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Wednesday, November 17, 2004

Massive Deficits

Prior to the election, there was an argument that went something like this:

A. The United States has massive federal deficits;
B. Massive federal deficits are devastating to an economy; and
C. Bush caused the massive federal deficits.
D. Don't re-elect Bush (i.e., vote for Kerry)

I liked the conclusion, so prior to the election it seemed counterproductive to take issue with the premises. However, the election has come and gone and Bush has four more years, so it's as good as time as any to consider whether or not the premises are true.

Taken individually, each premise is true to a certain degree. Starting with premise A, it certainly would seem that a deficit that's larger than the entire GDP of all but a few countries on the face of the earth could be fairly described as "massive". Certainly, deficits that are massive enough would be devastating to an economy. And, at least in the short term, it could be argued that the Bush tax cuts contributed to the size of the deficits.

However, when looking at the data, premises A and B conflict. While the Federal Government's deficits are massive compared to the budgets of most entities, they are pretty modest compared to both the Gross Domestic Product (GDP) and the Debt of the United States. The remainder of this essay explains why.

Deficits are a budget shortfall. U.S. Government budgets span one year. Debt is the accumulation of deficits over time. It is usually more useful to consider debt and deficits as a percentage of income. For example, assuming a million dollar mortgage would be a problem for someone with a $20,000 annual salary, but no big deal for someone with a $5 million annual income.

A given amount of debt becomes a smaller percentage of GDP as GDP grows. As an example consider a scenario where a country has 5% nominal GDP growth, and government debt that is 60% of GDP. After one year, the country's GDP has increased by 5%. Instead of 60%, the debt from the previous year now represents 57% (.95 times 60%) of GDP. The government can incur a deficit of up to 3% of GDP without increasing debt as a percentage of GDP relative to the previous year.

This scenario is actually fairly similar to the current state of the economy and government debt in the United States. Consider the following table which spans the Clinton and Bush presidencies:

United States Debt
($ millions) Percent of GDP
Total Held by Total Held by
the public the public
1993 4,351,044 3,248,396 66.3 49.5
1994 4,643,307 3,433,065 66.9 49.4
1995 4,920,586 3,604,378 67.2 49.2
1996 5,181,465 3,734,073 67.3 48.5
1997 5,369,206 3,772,344 65.6 46.1
1998 5,478,189 3,721,099 63.2 42.9
1999 5,605,523 3,632,363 61.3 39.8
2000 5,628,700 3,409,804 57.9 35.1
2001 5,769,881 3,319,615 57.6 33.1
2002 6,198,401 3,540,427 60.0 34.3
2003est 6,752,033 3,878,438 62.8 36.1
2004est 7,320,769 4,166,061 64.8 36.9
2005est 7,837,499 4,386,515 66.0 36.9
2006est 8,353,379 4,602,648 66.9 36.9
2007est 8,857,525 4,796,647 67.6 36.6
2008est 9,387,680 5,002,947 68.3 36.4

The debt "held by the public" is:
All Federal debt held by individuals, corporations, state or local governments, foreign governments, and other entities outside of the United States Government less Federal Financing Bank securities.
The difference between "total" debt and debt held by the public is intragovernmental holdings:
Government Account Series securities held by Government trust funds, revolving funds, and special funds; and Federal Financing Bank securities. A small amount of marketable securities are held by government accounts.
Intragovernmental holdings are essentially debt the government owes itself. Social Security is an example of one of the Government funds that is currently running a surplus and loaning it back to the government. These are funds that will need to be replenished eventually. However, intragovernmental debt has no real effect on public debt or capital markets or interest rates.

As can be seen from the table, total debt went up every year. Since 1940, total debt has increased during more than 90% of the years. However, as a percentage of GDP, total debt dropped during five of those years. That's because, like the example above, nominal GDP growth more than made up for the absolute increases during those years. In this case, the 3% deficit equates to about $330 billion. The actual deficit for 2004 is estimated to around $450 billion and is somewhat higher, but has a relatively smaller effect on total government debt as a percentage of GDP.

In fact, the debt held by the public as a percentage of GDP is hardly budging this year. It's estimated to increase from 36.1% of GDP in 2003 to 36.9% of GDP in 2004 and level off and even shrink from there. Also note that the debt held by the public is projected to be substantially lower during the Bush years than it was during the Clinton years so it's highly unlikely that the debt will have a worse impact on the economy now than it did during the 1990s. Indeed, long term interest rates, both real and nominal, have fallen steadily since Bush took office and "caused" the "massive" deficits.

Government debt relative to GDP is changing little. Interest rates are falling. Core inflation remains low and stable. GDP growth and productivity growth are robust. Employment is steadily increasing. There seems to be scant evidence that the "massive" deficits are damaging our economy.

No doubt, if we continue to increase the total debt one or two percent every year, it will eventually be a problem. To get an idea of how long eventually might be, let's compare our 36% publicly held debt to other countries with highly developed economies. Here are a few estimates for 2003:
France: 68.8%
Germany: 64.2%
Japan 154.6%
We have lower debt than they do, much lower in the case of Japan. Their economies aren't great, but they are nowhere near collapse either. At the current rate of debt accumulation, it will take decades before our debt is as high as theirs.

How about relative to our own history? We're a bit below the middle of the range. The peak total debt was 121.7% of GDP in 1946. That year also marked the peak debt held by the public of over 100% of GDP.

How about the deficits relative to the debt markets? Here are a couple of statistics to give a feel for the massive size of those markets (I think the word "massive" is more appropriate here). For home loans:
Mortgage originations shattered previous records and reached $2.5 trillion in 2002. Including second mortgages, that works out to about 25 million loan originations, or 100,000 per business day.
The U.S. Treasury Bond Futures market on the Chicago Board of Trade have an annual volume representing about $5 trillion a year. A few trillion here, a few trillion there, pretty soon you're talking real money! In any case, the debt and capital markets dwarf the deficits and even total government debt. And again, the debt held by the public will actually shrink relative to GDP over the next few years.

In summary, you can describe the current deficits as massive, and you can say that massive deficits can wreck an economy, but it turns out the these massive deficits are simply nowhere near massive enough to hurt our economy.

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