratio (net debt/GDP) = 74.2% Source: Congressional Budget Office


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Debt vs. Deficit The government debt is the total amount that the government owes to members of the public The budget balance is equal to government revenues minus expenditures, a negative number when there is a deficit and a positive number when there is a surplus Each year the debt changes by the amount of the budget balance If there is a deficit, the government borrows more and the debt increases If there is a surplus, the government pays off old borrowing and total debt decreases November 30, 2015 Ed Dolan’s Econ Blog


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Next: Adjusting for the Business Cycle Next, to identify long-run debt trends, we need adjust for the effects of the business cycle Key terms: Potential GDP is the total output that the economy could produce if it were operating at full employment The output gap is equal to current GDP minus potential GDP, usually stated as a percent of potential GDP The output gap is negative at the bottom of a recession and positive at the peak of a boom November 30, 2015 Ed Dolan’s Econ Blog


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Automatic Stabilizers Automatic stabilizers are line items that automatically move the budget balance toward deficit when the output gap is negative and toward surplus when it is positive, even if there are no changes in tax or spending laws Examples: Income tax revenues increase when the economy expands, pushing the balance toward surplus Unemployment benefits increase when the economy is in recession, pushing the balance toward deficit November 30, 2015 Ed Dolan’s Econ Blog


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Current vs. Structural Budget Balance The current balance of the budget is the measured value each year of taxes minus expenditures The structural balance (sometimes called the cyclically adjusted balance) is the current balance minus the contribution of automatic stabilizers The structural balance shows what the budget balance would be under current laws in force if the output gap were zero, that is, if the economy were at full employment November 30, 2015 Ed Dolan’s Econ Blog


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The Primary Structural Balance The primary structural balance (PSB) is equal to the overall structural balance excluding interest payments on the government debt As we will see, the PSB is a key indicator of long-run debt trends November 30, 2015 Ed Dolan’s Econ Blog Example 1 (all numbers are percent of potential GDP): Structural balance = -5% Interest payments = 2% Primary structural balance = -3% Both the primary structural balance and overall structural balance are in deficit Example 2: Structural balance = -1.5% Interest payments = 2% PSB = +0.5% The overall structural balance is in deficit but the PSB is in surplus


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US Budget Balances, 1990-2015 This figure shows the three US government budget balances for 2000-2015 In a recession year (e.g. 2009) the current balance is below the structural balance (larger deficit) Near the peak of the cycle the current balance is above the structural balance (smaller deficit, as in 2006, or larger surplus, as in 2000) The primary structural balance is always above the current structural balance by a distance equal to interest on the debt November 30, 2015 Ed Dolan’s Econ Blog


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The Steady-State Primary Structural Balance Under any given conditions, there is some primary structural balance just sufficient to hold total government debt constant as a share of GDP We will call that the steady-state value of the PSB, or PSB* The panel at the right shows how to calculate PSB* given the debt ratio, the interest rate on the debt, and the rate of growth of GDP November 30, 2015 Ed Dolan’s Econ Blog Let . . . PSB* = the steady-state value of the primary structural balance DEBT = the initial ratio of debt to GDP INT = Total interest expense as a percent of GDP GRO = Rate of growth of GDP Then . . . PSB* = DEBT(INT-GRO) Note: The interest rate and growth rate can be stated in either nominal or real terms, provided both are stated the same way


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Example 1 DEBT = 0.5 INT = 0.04 GRO = 0.02 PSB* = 0.5(0.04-0.02) = +0.01 November 30, 2015 Ed Dolan’s Econ Blog Example 1: The Math If there is a constant primary structural surplus of 1% of GDP, the debt ratio will remain constant at 50% of GDP If PSB <1% (a smaller surplus or a deficit) the debt will grow If PSB>1% the debt will shrink Total interest payments (INT times DEBT) will be 2% of GDP, so stability of the debt implies an overall structural balance, including interest of -1% (a structural deficit)


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Example 1: Interpretation In Example 1, the interest rate (0.04) is greater than the rate of GDP growth (0.02) If the PSB is less than the steady-state value of 0.01 (e.g. 0.005) the debt ratio will grow without limit at an ever increasing rate If the PSB is greater than the steady state value (e.g. 0.015), the debt ratio will decrease without limit. (A negative net debt ratio means the government has financial assets that exceed its financial liabilities, as in Norway and some other oil-rich countries) PSB=.005 PSB*=.01 PSB=.015 Dynamics of Debt as % of GDP DEBT=0.5 INT=0.04 GRO=0.02 November 30, 2015 Ed Dolan’s Econ Blog


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Example 2 DEBT = 0.5 INT = 0.02 GRO = 0.04 PSB* = 0.5(0.02-0.04) = -0.01 November 30, 2015 Ed Dolan’s Econ Blog Example 2: The Math If there is a constant primary structural balance of -1% of GDP (a deficit), the debt ratio will be constant at 50% of GDP If PSB <-1% (a greater deficit) the debt will grow If PSB>-1% (a smaller deficit or a surplus) the debt will shrink Total interest payments (INT times DEBT) will be 1% of GDP, so stability of the debt implies an overall structural balance of -2% (a structural deficit)


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Example 2: Interpretation In Example 2, the interest rate (0.02) is less than the rate of GDP growth (0.04) If the PSB is too small (e.g. ?0.015 instead of the steady state value of ?0.01, the debt ratio will grow toward a new steady-state value, in this case 0.75 If the PSB is larger than the steady state value (e.g. ? .005), the debt ratio will decrease to a new steady-state value, in this case 0.25 PSB= -.015 PSB*= -.01 PSB= -.005 Dynamics of Debt as % of GDP DEBT=0.5 INT=0.02 GRO=0.04 November 30, 2015 Ed Dolan’s Econ Blog


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Interest Rates vs. Growth Rates: What is “Normal”? As the examples show, the risk that the debt will grow without limit at an ever faster rate exists only when the rate of interest is greater than the rate of growth of potential GDP Economists have long thought that is the normal case. As this chart shows, in the US, from 1982 through 2001, the nominal interest rate on the federal debt averaged 1.1 percentage points higher than the growth rate of potential nominal GDP November 30, 2015 Ed Dolan’s Econ Blog


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Interest vs. Growth Rates in the Inflationary 60s and 70s In contrast, from 1965 through 1981, the growth of nominal potential GDP averaged 4.4 percentage points above than the interest rate on the debt. During that period, inflation constantly accelerated. It seems plausible that chronic underestimation of future inflation kept interest rates abnormally low (compared with rapid nominal GDP growth) during those years November 30, 2015 Ed Dolan’s Econ Blog


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Could Low Interest Rates be the “New Normal?” From 2002 through 2015, interest rates averaged 0.8 percentage points below potential GDP growth, and 1.2 percentage points lower in the most recent 5 years Some economists are beginning to think ultra-low rates may be the new normal, citing factors like China’s slowdown, a world-wide savings glut, and chronic low inflation (or even deflation) in Japan, the EU, and the US Interest rates lower than GDP growth greatly reduce the risk of explosive debt growth November 30, 2015 Ed Dolan’s Econ Blog


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Is the US Federal Deficit Currently Sustainable? Each year the Congressional Budget Office issues a budget outlook with estimates of all parameters of our model As of 2015, the CBO estimates a current budget balance of -2.6% of GDP, a structural balance of -1.9%, and a primary structural balance of -0.6% The estimated steady-state PSB for 2015 is -1.7% The federal debt is sustainable given those numbers, since the current PSB for 2015 is greater than the steady-state value (-0.6 > -1.7) November 30, 2015 Ed Dolan’s Econ Blog CBO Estimates for 2015 DEBT = 0.74 INT = 1.7% (nominal) GRO = 4% (real potential GDP growth of 2.2% plus 1.8% inflation) PSB* = DEBT(INT-GRO) = .74(.017-.04) = .74 X -.023 = -.017 = -1.7%


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Will the Debt Continue to be Sustainable? Although the CBO forecasts a decrease in the debt ratio in the immediate future,it expects the debt ratio to begin rising again after 2019 By 2025, the forecast for the current PSB is about -0.7% of GDP compared to a forecast steady state value of -0.8% of GDP Reasons for renewed growth of the debt: Growth of mandatory outlays due to an aging population and other factors Increase in real interest rate Slowing growth of real potential GDP However, interest rates are expected to stay below GDP growth, so growth of the debt ratio should remain limited November 30, 2015 Ed Dolan’s Econ Blog


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The Bottom Line As of 2015, the primary structural balance is high enough to bring the debt ratio down gradually If there are no policy changes, demographic factors will cause the debt ratio to grow gradually toward a moderately higher limit after 2019 Renewed growth rate of the debt ratio after 2019 could be reversed by increases in taxes or reductions in spending totaling less than 1 percent of GDP The bottom line: Available evidence does not support the view that the federal debt, given current policies, is growing out of control in a way that endangers America’s future November 30, 2015 Ed Dolan’s Econ Blog


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Click here to learn more about Ed Dolan’s Econ texts or visit www.bvtpublishing.com For more slideshows, follow Ed Dolan’s Econ Blog Follow @DolanEcon on Twitter


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