Selective-attention deficit disorder

debt/gdp ratio

debt/gdp ratio

So who’s the party of fiscal responsibility again?  That mantle seems to be claimed by whichever party does not occupy the White House.  In the late 1970s, Ronald Reagan and other Republicans charged that Jimmy Carter’s deficits (although puny in retrospect) were inflationary and needed to be stopped.  As president in the 1980s, Reagan presided over the largest deficits ever (in absolute terms) and the first-ever major peacetime increase of the national debt-to-GDP ratio in history.   Leading Democrats pounded him for the deficits, and Reagan swatted them away as “born-again budget balancers.”  Dick Cheney said later (quoted in one of the Bush 43 administration tell-all books), “Reagan proved that deficits don’t matter.”  Economists by and large weren’t buying it, but aside from relatively high real interest rates and relatively low levels of business investment, the economy was prospering as it hadn’t in two decades, and Democratic attacks on Republican deficits found little traction.  Just ask Walter Mondale.

As we can see from the red line in the diagram, courtesy of my former professor Willem Buiter, the debt/GDP ratio (our best measure of the overall burden of federal deficits and debt):

  • mostly fell during the 1970s, as appears to be the norm for the economy in peacetime (at least in non-recession years);
  • more than doubled during the 1980s and all through Bush 41’s presidency, from about 24% to 54%, likely due to tax cuts, the Reagan military buildup, and the growth of health care costs and entitlements spending;
  • fell sharply during the Clinton years to about 34% in 2000, likely due mostly to the booming economy and the post-USSR “peace dividend”;
  • rose sharply in the Bush 43 presidency, likely due initially to the 2001 recession, tax cuts, and Medicare prescription drug expansion, then to the Iraq and Afghan wars, rising health care and entitlement costs, the aging of the population (including early baby boomer retirements), and of course the 2008 recession and bank bailouts.

So what? you ask . . .

. . . And that’s the right question, much as it eludes politicians, journalists, and even many economists.   Is a higher debt/GDP ratio necessarily a bad thing?  No, not if it represents spending on public investments with big payoffs (like the interstate highway system) or critical emergency spending (like fighting World War II.  Reagan supporters might argue that his rapid defense buildup ended the Soviet threat once and for all and hence was worth it — not an argument I accept or want to get into here; just sayin’).   Yes, if it’s for wasteful spending or for tax cuts not matched by spending cuts.  The tougher question is, How high a debt/GDP ratio is too high?  We don’t know. At least, I have yet to see a clear and compelling answer.   Buiter believes the current level is dangerously close to that threshold and on pace to go past it.  Congressional Budget Office forecasts are for very large deficits of about 13% of GDP (i.e., about twice as large as Reagan’s largest deficit) in the next couple years, in which time the gross debt/GDP ratio (the blue line) would shoot up to 100%.  (The gross debt/GDP ratio is higher than the net debt/GDP ratio because it includes government debt held by the government itself, notably T-bonds held by the Social Security Trust Fund).

100% is a number that gets one’s attention, and it would mean a near-doubling of the gross debt/GDP ratio since 2000, but even the always-insightful Buiter fails to make a complete case as to why this is so bad.  As he himself notes, the current U.S. debt/GDP ratios are similar to those of our European trading partners, and many of them face similar prospects of paying for the needs of an aging population and coping with troubled economies and financial systems.  Perhaps the strongest counterargument is that we have been here before. But we’d need to go back further than Buiter’s chart does to see it. Take a look at the next chart, from The Skeptical Optimist:

Debt to gdp ratio 1792 to 2005

Debt to gdp ratio 1792 to 2005

At the end of World War II, in 1945, the U.S. national debt was a whopping 120% of GDP.  It fell to half that level within a decade, and fell continuously to less than a third of that level, during the next two generations. To be sure, we had a few things going for us than that we may not have over the next few decades:  unrivaled economic supremacy, big trade surpluses, and fabulous economic growth until 1973.   The Skeptical Optimist is right on when he says that economic growth is what causes the debt/GDP ratio to fall in most periods.  Debt/GDP fell even during the meager economic growth of 1973-1980 (though that may have been mostly due to unexpectedly high inflation).

The Obama Administration and Ben Bernanke have basically been on the same page lately about deficits and debt, and I think it’s the right page:  Some form of bank bailouts and spending stimulus makes sense now, in order to help stabilize the economy and relieve the misery of unemployment, but deficit reduction, especially curbing the runaway growth of health care and entitlement spending, will be needed as soon as the economy gets on track.  Allowing more skilled immigrants into the country could help a lot with the revenue side of the equation.

In the meantime, it’s helpful to remember that there are fates worse than debt.  Continued economic collapse, for example.  Seeing the economy through red-ink-colored glasses, as Dean Baker reminds us, causes one to miss the larger picture.  Paul Krugman points out, with graphical help from Brad Setser, that the rise in government borrowing is offset by the drop in private borrowing that the recession in the first place.  There are plenty of savings to go around; since there’s less loan and corporate bond activity, those savings are now being invested in government bonds.

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