By John H. Makin and Daniel Hanson
An abrupt spending sequester at a rate of about $110bn per year ($1.1tn over 10 years) scheduled to begin March 1 could cause a US recession, coming as it does on top of tax increases worth about 1.5 per cent of GDP enacted in January. The April deadline for a continuing resolution to fund federal spending could lead to a fight that shuts down the government, placing a further drag on growth.
These ad hoc measures, aimed at creation of an artificial crisis, will fail to produce prompt, sustainable progress towards reduction of “unsustainable” deficits because deficits have been, and will continue to be for some time, eminently sustainable. The Chicken Little “sky is falling” approach to frightening Congress into significant deficit reduction has failed because the sky has not fallen. Interest rates have not soared as promised and, in fact, interest costs for the federal government have remained steady at a tiny 1.5 per cent of gross domestic product since 2002, having fallen to that level from a 3 per cent average during the decade prior to 1997.
Trillion-dollar federal budget deficits have continued to be sustainable because the federal government is able to finance them at interest rates of half a per cent or less. Two per cent inflation means that the real inflation-adjusted cost of deficit finance averages −1.5 per cent, much to the dismay of savers – many of them retirees – seeking even a modest return on “safe” assets.
The debt-to-GDP ratio, the most frequently mentioned metric of “unsustainability” of deficits, is not a reliable guide for gauging the sustainability of deficits, notwithstanding the warnings that ratios above 85 to 90 per cent represent a dangerous zone. Spain and the US have almost identical debt-to-GDP ratios of about 80 per cent, though Spain’s ratio is actually a bit below the US ratio and its deficit is smaller as a share of GDP. Yet Spain has already experienced a fiscal crisis that drove interest rates on its 10-year bonds more than 7 per cent, well above sustainable levels, especially given its worsening recession and more than 30 per cent unemployment rate. Spain had to be rescued by the European Central Bank with substantial artificial support for its bond market.
Why do countries such as Spain with moderate debt-to-GDP ratios experience financial crises, while others with similar (US) or substantially higher (Japan) ratios are able to keep borrowing at very low interest rates of 0.8 (Japan) to 1.8 (US) per cent? The answer lies with the debt-to-GDP metric. The debt-to-GDP ratio rises for two reasons: 1) the primary deficit (the difference between government spending and tax revenues) rises; and/or 2) the difference between government interest cost (the yield on government debt) and the growth rate of nominal GDP is positive.
Spain experienced a sharp jump in interest costs after the 2008 financial crisis, despite a relatively low debt-to-GDP ratio of just over 40 per cent. Spain’s 1999 entry into the eurozone permitted it to borrow at much lower interest rates, while experiencing fast growth during the decade from 1997 to 2007. The Spanish government and Spanish borrowers responded with a surge in borrowing that drove up debt, but interest rates remained low relative to GDP growth. When the eurozone crisis hit in late 2009 after Greece revealed its previously unreported disastrous government finances, interest rates on most bonds of highly indebted European countries, including Spain, jumped.
As the crisis dragged on and Spain was forced to implement austerity to obtain financing for their deficits, growth dropped sharply, causing further concerns about the countries’ ability to service debts. Interest rates rose dramatically. The difference between interest costs and nominal GDP growth grew so fast that even with reductions in the primary deficit, the debt-to-GDP ratio rose. In contrast, US GDP growth at nearly 5 per cent remains high relative to very low average federal government borrowing costs of about 1.5 per cent. This fact subtracts 3.5 percentage points from the average growth rate of the US ratio of debt-to-GDP.
The real danger facing American policy makers is, contrary to the cries of imminent “crisis” and “unsustainable” deficits, and debt accumulation, the current sustainability of trillion-dollar deficits, thanks to very low borrowing costs relative to GDP growth. Eventually, the Federal Reserve’s QE programme of large government debt purchases at a current rate of $800bn per year, largely aimed at sustaining the growth of outlays on entitlements that do not support economic growth, will cause inflation to rise. The Fed’s latest move to target the unemployment rate with more quantitative easing only adds to the threat of inflation because the only way monetary policy can affect growth or employment is by engineering a higher-than-expected rate of inflation.
Despite the current absence of rising inflation, Washington is flirting with a debt trap, where abrupt austerity forced by the sequester and/or a government shut down would actually boost the ratio of debt to GDP by depressing growth too rapidly. That outcome will be far more costly in terms of forgone income and unemployment than moving preemptively to reduce American primary deficits to about 3 per cent of GDP over a half decade. The Simpson-Bowles Commission has supplied the framework that would allow the debt-to-GDP ratio to stabilise, signalling a truly long-run sustainable fiscal stance. Specifically, a nominal growth rate of 5 per cent, composed of 3 per cent real growth and 2 per cent inflation, will, given 2 per cent average borrowing costs, stabilise the debt-to-GDP ratio given a 3 per cent primary deficit. That is the meaning of long-run deficit sustainability.
By 2018, once the debt-to-GDP ratio has stabilised under such a programme, reducing the primary deficit to 2 percent a year (given a growth rate of 3 percent above borrowing costs) will reduce the debt-to-GDP ratio gradually by 1 per cent a year. That is the meaning of sustainable long-run reduction of government debt relative to income, which will ensure moderate deficit financing costs for decades to come.
John Makin is a resident scholar at the American Enterprise Institute (AEI) and the author of AEI’s monthly ‘Economic Outlook’. He is a former consultant to the US Treasury, Congressional Budget Office and the International Monetary Fund. Daniel Hanson is an economic researcher at AEI