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Stories to Watch: Unsustainable Fiscal Policy
It's hard to grow your way out of debt; the choice between hard default and hyperinflation; those of us who cried wolf should have been heeded
The fall in the U.S. public debt/GDP ratio from 106% in 1946 to 23% in 1974 is often attributed to high rates of economic growth. This paper examines the roles of three other factors: primary budget surpluses, surprise inflation, and pegged interest rates before the Fed-Treasury Accord of 1951. Our central result is a simulation of the path that the debt/GDP ratio would have followed with primary budget balance and without the distortions in real interest rates caused by surprise inflation and the pre-Accord peg. In this counterfactual, debt/GDP declines only to 74% in 1974, not 23% as in actual history. Moreover, the ratio starts rising again in 1980 and in 2022 it is 84%. These findings imply that, over the last 76 years, only a small amount of debt reduction has been achieved through growth rates that exceed undistorted interest rates.
Pointer from Tyler Cowen.
Oy. Their conclusion is correct, but nobody needed to use an opaque simulation model to get there. Thirteen years ago, I explained it using a simple table.
One point that stands out is that the years of dramatic reductions in the ratio of debt to GDP were years in which the United States ran primary surpluses. The only other chapter in history where the debt to GDP was reduced was the Inflation Shock. Even then, it was not reduced by much, and this chapter was followed by the Bond Market Vigilantes chapter, in which investors punished the government for its prior inflationary transgressions.
In short, there is no precedent for reducing the ratio of debt to GDP by simply growing our way out of it. Instead, policy choices must be made in order to restore a primary surplus.
Some of my essays have stood the test of time, but only I remember them. That is one example.
If you are wondering why a government that has a choice of not defaulting would choose to default, it is worth remembering that printing more money to pay off local currency debt has a cost of its own, since it debases the currency, pushing up inflation. Inflation, especially when it becomes stratospheric, causes investors and consumers to lose trust in the currency, and given a choice between default and debasement, many governments choose the latter.
The U.S. always has a choice not to default. It can print money to pay off bonds. But under duress, if it looks like we are headed for hyperinflation, the attractiveness of money printing relative to formal default may look different than it does today.
Throughout almost my entire life, I’ve heard the budget deficit called a ticking time bomb. And yet for the most part the national debt remained relatively low as a share of GDP. Something changed in the late 2010s, when the US went from being a responsible nation to something akin to a banana republic. There were no more “grownups in the room” to scold Congress when reckless fiscal policies were adopted. The budget deficit doubled during an economic boom, a period where it would normally be falling as a share of GDP. These policies (spend more and tax less) proved popular with the general public and were maintained (and even extended) when a new administration took power in 2021. And now the wolf is here, we really do have a debt problem.
…Future generations will face some very unpleasant choices due to the irresponsible behavior of the Federal government over the past 6 years. I would not wish to be elected president in 2024.
I was one of those who was a fiscal hawk twenty years ago. My belief was that the best way to ensure fiscal solvency was to raise the age of eligibility for Social Security and Medicare. We should have done that before the Baby Boomers were on the verge of retirement. Now it’s too late.
At some point, the obligations to pay interest on the debt and to spend on entitlements to seniors are going to exceed what the government can collect in taxes, while still spending on necessary things like defense, not to mention unnecessary things like industrial policy and free college.
The fact that we have avoided the “very unpleasant choices” so far does not mean that those of us who warned early about the issue were crying wolf. It does mean that those choices are going to be more painful than if we had been listened to.
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