Is It Really Important to Stabilize the Public Debt? And, If So, When and At What Level?

February 10th, 2013 at 2:01 pm

Suppose, just for entertainment purposes, that we wanted to have a sane, rational, and even informative discussion about what to do about our public deficits and debt (the latter being the cumulative sum of the former)—one that asks the questions posed in the title but doesn’t automatically default to the “hair-on-fire, we’re Greece!, hard choices, serious sacrifices” that we too often get from the deficit reduction industry.

First off, “stabilizing the debt” means to stop the debt ratio—debt/GDP—from rising (where “debt” means debt held by the public—that’s what matters for all that follows).  For our debt to grow more slowly than our GDP, our deficits don’t have to be zero, but they do have to be below 3% of GDP.*  Why is that a good thing?

Well, in fact, it’s not always a good thing.  In times of crisis—recessions, depressions, war—the ratio goes up for good reasons.   Our borrowing temporarily outpaces our growth in order to offset some disaster.

But there are also good reasons to lower the debt ratio when the economy’s solidly back on track.  First of all, in weak economies, interest rates tend to fall and servicing our growing public debt tends to be the least of our worries.  But as the economy improves and interest rates go up, it’s more expensive to service a larger stock of debt, so in the “interest” of not having to devote resources to debt service that we might rather use for education, infrastructure, and so on, it’s good to get the debt on a declining trajectory.

Also, a lower debt ratio leaves you better positioned the next time your public debt needs to go up.  It’s easier to make that case when you start at 40%—where we were in 2009—than north of 80%.

A debt ratio that keeps growing in good times and bad signals a persistent imbalance in the willingness to raise the needed revenues to pay for government without borrowing.   This sounds like the very definition of unsustainable and eventually government borrowing will crowd out everything else while spooked investors insist on large interest rate premiums, further pressuring the debt spiral.  At that point, “we’re Greece” has more bite.

On the other hand, there’s Japan, whose debt ratio has been rising since 1990 and is now around 200% (that’s gross debt; debt held by the public is around 150%, but still, the point is it’s gone in one direction for decades).  Yet, interest rates remain low and investors still consider Japanese debt to be safe.

So one should avoid global rules, like “a debt ratio over 90% spells doom” or “if we don’t lower our debt ratio the bond vigilantes will attack and force rates way up” or “public borrowing always crowds out private borrowing, leading to slower growth.”   There’s no good evidence for any one of these claims, which is not to say public borrowing, for example, will never compete with private borrowing thus pressuring rates and slowing growth.  It’s saying, like in the Japan case, you’ve got to look at cases.

Me, I think the best position is to be a Cyclical Dove and a Structural Hawk (CDSH).  If you’re a CDSH, your fiscal question in recessions and sloggy periods like the US (and much of Europe) are experiencing today is this: “is our budget deficit large enough to offset the demand contraction from the private sector?”

When strong private sector growth is back, the CDSH asks “now that we’re back to robust growth, are our revenues and spending lined up such that the debt we built up during the down economy will soon start to recede?”  That is, deficits and debt that grow in full employment economies are called “structural” budget deficits as distinct from cyclical ones.  They’re to be avoided.

OK, so…back to cases, like right now.

As noted, though few are listening, the CDSH fiscal policy right now is “accelerator now, brake later.”  (Although as noted in recent posts, I’ve shifted from “help!” to “do no harm!”).  But this position leaves two interesting and debated questions: when is later and at what level should the debt ratio be stabilized?

The first question is easier.  It’s when the indicators of growth are consistently flashing “go.” GDP is growing above trend, unemployment is coming down, private investment flows are moving again.  Interestingly, the Fed has explicitly adopted this type of rule, based on unemployment and inflation.

For a thoughtful debate on the second question—at what level would we want to stabilize the ratio?—see these two papers from CBPP, by Richard Kogan, and EPI, by Ethan Pollack (the CBPP analysis will be updated any minute based on new CBO numbers but the results are unlikely to change much).

The Center argues for stabilization of the debt ratio at about its current level of 73% by the end of the 10 year budget window.  EPI argues that this is an arbitrary level and there no reason not to stabilize at a higher level, which would, of course, require less deficit reduction—about half of what CBPP calls for—and thus arguably be less damaging for growth.  Both positions are consistent with the tenets of CDSH, but EPI clearly argues for more accelerator now and less brake later.

In this spirit, EPI stresses a point I’ve made many times: more temporary spending now in the interest of jobs would raise the level at which the debt ratio is stabilized but not its growth.  Their figure below shows their two stabilization scenarios, both of which stabilize at higher levels than CBPP.  The higher line stabilizes at around 85%, though if you want to assign a growth multiplier to the stimulus, it would stabilize at a lower level than that, as GDP would grow more quickly (however, beware: both sides can do such “dynamic scoring” and R’s take such methods to weird, indefensible places).

Source: EPI, Ethan Pollack

So who’s right?  I think the two strongest arguments above for CBPPs approach are a) stabilizing at a lower level leaves us less exposed to higher interest payments when rates finally start to rise, and b) it will be a heavier political lift to argue for a cyclical deficits next time we hit a rough patch if we’re starting at 85% versus 73%.  But I can certainly see arguments to the contrary.

At the end of the day, economic growth is really the most overlooked variable here.  At least in my lifetime, the only time I’ve ever seen the debt ratio fall in earnest was when the economy was at full employment.  Though we relentlessly target the numerator of the debt ratio, the real action is in targeting the denominator.  That doesn’t invite fiscal profligacy—if you want to hang with the cool kids, you’ve got to be a CDSH.  But it does suggest that once again, we’re looking for fiscal rectitude in all the wrong places.


*This goal is called primary balance, meaning the gov’t is raising enough revenue to pay its annual operating costs, but must still borrow to pay interest costs.  The formula for primary balance is d_2/GDP_2=D_1/GDP_1*(g/1+g) where d=deficit, D=debt and g is the nominal GDP growth rate.  Right now, using actual GDP 2012 and CBOs 2013 estimate, the nominal growth rate is 3.1%, and the 2012 debt/GDP ratio is 72.5%.  Thus, primary balance for 2013 is a deficit/GDP ratio of about 2.2%.

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3 comments in reply to "Is It Really Important to Stabilize the Public Debt? And, If So, When and At What Level?"

  1. Misaki says:

    GDP growth is easily divided into productivity and population growth. Productivity growth might depend slightly on unemployment due to hysteresis (people losing skills), but there is really only so much you can do to target the denominator in the debt equation.

    Also note that GDP may be somewhat dependent on inequality so the number becomes inflated and recent productivity growth may have been overstated (firms understating hours for people working overtime might be a reason for overstatement of productivity growth during the last few years, but I’m talking about a longer timespan).

    It is true that working less would lower the denominator in the debt equation (especially if inequality does inflate the official real GDP), but it would also lower the deficit and so improve the long-run debt ratio.


    The average person might dislike deficits simply due to inflation. It messes up contracts and things which assume a low rate of inflation, as well as the cost of pennies. And tying contracts to inflation can lead to cases like Brazil where this just let the government spend even more.

    But ignoring that. As a matter of policy and if people changed how they thought about inflation and money, consider what happens if all government spending is “useful”.

    There would no need to be concerned about excessive government spending if it really does compete with private spending. The phenomenon of ‘overheating’ at low unemployment is really just due to too much money in the economy (inequality) and insensitivity to prices, so ignoring that too, we could conceivably have the government being limited in its spending simply because it doesn’t pay enough to fill all open job openings. People would prefer the private sector at the margin.

    So even structural deficits would be fine, because they would lower inefficiency from high taxes. (I am not aware of inefficiency resulting from expected inflation.)

    But obviously, not all government spending is useful. This is the reality in which we work. And unlike in Japan where people see value in looking for low prices, people in the US just accept high prices leading to inflation so deficits are not as politically viable. (Not to say that even Japan spends enough to prevent all social problems from involuntary unemployment or underemployment, or discrimination due to the assumptions about benefit to society from working long hours.)

  2. rjs says:

    the BIS wants us to issue more debt, irregardless; per BIS: “the purpose of government debt is not to fund government spending. It is to provide safe assets.” The BIS proposal for ensuring the supply of global safe assets in effect treats currency-issuing governments – especially the US – as the world’s savings banks.

    from my post a year ago, when i was first grasping at this:
    the outstanding US debt & other safe assets are in such short supply that financial markets, & more specifically the shadow banking system, is unable to function properly…US debt has a special function in the financial markets; without it, the financial markets freeze up…what’s important to understand is that short term US government debt has become, at least in part, the worlds money supply; a million dollar Treasury bill is used as money by the international banking system and by sovereign wealth funds in the same sense that you use a ten dollar bill in your wallet…thus, any contraction of the supply of the reserve currency (our treasury debt) has a negative impact on the world economy in the same manner that a contraction in the domestic money supply impacts our nation’s economy (see IMF paper on this, PDF)

  3. Smith says:

    Disregarding the politics, economic conditions make an overwhelming case for stimulus. Additionally, since the economy is under performing by more than $1 trillion, and we are faced with a Japan like lost decade (already half way there), it pays for itself. The accelerated increase in GDP creates enough extra tax revenue in a few years to cover the cost of the stimulus. That’s without considering the savings from borrowing now at low rates for infrastructure, or savings from rehiring teachers instead of having them collect unemployment. That’s also discounting the fact we wouldn’t mind 3 to 4% inflation, further reducing government and consumer debt, and aiding exports. Moreover, the debt is mostly money we owe ourselves, in real terms (66%) and relative terms (Krugman, net foreign debt about 3 to 4%, .11 *.34). The case for prolonging this recession in order to prepare for a possible future recession is weak, to say the least. Consider starting the y axis on your graph at 0. Should households owe $106,000 or $120,000? (75% vs 85%) I think the $14,000 investment will pay for itself many times over.