Monday, April 8, 2013

Debt to GDP

Greg Mankiw wrote up a really nice article last week in the NYT about the debt to GDP ratio. After a lot of facts, he makes the main point:
Military and economic catastrophes are, by their nature, unpredictable. While we can’t plan on one, prudence requires that we take their possibility into account. In normal times, when we are lucky enough to enjoy peace and prosperity, the debt-to-G.D.P. ratio shouldn't just be stable; it should be falling. 
While the article is great, it really lacks a good picture. Mankiw talks about the debt to gdp ratio over time, so I made a graph using the CBO data to illustrate those facts. I think having this picture makes reading the article a lot easier.
Note that the CBO projections take into account the President's proposal of maintaining the current debt/GDP ratio (rather than allowing it to drop over time, as it has after past spikes).

In addition to pointing out Mankiw's article, I would like to make some additional points.

1) During the Reagan years, defense spending was increased dramatically and tax rates were cut. Laffer and others argued that people would work harder or report more taxable income due to lower rates, and the rate cuts would not only pay for themselves, but would also pay for the increased spending. The increase in the debt to GDP ratio over the Reagan years shows that the increases in spending weren't all paid for.

2) The increases to the debt/GDP due to the War on Terror and W.'s policies in his first 7 years pale in comparison to the financial crisis and policies following.

3) The CBO projections going forward optimistically assume that the economy will still return to the old GDP trend line of steady 2-3% growth in relatively short order (for instance, see the second figure in this document). This requires some years of 4-5% growth very soon. This is opposed to the idea put forward by Cochrane and others that we are on a new, lower trend line (e.g. here and here) -- the basic idea being that the financial crisis and government policies enacted during and after the crisis prevent the economy from returning to trend. If the economy does not return to the old trend, the spending levels proposed by the administration will continue to balloon not only the level of debt, but the debt to GDP ratio, as well.

4) Mankiw warns of the unpredictable crises that will surely happen in the future which will necessitate a large amount of borrowing, but what about the crisis we already know is coming? Social Security, Medicaid  Medicare, and other welfare programs are drastically underfunded and it's nearly impossible to pay out on promised benefits indefinitely.

Actually, the debt to GDP ratio graph makes clear why those programs have suddenly come under scrutiny as part of a budget deal NOW but they weren't prior to the crisis. Prior to the financial crisis, SS, Medicare, etc. were funded for between 20-40 years before serious problems crept up. Of course, anytime there are under-funded, over-promised programs, it's better to fix them as soon as possible because it gives people more time to adjust, but it's at least understandable why politicians did not want to touch them. Why were they okay for a couple decades, at least, in 2008? While the War on Terror and W's policies were running a deficit, there were medium term budget SURPLUSES predicted. As late as March 2008 (see page 8), the CBO was predicting surpluses from 2012 to 2018 or even later. Not forever, though. Eventually welfare programs would balloon out of control, running up unsustainable deficits. But as long as there was some surplus years, there was credibility that the problems would be dealt with at a reasonable point and the country could take on reasonable amounts of debt to help pay for those programs later. After the financial crisis, all medium term surpluses vanished and were replaced with large deficits as far as the eye can see. There is no rosy medium term, now. Growth disappeared, tax revenue declined, and our ability to borrow heavily in the feature to pay for ballooning welfare programs is gone. We have to be realistic about what promises can be kept and to whom, or the pain of failing to meet those promises in the feature will be even greater. We only have to look to Europe to see that.

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