Friday, May 14, 2010

Is the Current Federal Budget Deficit a "Crisis"? YEP

The Lessons of History

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.

In fact, looking at the deficit as a percent of GDP may understate the difficulty of the policy choices. Americans pay more in taxes to state and local authorities than do the residents of many other nations. As a result, the share of GDP available to be taxed by the federal government is not as high as elsewhere.

In any event, in a non-recessionary economy, the federal government's ratio of revenue to GDP is generally around 20 percent. While a $1 trillion primary deficit represents less than 7 percent of GDP, it represents about 30 percent of full-employment revenues. Eliminating a primary deficit of that magnitude will not be easy, particularly when the major expenditure components are entitlements, which are under pressure to expand rather than contract.

I do not think it is overstating things to describe our current budget situation as a crisis.