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Tutorial: Is the Government Debt Out of Control?
1. 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.
2. 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
3. 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
4. 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
5. 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
6. 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
7. 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
8. 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
9. 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
10. 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
11. 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)
12. 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
13. 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)
14. 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
15. 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
16. 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
17. 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
18. 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%
19. 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
20. 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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