Is the Deficit Unsustainable? Depends.
Galbraith begins “By general agreement, the federal budget is on an ‘unsustainable path.’ Try typing that phrase into Google News. When I did it, 19 of the first 20 hits referred to the federal debt.”
When I tried it, the first 24 entries referred to the federal deficit, and virtually all of them pronounced our current fiscal course unsustainable.
Of course, it all depends upon what one means by unsustainable. For many it refers to some future moment when the government can no longer roll over its debts and the bond market closes, forcing the equivalent of a bankruptcy. Obviously, at least if you understand what it means to be a sovereign nation with its own currency, this is idiotic, since sovereign governments can always pay their debts by creating new money.
A more reasonable concern is inflation, but the Congressional Budget Office (CBO) whose work is often cited as proving that the economy is set on an unsustainable path, predicts that inflation will stay at around 2% per annum for the foreseeable future, even if the federal government stays on the same unsustainable budget path. Here is a link to the CBO analysis of the president’s budgetary proposals for FY 2012.
Galbraith, always the practical economist, shows us in the article the result of a rising debt–to–GDP ratio using a formula by economist (and former Bank of England advisor) William Buiter:
∆d = -s + d * [r-g/(1+g)]
where
∆d = change in the ratio of debt to GDP
d = starting ratio of debt to GDP
s = “primary surplus” or government budget surplus after deducting net interest payments (as shares of GDP). A positive surplus reduces ∆d, which is why it carries a minus sign
r = the real interest rate, defined for our purposes as the interest rate adjusted for inflation.
g = the real rate of GDP growth, again defined for our purposes as the rate of GDP growth adjusted for inflation.
(This is taken from Galbraith’s description in the article)
Clearly, the change in the ratio of debt to GDP is linearly related to the actual annual deficit as a share of GDP (represented by s in the formula).
The interesting part of the formula comes after the plus sign. If the real interest rate on government debt is less than the rate of GDP growth then d * [r-g/(1+g)] will be negative and therefore tend to reduce the growth in the debt to GDP ratio. Galbraith points out that this was mostly the case from the end of WWII until 1980, that average real returns investors received from investment in public debt was negative in 18 of those 36 years, and slightly negative on the average during that period. The CBO assumes that the interest on federal debt will rise to about 4.5% nominal or 2.5% real within five years. Galbraith finds no reason why that has to be so:
Because to an investor safety is valuable, and because under capitalism making money ought to require taking risk. There is no reason why a 100 percent–safe borrower should pay a positive real rate of return on a liquid borrowing! The federal government doesn’t need to compensate for risk. It isn’t trying to kill off a high and intractable inflation. It also doesn’t need to lock in borrowing over time; it pays the higher rate on long bonds mainly as a gift to banks. Moreover, it controls both the short-term rate and the maturity structure of the public debt, and so can issue as much short debt at a near-zero rate as it needs to.
Given the assumption that the government pays a slightly negative real rate on its debts, and the further assumption that the primary deficit stays at 5 percent of GDP, the debt-to GDP ratio will stabilize at below 130 percent of GDP, not much above the ratio in 1946. As Galbraith points out, it may be unattractive, but it is stable, and therefore by definition, it is not unsustainable.
Galbraith’s conclusion:
The significant conclusion is that there is a devil in the [CBO] interest rate assumption. If the real interest rate on the public debt is assumed to be greater than the real growth rate, unstable debt dynamics are likely. The offsetting primary surplus that is required for stability is an onerous burden for most countries, and to achieve it in the United States would be practically impossible, since the required cuts would undermine GDP growth and tax revenues. This is why the various budget plans now in circulation will not work out, if they are ever implemented. However, where the real interest rate is below the growth rate or even slightly negative, the fiscal balance required for stability is a primary deficit, and the sustainable deficit gets larger as the debt “burden” grows. This is why big countries with big public debts can run big deficits and get away with it, as the United States has done almost without interruption since the 1930s.
In short, the deficit vultures are dead wrong. Their “remedies” are nothing but snake oil, and their real objective— to dismantle every single public institution in the United States that actually helps the average guy—is obscured by a faux rectitude about public thrift.