Tuesday, May 4, 2010

US Debt Projections

This morning, I have been meditating on two graphs.  The first, above, is from the most recent US Congressional Budget Office Budget and Economic Outlook and shows the CBO's projection for "Federal Debt Held by the Public" as of Jan 2010.  It's important to understand that this does not include federal debt held by the social security trust fund and similar, and so future deficits in that trust fund will show up as increases in the federal debt held by the public.

The most obvious features of the graph are the run-up in debt during the Reagan-Bush years (aided by several oil shocks), the decline during the Clinton years (assisted by a massive Internet bubble), the more modest increase under Bush-II, and then the massive shock caused by the financial crisis - federal debt will, the CBO thinks, increase by about 35% of GDP, and then stabilize.  Ie, the government rescue of the financial system, etc, will roughly double the size of the federal debt.

I take the CBO to be a technocratically competent organization and reasonably non-partisan, and so I assume that reasonably forseeable things (like increases in payouts for social security and medicare) are accounted for here.  Indeed we see tables like this, with the details of those particular issues:

Indeed those things will increase a lot over the next ten years as more of the baby-boom retires.

Still, on the face of it, a federal debt stabilized at about 70% of GDP does not strike me as a definitely fatal condition.  If things continue in an orderly manner, and in particular assuming long term interest rates on US treasuries are modest, this seems like a quite manageable debt burden.  If we suppose that the federal government can borrow at 4%, then it needs about 3% of GDP to service the debt - not without political consequences, certainly, but hardly likely to be a threat to the republic.  This, I assume, is why treasury interest rates are quite reasonable at present.  There is no identifiable, forseeable problem which would cause the US to have trouble servicing its debt.

I think where the problem comes, rather, is that it's much less clear that the US can absorb another shock of this magnitude without running into fairly serious trouble.  In particular, it's instructive to go back and look at the 2006 Budget and Economic Outlook and look at the exact same Figure 1.2:

This adds two interesting things to the mix.  Firstly, we see that the 35% shock to federal debt levels that we now project in 2010 was entirely unforeseen in Jan 2006.  This was pretty close to the peak of the housing bubble, and we see that even the CBO's technocrats were completely unaware of the scale of the problem.

Also, this second graph goes back far enough that we can see the WWII shock - in which federal debt increased by almost 70% of GDP.  So, considered as a shock to the federal budget, the recent economic crisis was about half the size of WWII, which is an impressively large shock to be completely unforeseen by mainstream society.

Of course, the WWII debt was paid off pretty rapidly in the following decades.  However, it seems to me unwise to take that as a precedent: the circumstances were fairly unique.  The US was a major oil exporter with most of its oil production ahead of it, and the world's manufacturer - its economic competitors were in ruins from the war.  Thus GDP growth and the trade surplus were both very high in the 1950s and 1960s, and paying off the large debt was quite doable.  A United States with an aging population and the need to import large quantities of oil and manufactured goods from overseas is a quite different proposition - a repeat of the post-war suburban boom seems very unlikely.  Our biggest growth industry in the next decade or two may be nursing homes.

And so, if we were, for one reason or another in a dangerous world, to experience another shock of 30%+ magnitude of GDP, it seems to me we'd be in trouble.  Above some level, there is the potential for a vicious circle (as recently happened to Greece) as investors demand higher interest rates to loan, thus making the debt even harder to service, thus causing investors to insist on even more reward for the risk of lending.  Clearly, this can happen with domestic debt as well as debt in foreign currencies.  At the end of the day, since it's a fiat currency, the central bank can always inflate it away - but that's just a more gradual and polite way of defaulting (and no better from the standpoint of the debt owners).

So I guess I come down here: rescuing the financial system was necessary (though I think the terms on which it was done were far too generous to the private sector, and quite reckless of the taxpayer's interest).  However, I don't think it would be terribly prudent to increase the public debt much further than is presently projected if we can help it.


Burk said...

Hi, Stuart-

What you are missing here is a rational criterion. Why is 70% high and not low? You seem to be talking about gut feelings and discomfort, not serious limits to debt. Japan has debt of 2 times GDP. Are they facing revolt in the streets? No. Taking historical levels alone is not necessarily helpful if the mechanisms involved are not clearly understood, but are simply analogized with household budgeting, which is not analogous at all.

The one concrete item you point to is the ongoing servicing cost. But even that is not really the key element, since barring inflation, more money can be printed to service this debt at the will of the federal government.

The real limit is inflation. If the stock of money and credit exceeds the real capacity of the economy to produce goods, then inflation results. Japan is fighting deflation, despite all its debt. We flirted with deflation, but seem to be back on an even keel now, after huge fiscal and monetary injections.

High inflation is a sign that the state is demanding too much real production, and not displacing enough of that demand from the private sector though taxation and the like. The solution is either fiscal (to cut state spending) or to squeeze private demand by raising taxes, interest rates, issuing debt, etc. High private saving is another way of reducing private demand in relation to resources, as happens in Japan.

In this situation (high inflation), a fiscal deficit becomes increasingly onerous, due to rising market interest rates, which encourages fiscal tightening and discourages debt issuance. A large accumulated debt would increase the pain by having to be refinanced at the higher rates.

So the bottom line is that if we can though prudent fiscal and monetary policy keep inflation under control .. which means in general keeping the state economic demand within the bounds of its demand displacement through taxes, debt issuance, etc. .. then we will be fine, even with very high debt levels.

I think that inflation is now pretty well understood at the Fed and other relevant levels, so we can be pretty confident that the debt levels will not be a problem as far as we can tell.

Burk said...

I guess the next thing to ask is whether inflation could run beyond our control in the event of serious resource shocks (peak oil). Since our energy intensity is declining, and we are making tentative moves to other resources, it seems to me that such inflation would be manageable, and also transient. But that is the big need- to plan ahead in that respect.

Gary said...

Comparing the debt levels right after WWII and now -- although at similar levels -- the times ahead suggest that the current situation is far more precarious. Right after WWII, there was need for a massive rebuilding world-wide, a dark decade of pessimism was lifted, and we entered the boom years of the 50's and 60's that grew the economy so that previous debts were negligible. Now - we are entering a period of increasing pessimism, peak oil, climate change and resource depletion. A period of prolonged strong economic growth seems unlikely.
The level of government debt is dwarfed by the level of even more risky private debt. A period of severe debt deflation would be devastating to more than just central governments.
So, can the economy continue to grow in the future, given the planetary constraints? If not, how do central banks control the money supply to "fit the economy" and still service the existing long term obligations?

Stuart Staniford said...


I think I'll respond at greater length to your interesting challenges tomorrow when I have more time. But in the meantime, let me ask this: in your view, what multiple of GDP could federal debt rise to without causing problems, and why?

Stuart Staniford said...

(I meant in the US specifically, if that wasn't clear).

Burk said...

Yes, that is a good question. My answer would be that there is no particular level that is good or bad. The important variables lie elsewhere, especially in inflation and unemployment.

For instance, Japan's level of 2X GDP is perfectly fine, despite the bond ratings agency's robotic downgrading of its public debt. Apparently in Japan, there is little social security, and generally a strong savings ethic, perhaps as a hangover from their truly traumatic history. So they have been diverting huge amounts of GDP from consumption into savings, and much of that into their government/postal system, which ends up as public debt. As the demographics are turning, this debt will be be drawn down a bit and create more consumption.

It might be good for the government of Japan to issue less debt and force savers to invest in the private market, raising business investment (or creating housing bubbles, etc.). They are dealing with deflation, after all. But the debt has functioned as a giant communal piggy bank, with no untoward consequences.

On the other hand, Zimbabwe also has a debt of 2X GDP, or had in the recent past, as part of a huge economic disaster- inflation, debasement of the currency, falling GDP, etc.

Suppose as a thought experiment that the government made room for its own consumption entirely through debt issues rather than taxes. That is to say, it reduced private consumption by soaking up private money through bonds, rather than coercing surrender of taxes. Supposing that the state soaks up one third of economic production, it has to persuade everyone else to part with that much in the form of savings, which would be, say, 4 to 5 trillion of deficit per year in the US.

Doing that kind of persuading would be very difficult, requiring an ever-increasing interest rate, or liberty bond propaganda, or frank coercion. Likewise, keeping all that money out of circulation indefinitely (to prevent inflation, thus implying ever-rising debt) would also eventually require coercion, amounting eventually to taxation, in essence.

The enormous coercion and interest rate issues aside, this would be an effective way to make space for government consumption, accumulating ever-rising mountains of public debt, with each person getting notionally wealthy in government bonds that they are not allowed to spend. The issue is purely whether it could be done voluntarily. And the central signal of that in the current normal regime is the interest rate and inflation rate, which are both low, thus permitting more of the same.

Stuart Staniford said...

Burk: I certainly agree that the analysis has to be highly country specific - the Reinhart/Rogoff data makes that very clear, and we know Greece is getting in big trouble at much less than 2X GDP. That's why I clarified that I was asking specifically in the US context.

I'm not sure inflation or unemployment are very good guides in that they are concurrent indicators of a problem, not leading indicators. I think we should run public finances in a way that we have some margin for error - we can absorb a major unexpected shock without triggering a sovereign debt crisis. As the Greek crisis makes clear, a country can experience the equivalent of a run on its public debt, and this can arise pretty rapidly.

Certainly, I agree that my criteria are subjective - I think necessarily so. In the end, debt default is a political act - governments decide to default because that becomes less politically painful than doing what it would take to keep managing the debt. And the confidence of investors is likewise very much a matter of mass psychology etc. So it's never going to be a matter of precise mathematical formulae. Still, I'll try to make my thoughts a little clearer in the morning.

Burk said...

But Greece's euro-denominated debt has very little to do with our dollar-denominated debt. The proper analogy is to California's dollar-denominated debt. California can't inflate its debt away or alter its exchange rate vs Ohio- we are very constricted in that respect, as is Greece.

I agree that the Federal debt comes up against ultimately political limits. The pain point of that limit is the interest rate buyers are willing to accept. While Greece and California are begging people to buy its debt, the US is not begging at all. Nor is Japan.

As for future risks, these also differ fundamentally between the constrained Greece/California situation and the far more powerful US/Japan situation, I think. It would take a long time to tease out these critical differences from the mishmash of the Rogoff data set.

Japan has not had inflation pressure on its currency despite what you would call huge debt levels. And I believe this is because they have not been aggressive enough! They really should have done more fiscal spending without debt offsets- that would have been the way to use their fiat currency power to directly fight deflation, which has been extremely painful for them (in addition to better bank policy, etc.).

But like in the US, they apparently have an antiquated mindset that all their government spending has to be "funded" through either taxes or debt and the like. So they continue to suffer from inadequate aggregate demand. The case of Japan is highly instructive, warning us away from hysteria related to any particular "bad" level of public debt, unrelated to other factors.

And unemployment.. that is a good metric for inverse inflation pressure, since inflation is likely to be low when resources such as labor are slack. For my part, I still don't fully understand stagflation as far as the theory goes ... I need to work on that some more.