“Sustainable” Debt — 18 March 2013

I am not terribly optimistic about the President’s recent conversion to bipartisan effort.  Not when, only a week beforehand, the White House strategy was leaked to a friendly press: they are playing for 2014.  President Obama is planning on getting nothing done for the next two years and blaming it on the Republicans, so as to take control of the House again and press the liberal agenda in his last two years.

So the outreach to the GOP is pure gamesmanship, a chance for the President to burnish his “nice guy” credentials, and blunt the perception that he is a hard-edged partisan.  The bald cynicism of this was underscored by a White House aide: “This is a joke. We’re wasting the president’s time and ours,” complained a senior White House official who was promised anonymity so he could speak frankly. “I hope you all (in the media) are happy because we’re doing it for you.”

Bu in truth, there are deeper reasons to believe the charm offensive will go nowhere, and these reasons would exist in the absence of official cynicism.  I was alerted to this recently when the President said to interviewer George Stephanopolous: “we don’t have a debt crisis.”  We don’t?  Then we’re all excited about nothing?

If you look at the statements from Obama, Nancy Pelosi, and others, you’ll notice that they speak in terms of “sustainable” debt position.  Just what is a sustainable debt position?  I did a little research, and found this article by James K Galbraith, a liberal economist and one who I think helped lay the groundwork for the President’s “what me worry?” attitude.  In it, he tells us what a sustainable debt load is: it’s one that’s not getting worse.

In an attempt to sound clinical and non-political, Galbraith lays out a formula developed by economist Willem Buiter, which says essentially this: the growth of the federal debt is a function of both the budget deficit and interest rates.  Here it is simply: say we have existing debt of 100% of GDP (we’re getting there), and a deficit of 5% of GDP.  You’d think that the debt next year would be 105% of GDP.  But if GDP grows by 3% (we’d love to have some of that these days), and the cost of financing that debt – interest rates – is only 1%, the growth in our public debt will be not 5%, but 5% + (1%-3%) = 3%.  This is because the denominator, or GDP growth, is growing faster than the cost of financing the debt.

So far, so dry.  What’s the big deal?  Galbraith says that interest rates, not the deficit, are the key: if interest rates stay below the rate of economic growth, then we can actually run a deficit and still not increase the overall debt.  This is doubtless true, but the assumptions have to be heroic: if we have a 5% deficit – it’s currently about 7% – we would have to have interest rates five percent below the rate of growth in order to keep the debt from rising.  Right now, of course, interest rates are only 1% lower than GDP growth, which is why that debt clock keeps ticking.

Nevertheless, if you take the long view, and make these big assumptions, you can say with some confidence that all we need is an extended period of ultra-low interest rates and some normal economic growth, and a return to normal deficit levels, and our federal debt stabilizes.  That means all these dogfights about spending cuts and tax increases are unnecessary.  All we have to do is lean on Ben Bernanke and his successors to keep interest rates well below the rate of GDP growth.

This is just the sort of claptrap an ivory tower economist would love.  One can say with numbers – supposedly liberated from the passions of political contest – that the deficit can be made manageable in the long run if we just do a few things right.  But there are just a few chinks in that argument:

First of all, how high does the debt burden go before these magic stabilizers work their effect?  Galbraith actually says that the larger the debt level, the easier it is to get under control, because the interest rate factor works on a larger multiplier.  A 3% favorable interest rate gap when the deficit is 100% of GDP offsets a 3% deficit; but a 3% gap when the deficit is 200% of GDP offsets a 6% deficit.  See what I mean?

What he doesn’t discuss is what happens to the economy when our debt is that high – even if it is not getting any worse.  Think of the amount of tax revenue that must be diverted to pay interest on the debt – even at low levels.  That’s a pure drag on economic growth.  Think also of the interest rate risk imposed by debt at that level.  If the Fed decided it had to raise interest rates to fend off inflation, with the debt at, say $20 trillion, every 1% hike would increase our deficit by $200 billion – that’s about a quarter of this year’s deficit.

And remember, Galbraith is talking about stabilizing the debt at that level, not reducing it.  So those interest bills become a permanent annual feature in our budget.  But at least it’s sustainable!

There’s another, even bigger problem, and it comes from the “be careful what you wish for” department.  Interest rates that are significantly lower than the rate of growth are dangerous.  When interest rates are below growth rates, you get inflation.  If you hold rates below growth for years at a time, you get not just inflation but asset bubbles.  That’s what the Greenspan Fed did in the first decade of this century.  Interest rates were held well below GDP growth, and the stock market – and infamously, the housing market – shot upward.  Until, that is, they shot downward.

So the notion that our debt problems can be cured if we just have patience and work gradually over time to bring our deficit down to a sustainable level is fraught with peril.  To the extent that Galbraith’s logic is driving policy, we are targeting an environment in which we will lock in high and permanent levels of debt and inviting an inflation that will decimate the savings of seniors and hobble the economy.  And of course, with high inflation comes higher interest rates and lower growth, and there goes your sustainability.

President Obama may be right that we are not in a crisis now – certainly not like Greece or Cyprus – but complacency like he is showing is one sure way to get us there.

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