Tuesday, August 2, 2011

"Growing" out of debt

Debt is central to any discussion about the US economy nowadays. How to reduce the massive $14.3 trillion public debt and the $1.6 trillion (11% of GDP) fiscal deficit?

Conventional solutions include cutting expenditures, raising taxes, inflating away debts with higher inflation, and the final resort partial and selective sovereign default. However, as I have blogged earlier, all of them are fraught with dangers. As Lane Kenworthy pointed out in a recent post, any government's debt levels "are a function of government expenditures and revenues and economic growth".

In the current macroeconomic circumstances, Catherine Rampell hits the nail on the head by describing "economic growth" as the secret weapon to bring the debt back to sustainable levels. Growth creates its own set of dynamics, the most important of which is to boost revenues and bring down the real debt burden. It is therefore no surprise that the largest contributor to America's massive public debt stock, other than Bush era tax cuts, has been the decline in revenues caused by the recession. In fact, of the $12.7 trillion in additional federal debt that was accumulated over the last decade, about a third came from the souring economy.

However, the traditional sources of economic growth remain depressed. Household consumption which forms more than 70% of US GDP remains weak as households grapple with debt-ridden balance sheets. Weak consumption means that businesses have little incentive to invest. Trade, the other traditional engine of growth, too is depressed on the face of weak economic prospects among the major US trading partners in the developed world.

This leaves the government with the responsibility of shouldering the major share of the recovery burden. But government spending comes with a fiscal cost, which adds to the already high debt stocks. It will succeed if the rate of GDP growth caused by the stimulus exceeds the rate of growth in debt stock due to the additional fiscal demands. Fortunately, given the specific conditions, all evidence and macroeconomic theories points to this being the most possible outcomes.

Expansionary policies, fiscal and monetary, have traditionally been the engines thaht put recession-hit economies on the path of recovery. In contrast, austerity has most often had the effect of deepening the recession. The fiscal and monetary stimulus spending, while substantial, is not that large when seen as a share of the total debt stock. As mentioned earlier, if the multiplier due to growth (in the prevailing macroeconomic conditions) is taken into consideration, a net cash inflow is the result.

However, even if short and even medium-term debt reduction objectives are achieved, as they look very much possible, the long-term debt reduction prospects for the US economy looks bleaker. There are important structural factors, mainly related to demography. The aging population means ballooning health care costs. It is therefore critical that these longer term factors are effectively addressed for America to make any meaningful dent on its long-term fiscal balances.

It is not just the US that is suffering a debt overhang. It is as big a problem on the other side of the Atlantic and in some developing countries.

The agreement reached between President Obama and Congressional leaders of both parties on Sunday to raise the debt ceiling (by $1.6 to 1.9 trillion) has firmly embraced the fiscal consolidation route to debt reduction. The agreement calls for at least $2.4 trillion in spending cuts over 10 years, including on Medicare, Medicaid and Social Security, with a new Congressional committee to recommend deficit-reduction proposals. It does not contain any proposal to increase taxes. It has been criticised by economists as making a weak economy weaker, a catastrophe on multiple levels, and even plain extortion.

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