Thursday, July 31, 2014

Economic strength the solution to Federal debt problems

I disagree with the economic pessimists who believe that persistently slow growth will be the norm for years to come.

Yes, huge federal government deficits and debt are a major drag. It’s also true that budget surpluses aren't likely to materialize to shrink the $17 trillion-plus national debt, even if growth resumes.

Nevertheless, there is a strong possibility that government debt relative to gross domestic product will fall appreciably, as it did after World War II. Back then, deficits were relatively small, so GDP outran gross federal debt. The debt-to-GDP ratio dropped from 122 percent in 1946 to 43 percent 20 years later.

The ratio fell even further in the late 1960s and 1970s as inflation, caused by rapidly rising federal spending on Vietnam and Great Society programs, pushed taxpayers into higher tax brackets and filled government coffers. Higher corporate-tax revenues also resulted from under-depreciation and inventory profits.

A more recent example of a reduction of the federal debt-to-GDP ratio came in the 1990s under President Bill Clinton. Robust nominal growth of 5.5 percent a year caused deficits to shrink so much that small surpluses existed in fiscal years 1998 to 2001. Federal tax receipts rose 7 percent on average, faster than nominal GDP, and outlays grew slower, at 3.6 percent. The dot-com bubble lifted individual income-tax receipts at an 8 percent annual rate and corporate taxes by 8.3 percent a year.

On the outlays side, national defense spending fell 0.2 percent a year as the Cold War ended. Medicare spending jumped 7.2 percent annually but was only 7.8 percent of outlays in the 1990s. Social Security spending climbed 5.1 percent a year, less than social-insurance receipts.

In contrast, in the 2000-2012 years, nominal GDP growth slowed to 3.9 percent while anti-recessionary tax cuts and rebates shrank federal receipts’ annual growth to 1.6 percent. Outlays climbed at an average 5.8 percent rate, driven by Iraq and Afghanistan spending and by Medicare outlays. Not surprisingly, the resulting huge deficits drove gross federal debt-to-GDP to 103 percent in fiscal 2012.

The message is clear: Rapid economic growth pushes down the federal debt-to-GDP ratio directly as the denominator rises. Rapid growth indirectly affects government debt, too, as taxpayers get pushed into higher tax brackets, corporate profits grow faster than the economy, and tax cuts and government spending on social-welfare programs are curtailed.

Conversely, slow economic growth, as in the 2000-2012 period, pushes up the ratio directly. It climbs even more as the weak economy spawns tax cuts and counter-cyclical outlays.

So the resumption of rapid economic growth is the answer to the federal debt problem. Of course, the 800-pound gorilla in the room is the need for greater Social Security and Medicare outlays for retiring post-war babies. So far, Congress and the Barack Obama administration prefer gridlock to solving the looming entitlement-spending explosion. The more time passes, the more disruptive the solution must be. I believe, however, that Washington will do the necessary thing when there is no other choice.

As for the Reinhart-Rogoff argument -- that high government debt depresses GDP -- my view is that government debt doesn't depress economic growth, as they contend, but the other way around. Slow growth depresses tax revenue and raises government social spending, causing deficits and debt levels to rise.