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:

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%.

The Inflation of Gold

Note: I originally published this on

There are gold bulls, and there are gold bears. There are those who will tell you gold is going to $6000, and those who will tell you it’s going to $600. The reality will depend in no small part on how major macro events unfold over the next several years (see a couple of gold-moving scenarios at bottom). What I’d like to focus on here is the dynamics of gold supply and demand, in order to introduce the notion that gold itself has a rate of inflation. Just as a rising US money supply can breed inflation in the broader economy, a rising gold supply can breed “inflation” in gold, meaning that gold’s purchasing power (its price) can drop in dollar terms.

US Money Supply

The St. Louis Federal Reserve does an excellent job of tracking the money supply through its Adjusted Monetary Base, which sums up the various components in the money supply to create a single metric. Their latest research shows that the Adjusted Monetary Base did indeed climb rapidly during the tail end of the recession, but that it is now showing zero growth. The velocity of money has yet to recover to pre-recession levels as well, which explains why the 2008/2009 money drop by the Fed did not cause broader inflation.

Gold Supply and Demand

First, gold supply: the World Gold Council reports that mine production has averaged 2497 tonnes per year over the last five years (see the text in supply section of article). This amounts to a 1.5% annual increase in physical gold stocks. While 57% of this gold is used in jewelry, and 11% goes to industrial uses, a key feature of the gold market is that gold is never destroyed. Other commodities like oil are constantly being consumed – hence fears about peak oil, or potash shortages. But since gold is never destroyed, gold demand must constantly rise to account for both increased mining production and increased total stocks. Currently, investment demand is the key driver of gold prices – while both jewelry and industrial gold demand can be met by current mining production, investment demand is being met only through increased gold recycling.

Gold vs USD

Long term gold charts show that previous gold rallies occurred in the context of high inflation. The current rally has occurred with an absence of high inflation, as the CPI crossed 5% only once in the last decade. Back to the original idea – the world’s gold supply is rising faster than the US money supply at the moment. If this situation persists, then a gold collapse is inevitable, as gold’s inexorable supply increase couples with a stable dollar to push gold prices down. Clearly gold bugs believe the opposite: that inflation will come roaring back, and that dollar money supply will explode. But anything less, and gold prices are likely coming back to earth.

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What Happens When The US Can Borrow No More?

In a previous post, I noted that the US can handle a debt load up to about $20 Trillion, even in the absence of rapid economic growth. Unfortunately, we appear to be rapidly headed past that figure, with the White House’s official projection showing that total debt will pass $20 Trillion by 2016 [1], and will rise above $25 Trillion by the end of the decade!

The growth of the federal debt is thus unsustainable, as even politicians now acknowledge. Eventually, bond markets will be unable to consume the volume of debt that America needs to issue in order to continue spending. What happens at that point, when the US can no longer borrow to fund current spending?

Here are the options for 2015, using the assumption that real GDP growth and inflation will both average 2% through 2015, with a resulting budget deficit of $1,014 Billion [2]:

  1. Cut Spending: Spending cuts of $475B will be needed to reduce the budget deficit below 3% in 2015. A 3% budget deficit is generally viewed as sustainable by economists [3]. Budget cuts this size would necessarily have to include cuts to Defense, Medicare, or Social Security, as they together make up 2/3 of the Federal budget.
  2. Raise Taxes: As with spending cuts, $475B in taxes would be needed to drop the deficit below 3% in 2015. Taxes would have to be raised to 21% of GDP to close the gap, the highest total tax burden since at least 1975.
  3. Monetize Debt: Since the start of financial crisis, the Federal Reserve has been purchasing US treasuries in order to keep interest rates down and to inject cash into the economy. The Fed could also bail out government finances by buying the $475B in excess Treasury issuance in 2015, but this is the equivalent of printing money. Such an approach will create inflation, and is unsustainable in the long term.

The federal government is likely to attempt a combination of all three approaches in order to minimize the pain on any one interest group. Inflation will likely rise above its recent norm of 2% as the Federal Reserve quietly injects money into the economy. The federal government’s total tax burden will likely rise to at least 20% of GDP, and spending cuts in the hundreds of billions will be required. The sacred cows of Medicare, Defense, and Social Security will be cut, since there’s little to cut outside these programs. The future looks increasingly to hold higher taxes and less government services, a penance decades in the making.

[1] See table S-14 for the OMB’s debt projections.

[2] The OMB uses rosy economic growth projections (table S-13) of over 4% for most of the years between now and 2015. I use a more conservative 2% for real economic growth and 2% for inflation, for 4% total nominal GDP growth (vs. 5.6% used by the OMB). Using 4%, I estimate GDP at $18 Trillion in 2015, whereas the OMB projects $19.4 Trillion. My lower GDP estimate also lowers projected government revenue proportionally, so that my budget deficit estimate for 2015 is $1014 Billion (versus $752 Billion OMB estimate).

[3] Why is a 3% budget deficit acceptable? Long term real economic growth in the US is around 3.75%, so a 3% budget deficit will over time cause the overall debt to grow more slowly than the economy. As the debt-to-GDP ratio shrinks, interest payments on the debt become easier and easier to pay via the growing tax base.