Monday, March 21, 2005

The national debt, 50 years from now

Skeptical Optimist Steve Conover takes a look at the national debt over the next half-century. One of his scenarios assumes steady (which could even be average) numbers similar to today's GDP growth: 3.3% GDP growth, tax levels of 16.8% of GDP, 2.2% inflation, 4.0% average interest on the debt, and 5.2% growth in government spending. According to Mr. Conover's model, with those numbers, by 2055 the national debt will fall from 66% of GDP to 41% of GDP.

Update: I should add my answer to Mr. Conover's question, "Is sustained growth of 3.3% attainable? Are the inflation and spending assumptions sustainable?" I say, yes and yes. An average growth rate of 3.3% is perfectly normal growth, and not so high that the Fed will have to tinker much with inflation. Fiscal discipline, however, has to come from within the hearts of our government officials. In short, I think those are perfectly reasonable assumptions. It's true that this scenario presumes lenders' continued (constant?) willingness to continue loaning us money. However, as long as we remain the most creditworthy of the large economies, as long as the EU and Japan remain stagnant, our creditors will have no problem lending to us. One of my own ideas is that the limit on U.S. debt isn't whether the rest of the world is willing to lend to us, but whether they have any savings left to lend to us.

Another thing I'd like to update with is my frank admission that with Republicans controlling the executive and legislative branches, the federal budget has increased by a lot more than 5.2% annually. I really, really hope President Bush can use his veto pen and finally get Congressional spending under control.

However, I still find Mr. Conover's projection startling, and I think it's a real victory for supply-side economists. It's also a huge slap in the face to the new "fiscally conservative" Democrats. And to Paul Krugman, too, who's hardly a fiscal conservative but perenially insists we're headed for a "fiscal train wreck."

I've noted before that John Stuart Mill said, "War is an ugly thing, but not the ugliest of things." And my own twist is, "Debt is an undesirable thing, but not the most undesirable of things." Nobody goes into debt for simply the sake of having debt, but prudent debt isn't intrinsically bad. As long as banks and other countries are willing to lend money to our different tiers of government, we can achieve faster economic growth than what we pay in interest. That's the whole idea behind borrowing: the benefits exceed the cost of interest.

Mr. Conover's scenario might seem impossible. Each year, government spending increases 5.2%, government pays 4% interest on the national debt, the economy grows at a 3.3%, yet the national debt falls as a percentage of GDP. This is because GDP growth is measured in real terms, adjusted for inflation. Debt and interest payments are in nominal terms, not adjusted for inflation. So if the economy grows 3% and inflation is 2%, nominal growth is 5%, and enough to pay on a 4% bond. Also, government spending is also in nominal terms: Mr. Conover's scenario uses inflation plus 3%, so actually government is growing less than the economy. All you need is for real GDP growth to exceed the inflation-adjusted values of interest payments and government spending increases.

There's another reason the national debt can still shrink as a percentage of GDP, but I'm not sure how or if Mr. Conover accounts for it. I once said: "Raising taxes is not the solution you anti-supply-siders think it is. You completely ignore the 'I' word in economics. Keynes had it wrong: it's not inflation. It's incentive." [Update: corrected my own quote, oops] Taxes are, by nature, a disincentive to creating wealth. The whole idea behind supply-side economics, especially the Laffer Curve, is that cutting taxes gives people an incentive to work more and create more. Now, most Americans are so detached from their governments that a budget deficit, i.e. borrowing money, may not be as much of a disincentive as higher taxes are. We're fine so long as our economic growth exceeds our interest payments, that's a good thing.

There are still some Americans who embody Ricardian Equivalence, but very few. Ricardo theorized that it's the same effect if a government borrows or raises taxes: when people see their government taking on debt, they save more in anticipation of having to pay higher taxes so that government can pay off the debt. Since their savings are part of what government borrows, it's the same as if government increased taxes. I think that was true of most Americans once upon a time, but not today. I don't see that Americans today save more, consciously or not, even when budget deficits increase. Americans save so little compared to the rest of the world (by any standard, whether the BEA household rate or the Fed's flow of funds rate). Most of our debt is financed from anywhere but home, especially China, Japan and South Korea.

I'm only a humble foot soldier in the supply-side movement, but this is where I think Ricardo went wrong in his equivalence: he didn't account for incentive. Let's say I make $50,000 a year and save $1000 each year (2%). After an increase in the federal budget deficit, my own taxes will have to go up, say, $50, as my share of the increased interest payments. Let's even say Ricardian Equivalence happens, and that I save an extra $50 in anticipation. Why doesn't the government just tax me $50 more in the first place? It's incentive: supply siders say that with higher taxes, people overall are inclined to work less and produce less. People notice higher taxes more than budget deficits.

(This is actually leading to a very wacky idea that I need to talk to real economists about. Stay tuned for details.)

I've sometimes thought about the reverse of Ricardian Equivalence: when there's a government surplus, will people save even less, because they see that government won't have to borrow as much? I'd like to hear criticism of this idea, because I've never heard anyone talk about "Reverse Ricardian Equivalence" (my term for it). I just e-mailed Dr. Ikeda, one of my old professors, about it.

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Blogger Brad Warbiany said...

It's too bad the left is so unwilling to even attempt to understand simple economics.

You lost them at the first paragraph...

Great writeup though! It makes a lot of sense.

Perhaps someone can explain to these idjits the difference between compounding interest in an account and a simple wealth transfer as well...

Tuesday, March 22, 2005 2:10:00 PM  
Blogger TDM said...

A simple way to say it:
Deficits matter less than taxes.

A should be balanced between taxes and borrowing such that taxes and deficits matter the same amount.

Friday, March 25, 2005 6:44:00 AM  

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