Debt & Deficits

1. Debt & Deficits April 2009 W&L Econ 102 Smitka

2. US$11 trillion in national debt

3. State / local debt modest in macro termsRemember, they’re not allowed to run big deficits!

4. History shows current debt level doesn’t represent a short-run “crisis”

5. Huge structural deficits [blue]even corrected for cyclical (recession-driven) component

6. Even when adjusted to real (share of GDP) level

7. And lots of debt held by non-residents

8. Because private savings lowRemember (S-I) + (T-G) = (X-M) and with low S and low T...

9. And while historically monetary policy eventually shifts savings a bit.... No help this time around! Remember C has fallen < === > savings rate has risen

10. 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

11. How repay? • We can’t – and (fortunately!) we don’t 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

12. 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

13. 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 don’t you want (a) longevity?! • From a LR budgetary perspective healthcare is the top priority, by a large measure

14. 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 can’t • In past history children only briefly cared for parents • Life cycle transfers were (a) within the family (b) from old to young • Now they’ll be (a) outside the family (b) from young to old

15. 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 isn’t reliable • People cashing their 401-K’s this year face poverty • No guarantee the young will buy when you need to sell • But since the young don’t vote, and the increasingly numerous elderly do, won’t politics push us towards tax-funded systems?

16. Don’t 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 can’t start yet • And high debt-to-GDP levels will raise the cost, modestly • How can your generation avoid this? • Have lots and lotsof children!! • You’d have to fund childcare • But your parents will still want to retire, so it really doesn’t help you • So don’t retire until age 70 ... and then retire to Mexico? • How will the politics of this social compact evolve? • A good senior thesis topic!