How High a Budget Deficit Can We Sustain?

The US can sustain a budget deficit of 5%, not 3% as commonly assumed, because 2.5% inflation and 2.5% real growth combine to keep the total debt/gdp ratio stable.

With both the financial crisis and European debt crisis having a root in excess borrowing, the American political debate has turned toward deficit reduction as well. If current budget deficits (averaging 10% of GDP since the financial crisis) are recognized as unsustainable over the long term, then what level of budget deficit is sustainable? At one extreme, politicians call for a balanced budget, and at the other extreme the budget deficit is considered a distant issue. Meanwhile, many economists set the sustainable deficit threshold at 3% of GDP, and EU rules formally set the budget deficit threshold at 3% as well. What is the basis for the idea of a “sustainable” budget deficit, and is the 3% figure too high or too low?

What is a sustainable budget?

Unlike individuals or families, a nation has an indefinite lifespan, and can therefore continually roll over its debt as long as markets deem it a worthy creditor. As long as a nation’s economy is growing, its capacity for borrowing grows as well. But if the debt grows at a rate faster than the economy, then it will eventually exceed the nation’s ability to repay it. The idea of a sustainable budget deficit is summarized by the chief economist of the Concord Seo Company Coalition, “President Obama’s fiscal commission set a goal of getting deficits down to about 3 percent of GDP within five years – 3 percent being the average annual growth rate of the US economy since World War II.”

The Real Sustainable Deficit Target

There’s just one problem with the 3% target for a sustainable budget deficit – it’s too low! While GDP growth is measured in real terms, inflation also eats away at the value of the US debt over time. For instance, assume that the US has no future economic growth, but continues to have 2% inflation. Assume that we also manage to (magically?) balance the US budget. With no economic growth, does this mean that debt/gdp stays constant? Actually, inflation would cause the numerical value of GDP to continue rising, while the debt stays constant. This would cause the debt/gdp ratio to fall by around 2% per year.

In practical terms, this means that we have to look at the rate of nominal GDP growth to determine a sustainable budget deficit level [1]. To be conservative, let’s assume 2.5% real GDP growth (less than the 3% post-war average) and 2.5% inflation (within Americans’ comfort zone, and less than the 90′s and 2000′s average). Taken together, this means that if nominal GDP grows at 5% per year, a budget deficit of 5% can be sustained long term. The difference between 3% and 5% of GDP is big, over $300 Billion in 2012. As the federal budget and spending again enter serious debate after the November elections, it’s important that politicians understand the government’s true borrowing capacity – and neither the populist “balanced budget” nor the typical economist’s 3% magic number stand up to examination.

[1] Here’s the actual nominal GDP data from the Fed: http://research.stlouisfed.org/fred2/howtobcome/data/GDP.txt

Using this data, we see that nominal GDP has grown at a compound annual rate of 6.6% over the post-war period (since 1947, when the data series begins). Over the past 30 years, nominal GDP has grown at a compound annual rate of 5.4% – and this period excludes most of the late 70′s and early 80′s inflation spike. Even over the past 20 years, which are skewed downward due to the financial crisis, the nominal GDP growth rate is 4.7%.

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6 Comments »

  1. Communal Award said

    There is only about ~900 billion paper and coin dollars.
    There is about ~14 trillion dollars worth of credit supplied by banks.
    There is about ~55 trillion dollars in total debt, again, supplied by banks.
    What backs the dollar is the faith that the 14 trillion dollars will some day pay the 55 trillion dollars off.

    Doesn’t it sound like Ponzi/Pyramid scam on global scale?

  2. fabooks said

    seems to me that all commentariat and players are united in a struggle to find an acceptable ideological path to bringing about a crude solution to the problem – inflating the debt away – but can’t quite bring themselves to say it…..the contest is between the financial establishement who feed from the transmission of credit, and credit junkies (e.g those with huge mortgages) versus the ungeared (e.g savers and pensionistas)

    my money is on inflation

    • fabooks – my point here was that inflation has always been part of the picture when it comes to debt. Even low (2%) inflation knocks out roughly 2% of the debt every year by devaluing it. 0% inflation or deflation are actually quite bad, as the Japanese can attest, and as anyone who still remembers the Depression can attest.

      So some inflation is always part of the picture with regard to debt, and you don’t need hyperinflation in this context – just couple 2-3% inflation to 2-3% GDP growth, and you’ve got a lot more room to work with than is normally realized.

      • Communal Award said

        Each state in India should have a unique currency to prevent Euro type collapse.

  3. TheTracker said

    The debt is not America’s primary problem. The main problem is that critical infrastructure for a 21st economy — from roads and bridges, to the internet, to education, to healthcare — is not being built and maintained effectively. In healthcare, especially, you are looking at perhaps 6% of the GDP that is being flushed down the toilet as pure waste, and probably a roughly similar amount in lost productivity from unnecessary sickness and disability.

    These things could be done by the state, or a well-regulated market, but in either case they require grown-up foresight and management. Which has not been forthcoming.

    The crisis will become more acute as the baby boomers retire and climate change becomes a bigger and bigger annual cost.

  4. John said

    What about interest on debt?

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