Debt & Deficits

April 2009W&L Econ 102

Smitka

US$11 trillion in national debt

State / local debt modest in macro termsRemember, they’re not allowed to run big deficits!

History shows current debt level doesn’t represent a short-run “crisis”

Huge structural deficits [blue]even corrected for cyclical (recession-driven) component

Even when adjusted to real (share of GDP) level

And lots of debt held by non-residents

Because private savings lowRemember (S-I) + (T-G) = (X-M) and with low S and low T...

No help this time around! Remember C has fallen < === > savings rate has risen

And while historically monetary policy eventually shifts savings a bit....

Sum of Effects

• Deficits exceed savings (net of investment)– Hence tend to drive up i

• And lower I and increase the trade deficit (X-M)• In other words, (modest) crowding out = lower LR growth

• Deficits financed by non-residents– We owe some of our taxes to the Chinese & Saudis– But we owe in US dollars

• So no Mexico-style foreign exchange crisis is possible• But in the future we will have to tighten our belts (cut some

combination of C, I, G) to export more and import less

How repay?

• We can’t – and (fortunately!) we don’t have to!–We simply roll over our [$11 trillion and growing...] debt• When $10 bil comes due, we mail out $10 bil in checks

– And institutional investors buy $10 bil in newly issued debt

– But interest costs matter• If debt-to-GDP ratio is high, interest costs can explode

– But much debt is long-term so stable if high i temporary

– Nevertheless....

• We cannot allow debt-to-GDP to rise forever

Stability

• Stability requires covering the cost of debt i• Net of growth

• At a zero deficit, D’ = D (1 + i) debt growth• Y’ = Y (1 + g) economic growth

– So need budget surplus of D/Y * (i – g) to stabilize• If i = 4%, g = 2% and 100% debt to GDP–We need a surplus of 2% of GDP• And 200% requires 4% of GDP, still manageable• Of course at present we have a deficit, so the swing in

tax rates must be larger

Long run issues

• Baby boomers will (are starting to!) retire– Those born in 1948 qualify for Medicare in 2013– Social security is roughly balanced

• We might need to raise taxes by 2% of GDP, easy to manage– Medicare is NOT stable

• We need to raise taxes by 4% (under the optimistic scenario)– And by more with (a) greater longevity and (b) higher healthcare

expenses, both looking likely ... and don’t you want (a) longevity?!

• From a LR budgetary perspective healthcare is the top priority, by a large measure

Addendum• All retirement is Pay-Go– We cannot save as a society for retirement

• Fallacy of composition between individual and macro– Small countries have wiggle room: they can accumulate foreign

assets to finance eventual trade deficits. But not the U.S.– The services and goods you consume at age 65 in

retirement in 2054 have to be produced in 2052• For you to consume those working can’t– In past history children only briefly cared for parents

• Life cycle transfers were (a) within the family (b) from old to young

• Now they’ll be (a) outside the family (b) from young to old

Addendum, continued

• So will saving be voluntarily or compulsory?• Voluntary = private savings to buy assets of retirees• Involuntary = govt financed transfers

– Social security, medicare» Public education and child care are conceptually similar!

– Voluntarism isn’t reliable• People cashing their 401-K’s this year face poverty• No guarantee the young will buy when you need to sell

– But since the young don’t vote, and the increasingly numerous elderly do, won’t politics push us towards tax-funded systems?

Don’t rue this!• Our society is fortunate

• that people live long enough to retire!– Plus we are beginning this process

– With really low tax rates, unlike the EU• But in a steep recession so we can’t start yet

– And high debt-to-GDP levels will raise the cost, modestly

• How can your generation avoid this?– Have lots and lots of children!!

• You’d have to fund childcare– But your parents will still want to retire, so it really doesn’t help you

– So don’t retire until age 70 ... and then retire to Mexico?

• How will the politics of this social compact evolve?• A good senior thesis topic!