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In a new note, MKM Partners economist Michael Darda highlights the relationship (as displayed in the above chart) between nominal GDP on one hand, and economic growth (and unemployment) on the other):
The U.S. fiscal deficit, while large, has been tracking the gap between U.S. output and its trend (or potential). In other words, “It’s the NGDP, stupid.” When U.S. NGDP plunged 8% below trend in 2009, deficits mushroomed to 10.4% of GDP as tax revenues fell and automatic stabilizers and other rescue programs kicked in.
As output and employment have begun to recover, however, deficits have eased from just more than 10% of GDP in 2009 to about 7% of GDP in 2012. If current trends continue, annual deficits would fall to about 3% of GDP in just more than three years, about the same time we may expect the unemployment rate to return to a normal level (5%-6%).
Ultimately, demographic pressures (mainly per-capita health care spending) will push deficits back up to unsustainable levels, but this doesn’t have much bearing on recent deficit trends, which are largely, if not wholly, cyclical.
Of course, to the extent policy uncertainty has retarded growth, that’s been a problem, too. There is also the opportunity cost of not pursuing pro-growth tax reform and entitlement reform. And I do think the debt is a near-term issue since it may already be slowing growth and puts the U.S. in a precarious position if we should suffer another financial crisis anytime soon. But Darda is mostly right on the causality direction.
Anyway, he also makes a good point about how the U.S. should escape its debt trap and close the growth gap in a potentially bipartisan way:
In our view, the best way to deal with both cyclical and structural deficits would be to combine a NGDP level path target from the Fed with long-term structural reforms to entitlements and the tax code (along the lines of Simpson-Bowles or Domenici-Rivlin). This would also help to limit the effect on incentives from raising the revenue share
of GDP to more adequate levels.
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