Download PDF The year-end fiscal cliff is the current hot economic topic, and many policymakers and pundits seem to think that forcing us over the cliff is the best way to force decisive action to reduce US debt. However, this tactic will not work in the United States because borrowing costs are so low. In countries like Greece, Spain, and Portugal, borrowing costs are much higher, and debt crises have emerged. However, with its very low borrowing costs, the United States is not in immediate danger of a crippling crisis. What is needed are gradual reductions in US primary deficits that result in a stable ratio of debt to GDP by 2015.
Key points in this Outlook:
- Efforts to force a fiscal crisis like the latest "fiscal cliff," designed to compel Congress to an agreement to cut the deficit, have failed and will continue to fail.
- Though the US deficit is in the trillions of dollars, the United States is not in immediate danger of a financial crisis on the level of Greece's because its borrowing costs are so low.
- Moving to reduce US primary deficits to about 3 percent of GDP over the next five years would help the debt-to-GDP ratio to stabilize and sustainably reduce government debt over the long term.
Congress is attempting, unsuccessfully, to reduce “unsustainable” deficits and debt accumulation by engineering “crises” that are meant to force politically challenging action on spending cuts (entitlements) and tax increases (loophole closing, higher tax rates on the “rich”). The mid-2011 debt-ceiling crisis fiasco and the upcoming year-end “fiscal cliff” are striking examples of this dangerous tactic. The debt-ceiling crisis succeeded in getting Standard and Poor’s to downgrade US debt from a AAA to an AA+ rating and in setting up the sequestration portion of the upcoming fiscal cliff that has damaged business and household confidence by raising overall uncertainty.
The tactic of threatening to go over the fiscal cliff will fail to produce prompt, sustainable progress toward reduction of “unsustainable” deficits because deficits have been, and will continue to be for some time, eminently sustainable. The Chicken Little “sky is falling” approach to frightening Congress into significant deficit reduction has failed because the sky has not fallen. Interest rates have not soared as promised and, in fact, interest costs for the federal government have remained steady at a tiny 1.5 percent of gross domestic product (GDP) since 2002, having fallen to that level from a 3 percent average during the decade prior to 1997. (See figure 1).
Why No US Crisis?
Trillion-dollar federal budget deficits have continued to be sustainable first because the federal government is able to finance them at interest rates of half a percent or less. Two percent inflation means that the real inflation-adjusted cost of deficit finance averages –1.5 percent, much to the dismay of savers seeking even a modest return on “safe” assets.
Congress and the White House may decry the crisis and the pain that will come if the deficit is not reduced, but no actual crisis has occurred to force politically difficult spending cuts and tax increases. More reasons for this frustrating outcome are embedded in the determinants of the ratio of debt to GDP, the most frequently invoked metric of fiscal stress.
The debt-to-GDP ratio is not a reliable guide for gauging the sustainability of deficits, notwithstanding the Reinhart and Rogoff warning that ratios above 85–90 percent represent a dangerous zone. Spain and the United States have nearly identical debt-to-GDP ratios of about 80 percent, though Spain’s ratio is actually a bit below the US ratio (see figure 2 for the behavior of debt-to-GDP ratios for major-deficit countries) and its deficit is smaller as a share of GDP. Yet Spain has already experienced a fiscal crisis that drove interest rates on its 10-year bonds over 7 percent, well above sustainable levels, especially given its worsening recession and over 30 percent unemployment rate. Spain had to be rescued by the European Central Bank with substantial artificial support for its bond market.
Japan’s experience is even more striking in illustrating the unreliability of the debt-to-GDP ratio as a crisis gauge. Its net debt-to-GDP ratio has climbed steadily from 60 percent in 2000 to 140 percent today. (See figure 2.) Meanwhile, interest rates on Japan’s 10-year government bonds have dropped to 0.7 percent today from 1.75 percent in 2000. During the 1990s, the same rate in Japan fell from a peak of 8 percent in 1990 to 1.75 percent in 1999 while Japan’s debt-to-GDP ratio was rising steadily. The Japanese borrowing crisis never came, though its debt burden rose to the highest level by far among industrial countries and major emerging economies.
Why do countries like Spain with moderate debt-to-GDP ratios experience financial crises while others with similar (US) or substantially higher (Japan) ratios are able to keep borrowing at very low interest rates of 0.7 (Japan) to 1.6 (US) percent? The answer lies with the debt-to-GDP metric. The percentage change in debt-to-GDP ratio is determined by two components: (1) the primary deficit (the difference between government spending and tax revenues), and (2) the difference between government interest cost (the yield on government debt) and the growth rate of nominal GDP.
Spain experienced a sharp jump in interest costs after the 2008 financial crisis, despite a relatively low debt-to-GDP ratio of just over 40 percent. (See figure 2.) Spain’s 1999 entry into the eurozone permitted it to borrow at much lower interest rates while experiencing fast growth during the decade from 1997 to 2007. The Spanish government and Spanish borrowers responded with a surge in borrowing that drove up debt, but growth remained high relative to GDP. This is illustrated in figure 3, which shows a decade-long period of high growth relative to borrowing costs that ended in 2007. When the eurozone crisis hit in late 2009 after Greece revealed its previously unreported disastrous government finances, interest rates on most bonds of highly indebted European countries, including Spain, jumped.
Then, as the crisis dragged on and the GIIPS countries (Greece, Italy, Ireland, Portugal, and Spain) were forced to implement austerity to obtain financing for their rising deficits, growth dropped sharply, causing further concerns about the countries’ ability to service debts. Interest rates rose dramatically. The difference between interest costs and nominal GDP growth grew so fast that even with reductions in the primary deficit, the debt-to-GDP ratio rose.
Figure 3 shows the sharp rise in Spain’s borrowing cost minus growth gap after 2007, and Figure 4 shows Italy’s similar, though less monotonic, experience. Figure 5 shows the experiences of five major countries plotted together. Japan, Germany, and the United States spiked into a post-2008 crisis zone (with borrowing cost above growth rate) when the Lehman Brothers crisis hit. Italy and Spain had a similar experience at first, but after a brief partial recovery in 2010 rose back up to the crisis zone in 2011 and 2012. Meanwhile, the United States and Germany recovered nicely, dropping out of the crisis zone from 2010 to the end of 2012. Japan’s experience was more mixed after 2008, with a jump back into the crisis zone in 2011 tied to the March 2011 tsunami and a drop back to a more sustainable level during 2012.
The United States Is NOT Greece
The importance of the borrowing cost minus growth gap in precipitating a financial crisis is demonstrated most spectacularly by the experience of Greece, as shown in figure 6, which compares Greece’s borrowing cost minus GDP growth gap with that of the United States. From the late 1990s, when Greece was scheduled to adopt the euro (most notably from 2000, when Greece was able to issue eurobonds) to 2008, Greece and the United States experienced virtually identical gaps, including negative gaps (borrowing costs below growth) during the 2002–07 “golden years” for debt accumulation.
After late 2009, when Greece revealed that its primary deficit had been far larger than previously reported, its borrowing costs soared while growth collapsed. The growth collapse was exacerbated by austerity programs aimed at reducing the primary deficit. Such ill-conceived efforts to condition bailouts on austerity were designed to reduce Greece’s debt-to-GDP ratio but actually caused it to rise. This happened because growth fell so rapidly that tax collections collapsed and the primary deficit was little affected while the borrowing cost to growth gap soared, as figure 6 shows. The gap then soared to 65 percentage points, while the US gap fell to a remarkably favorable –2.2 percent, where it remains today. (See figure 7.)
The hyperbolic claim that the United States is becoming Greece because of the absence of dramatic progress on deficit and debt reduction is unfortunately ridiculous. There is not yet a sign that a US fiscal crisis will emerge to force Congress to enact fundamental measures like entitlement reform to reduce the growth of spending, or tax reform to enhance revenues through faster growth.
US Current Debt/Deficit Sustainability Is Dangerous
The real danger facing American policymakers is, contrary to the cries of imminent “crisis” and “unsustainable” deficits and debt accumulation, the sustainability of trillion-dollar deficits. Eventually, probably much later than most pundits claim if the experience of Japan is any guide, the Federal Reserve’s monetary accommodation of US government debt accumulation, largely aimed at sustaining the growth of outlays on entitlements that do not support economic growth, will cause inflation to rise. The Fed’s latest move to target the unemployment rate with more quantitative easing only adds to the threat of inflation because the only way monetary policy can affect growth or employment is by engineering a higher-than-expected rate of inflation.
Once inflation rises and the Fed is forced to tighten, borrowing costs for both the government and private sectors will rise. Growth measured in real, constant-dollar terms will fall relative to real, inflation-adjusted interest rates along with tax revenues, and the US debt-to-GDP ratio will rise rapidly.
Escaping the Greek-style debt trap, where forced austerity actually boosts the ratio of debt to GDP, will be far more costly in terms of forgone income and unemployment than moving preemptively to reduce American primary deficits to about 3 percent of GDP over a half decade. That action would allow the debt-to-GDP ratio to stabilize, signaling a truly long-run sustainable fiscal stance. Specifically, a nominal growth rate of 5 percent, composed of 3 percent real growth and 2 percent inflation, will, given 2 percent average borrowing costs, stabilize the debt-to-GDP ratio given a 3 percent primary deficit. That is the meaning of long-run deficit sustainability.
By 2018, once the debt-to-GDP ratio has stabilized under such a program, reducing the primary deficit to 2 percent a year (given a growth rate 3 percent above borrowing costs) will reduce the debt-to-GDP ratio gradually by 1 percent a year. That is the meaning of sustainable long-run reduction of government debt relative to income that will ensure moderate deficit financing costs for decades to come.
1. Carmen M. Reinhart and Kenneth S. Rogoff, “Growth in a Time of Debt,” National Bureau of Economic Research Working Paper 15639, January 2010, www.nber.org/papers/w15639.