Debt

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Debt Deficits

• April 2009
• WL Econ 102
• Smitka

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US11 trillion in national debt
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State / local debt modest in macro
termsRemember, theyre not allowed to run big
deficits!
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History shows current debt level doesnt
represent a short-run crisis
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Huge structural deficits blueeven corrected
for cyclical (recession-driven) component
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Even when adjusted to real (share of GDP) level
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And lots of debt held by non-residents
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Because private savings lowRemember (S-I)
(T-G) (X-M) and with low S and low T...
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And while historically monetary policy eventually
shifts savings a bit....
No help this time around! Remember C has fallen lt
gt savings rate has risen
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Sum of Effects

• Deficits exceed savings (net of investment)
• Hence tend to drive up i
• And lower I and increase the trade deficit (X-M)
• In other words, (modest) crowding out lower LR
  growth
• Deficits financed by non-residents
• We owe some of our taxes to the Chinese Saudis
• But we owe in US dollars
• So no Mexico-style foreign exchange crisis is
  possible
• But in the future we will have to tighten our
  belts (cut some combination of C, I, G) to export
  more and import less

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How repay?

• We cant and (fortunately!) we dont have to!
• We simply roll over our 11 trillion and
  growing... debt
• When 10 bil comes due, we mail out 10 bil in
  checks
• And institutional investors buy 10 bil in newly
  issued debt
• But interest costs matter
• If debt-to-GDP ratio is high, interest costs can
  explode
• But much debt is long-term so stable if high i
  temporary
• Nevertheless....
• We cannot allow debt-to-GDP to rise forever

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Stability

• Stability requires covering the cost of debt i
• Net of growth
• At a zero deficit, D D (1 i) debt growth
• Y Y (1 g) economic growth
• So need budget surplus of D/Y (i g) to
  stabilize
• If i 4, g 2 and 100 debt to GDP
• We need a surplus of 2 of GDP
• And 200 requires 4 of GDP, still manageable
• Of course at present we have a deficit, so the
  swing in tax rates must be larger

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Long run issues

• Baby boomers will (are starting to!) retire
• Those born in 1948 qualify for Medicare in 2013
• Social security is roughly balanced
• We might need to raise taxes by 2 of GDP, easy
  to manage
• Medicare is NOT stable
• We need to raise taxes by 4 (under the
  optimistic scenario)
• And by more with (a) greater longevity and (b)
  higher healthcare expenses, both looking likely
  ... and dont you want (a) longevity?!
• From a LR budgetary perspective healthcare is the
  top priority, by a large measure

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Addendum

• All retirement is Pay-Go
• We cannot save as a society for retirement
• Fallacy of composition between individual and
  macro
• Small countries have wiggle room they can
  accumulate foreign assets to finance eventual
  trade deficits. But not the U.S.
• The services and goods you consume at age 65 in
  retirement in 2054 have to be produced in 2052
• For you to consume those working cant
• In past history children only briefly cared for
  parents
• Life cycle transfers were (a) within the family
  (b) from old to young
• Now theyll be (a) outside the family (b) from
  young to old

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Addendum, continued

• So will saving be voluntarily or compulsory?
• Voluntary private savings to buy assets of
  retirees
• Involuntary govt financed transfers
• Social security, medicare
• Public education and child care are conceptually
  similar!
• Voluntarism isnt reliable
• People cashing their 401-Ks this year face
  poverty
• No guarantee the young will buy when you need to
  sell
• But since the young dont vote, and the
  increasingly numerous elderly do, wont politics
  push us towards tax-funded systems?

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Dont rue this!

• Our society is fortunate
• that people live long enough to retire!
• Plus we are beginning this process
• With really low tax rates, unlike the EU
• But in a steep recession so we cant start yet
• And high debt-to-GDP levels will raise the cost,
  modestly
• How can your generation avoid this?
• Have lots and lots of children!!
• Youd have to fund childcare
• But your parents will still want to retire, so it
  really doesnt help you
• So dont retire until age 70 ... and then retire
  to Mexico?
• How will the politics of this social compact
  evolve?
• A good senior thesis topic!