1. Free Slides fromEd Dolan’s Econ Bloghttp://dolanecon.blogspot.com/Budget Basics (2): Debt Dynamics, the Primary Deficit, and Sustainability Post prepared June 12, 2010 Terms of Use: These slides are made available 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 Publishers.

2. Post P100612 from Ed Dolan’s Econ Blog http://dolanecon.blogspot.com/ Debt of the US Federal Government The debate over U.S. fiscal policy is about the government’s debt as much as its deficit Deficit: Total government revenue minus expenditures, must be covered by borrowing Debt: Total amount owed as a result of past borrowing The federal debt has grown steadily since the start of the century, and rapidly since the onset of the financial crisis In 2009 it reached a post-World War II peak Note: Only the debt held by the public is a matter of concern. Public debt excludes debt held by government agencies like the Federal Reserve or the Social Security Trust Fund. Public debt does include debt owed to foreign governments.

3. Post P100612 from Ed Dolan’s Econ Blog http://dolanecon.blogspot.com/ U.S. Debt Compared to Other Countries The U.S. debt in 2009 was slightly above average for the group of developed countries known as the Organization for Economic Cooperation and Development (OECD) Some OECD countries like Norway, Finland, and Korea, not shown on this chart, had negative net debts, that is, assets that exceeded their liabilities

4. Post P100612 from Ed Dolan’s Econ Blog http://dolanecon.blogspot.com/ Projections of Future Debt Growth Projections show the debt continuing to grow in the future Here are two estimates of debt growth from the non-partisan Congressional Budget Office The CBO baseline assumes no change in current laws The higher estimate assumes that all elements of the Obama administration’s budget plan, as submitted in early 2010, will be implemented

5. Post P100612 from Ed Dolan’s Econ Blog http://dolanecon.blogspot.com/ What Determines Debt Growth? Future growth or stabilization of the federal debt depends on a number of factors Political decisions about spending and taxes Assumptions about uncontrollable factors like demographics and technology Simple debt arithmetic that determines the dynamics of the debt over time The remainder of this slide show focuses on the third of these factors—debt arithmetic

6. Some Basic Debt Arithmetic Given an assumed value for the annual budget deficit, the rate of real GDP growth, and the rate of inflation, the long-run equilibrium value of the debt can be calculated by a simple formula Let . . . D* = equilibrium debt def = annual deficit g = rate of real GDP growth π = rate of inflation Then . . . D* = def/(g + π) Posting P100130 from Ed Dolan’s Econ Blog http://dolanecon.blogspot.com/ All values stated as percent of GDP

7. Post P100612 from Ed Dolan’s Econ Blog http://dolanecon.blogspot.com/ Example of Basic Debt Arithmetic As an example, assume that . . . The US debt starts from its 2009 value of 53% of GDP The deficit remains unchanged at its cyclically adjusted 2009 value of 6.5% of GDP Real growth is 3% and inflation is 2%, round numbers that are close to long-term averages Following the formula D*=def/(g+π), the debt would gradually grow toward an equilibrium value of 130% of GDP over coming decades

8. More Debt Arithmetic: The Interest-expense Squeeze Unfortunately, there is an unpleasant assumption hidden in the equilibrium debt formula The formula assumes that the total budget deficit remains constant at 6.5% of GDP, but it hides the fact that the division of expenditures between interest expense and expenditures on all other programs must change as the debt grows Let . . . D = current debt Exp = total government expenditures R = average nominal interest rate on the debt Then . . . Net interest expense = RD Program expenditure = Exp-(RD) Posting P100130 from Ed Dolan’s Econ Blog http://dolanecon.blogspot.com/ All values stated as percent of GDP

9. Post P100612 from Ed Dolan’s Econ Blog http://dolanecon.blogspot.com/ Program Spending and Net Interest, 2009 In 2009, the average nominal interest rate paid by the U.S. government was about 2.5%, allowing it to finance the outstanding debt (53% of GDP) at a cost of just 1.3% of GDP Total government spending was 24.7% of GDP. Of that, 94% could be devoted to programs like roads, defense, Social Security, education, and so on However, this favorable situation cannot be expected to last

10. Post P100612 from Ed Dolan’s Econ Blog http://dolanecon.blogspot.com/ The Interest-expense Squeeze in Action As before, assume a constant total deficit of 6.5% of GDP and total expenditure of 25% of GDP (approx. the 2009 values) Over time, as the debt grows toward its equilibrium value of 130% of GDP, interest expense eats up more and more of total spending* To keep the debt from exploding beyond its equilibrium value, program spending must be cut or taxes must be raised to cut the total deficit *Projections assume nominal interest rate will rise from low 2009 value to more typical value of 4.5%

11. Post P100612 from Ed Dolan’s Econ Blog http://dolanecon.blogspot.com/ Still More Debt Arithmetic: The Primary Budget Balance One more key concept of debt arithmetic is the primary budget balance: the total deficit or surplus, excluding interest expense With a total constant deficit, the primary deficit must fall to a value close to zero* as the debt approaches equilibrium In equilibrium, interest expense eventually squeezes out enough program spending to consume the entire deficit *A small primary deficit is possible in equilibrium if real growth is greater than the real interest rate. In the opposite case, there must be a small primary surplus to maintain an equilibrium debt ratio.

12. Post P100612 from Ed Dolan’s Econ Blog http://dolanecon.blogspot.com/ Sustainability of the Debt in the Long Run The long-run sustainability of the debt depends on what happens to the primary balance A constant total deficit with primary balance converging to zero puts the debt on a path to a stable equilibrium (130% of GDP in our example) If the primary balance is gradually moved to surplus, the debt will begin to decrease after a time If the primary balance is kept in deficit to protect program expenditures from the interest-expense squeeze, the deficit becomes unsustainable

13. Post P100612 from Ed Dolan’s Econ Blog http://dolanecon.blogspot.com/ Consequences of an Unsustainable Debt pdclipart.org If the primary balance remains substantially in deficit, the debt will grow without limit, leading to a “debt explosion.” At that point the government has three choices: Default on the debt Induce rapid inflation to reduce the real value of the debt Introduce emergency austerity measures, which can be very painful if, as likely, the debt crisis comes when the economy is already in recession

14. Post P100612 from Ed Dolan’s Econ Blog http://dolanecon.blogspot.com/ Primary Budget Deficits: International Comparisons A country’s cyclically-adjusted primary balance (CAPB) is the best single indicator of its long-run fiscal policy health A country with a large primary deficit must make large policy changes (spending cuts or tax increases) to avoid a debt crisis As of 2009, the United States had the second-largest primary deficit (negative CAPB) of all OECD countries

15. Post P100612 from Ed Dolan’s Econ Blog http://dolanecon.blogspot.com/ The Bottom Line The Bottom Line: Over the medium term, the United States must make substantial adjustments in fiscal policy, in the form of reduced program spending or increased revenues, if it is to put the debt on a sustainable path and avoid an eventual debt crisis. The Budget Basics series will be continued with a discussion of long-run projections and strategies for fiscal consolidation