Keeping deficits and debt within limits

Published in Standard-Examiner, Ogden, UT, April 7, 2009

By VIJAY K. MATHUR

The relevant part of federal public debt is privately held public debt, a concept of debt used in this discussion. It is similar to the often-used concept called "net public debt." Here I discuss the role of budget deficit in the conduct of tax and expenditure policy (fiscal policy) and its limits.

Budget deficit in any given year consists of interest payment on last year's public debt plus the difference between government spending and tax revenue net of transfer payments in the current year (called primary budget deficit if positive and surplus if negative); all variables are adjusted for inflation. Note that the official measure overstates budget deficits, not realizing that with positive inflation rate the Treasury makes payments to the debt holders with cheaper dollars.

Since the 1930s, budget deficits have been more common than surpluses. Budget deficits tend to increase in recessions and decrease in boom times. However, addition of discretionary spending in recessions and/or significant reduction in tax rates without compensating reduction in spending in boom times may aggravate the deficit problem. For example, during President Reagan's presidency (1981-89) budget deficit as a percent of Gross Domestic Product increased until 1983. But it remained significantly high in spite of the robust average economic growth of output of 3.7 percent per year during 1983-89.

It makes economic sense to balance the budget over the business cycle -- deficits during recession years and surpluses during boom times. Automatic stabilizers like income tax, payroll tax, corporate tax, unemployment compensation, Medicaid, food stamps and housing subsidies are built into the budget by law, and therefore they change with the state of the economy. For example, progressive income tax burden increases in boom times and decreases in recession years, thus providing stability to consumption expenditures and the economy. In recessions, discretionary spending and /or reduced tax rates, and automatic stabilizers contribute to budget deficits meant to boost the economy.

What is worrisome is the fact that since the 1980s deficits are not only persisting, but are increasing irrespective of the states of the economy, except during Clinton presidency. Higher debt is the result of past deficits, and therefore to stabilize debt the government must run budget surpluses equal to interest payments. However, since the economy tends to grow over time it is advisable to focus on debt to GDP ratio (debt per dollar of economy's income). A fruitful approach to understand the relationship between the debt to GDP ratio and budget deficits is proposed by economist Olivier Blanchard.

Blanchard shows that debt-GDP ratio would increase when real interest rate (adjusted for inflation) is higher than the inflation-adjusted economic growth, and/or the primary budget deficit (excluding interest payment on debt) to GDP ratio increases. During 2000-2008 privately held public debt has grown at the rate of 9 percent per year.

Using estimates from The Economist on nominal interest rate on long term Treasury bonds, inflation rate, GDP growth rate and OMB estimate of budget deficit to GDP ratio in 2009, I tentatively estimate that PHPD-GDP ratio of 41 percent in 2008 would grow to be 46 percent in 2009.

Obviously this 12 percent growth rate in the ratio cannot be sustained for a long time. Large deficits and hence debt may cause an increase in inflationary pressures and increase in interest rates, thus crowding out private investment, reducing consumption spending and economic growth, in turn making deficits as a fiscal policy tool unsustainable.

Note that using taxes as opposed to deficits to finance spending in recessions reduce consumption and work effort, thus diminishing the expansionary effect of spending on economic growth. In addition, changing tax rates from time to time to balance the budget is cumbersome and creates uncertainty in consumption and investment plans. Tax smoothing requires budget deficits in recessions and surpluses in boom times.

Obama's administration is facing a difficult task of fighting a very severe recession which requires expansionary fiscal policy and budget deficits. At the same time the President is facing the prospect of unsustainable growth in public debt. In order to decrease the budget deficits over time and therefore the debt-GDP ratio, it is crucial that:
* 1) policies in place generate robust economic growth higher than the real interest rates the Treasury has to pay to bond holders and
* 2) the federal government starts reducing over time the primary budget deficits-GDP ratio and perhaps moving toward budget surpluses when the economy is on the path of robust growth.

Mathur is former chairman of the economics department and professor emeritus of economics at Cleveland State University, Cleveland, Ohio. At present he resides in Ogden.