U.S Government Debt Since World War II
In the Washington Post, Joel Achenbach writes,
When I spoke to Peter Orszag, the director of the Office of Management and Budget, he expressed optimism that the administration can balance the primary budget — not including interest payments — by 2015.
Below is some analysis of how the ratio of government debt to GDP has evolved in the United States since World War II. The data come from tables B-78 and B-80 of the 2010 Economic Report of the President. I deleted the “transition quarter” in 1977.The change in the ratio of debt to GDP can be broken into two components. One is the ratio of the primary deficit to to the current debt. The other is what I call the “erosion factor,” which is the nominal interest rate minus the GDP growth rate. In a previous post, I suggested an analogy with a owning a rental property. The primary deficit is the operating loss on the property–rental income minus expenses, but not including interest. The “erosion factor” is the interest rate minus the price appreciation of the property.*
As of 1946, the ratio of debt to GDP was 108.67 percent. From 1947 to 1970, it fell to 27.96 percent. A substantial amount of the drop was due to the fact that the government ran a primary surplus in all but four of those years (the exceptions were 1953, 1959, 1962, and 1968), for a cumulative primary surplus of 43 percent of the 1946 debt.
I was surprised by this. I had not remembered these surpluses. One reason is that the primary surplus excludes interest payments. Including interest payments, the government mostly ran deficits, particularly in the 1960’s. Another reason may be that the U.S. only began to include Social Security surpluses in the overall Budget late in President Johnson’ second term. Had we used the “unified” budget from the beginning, the deficits would have seemed much smaller and we would have counted more surpluses. I assume that the data I am using have gone back and recalculated the “unified” budget for all of history.
The point here is that the sharp drop in the debt/GDP ratio from 1947 to 1970 was only about half due to the fact that the GDP growth rate was higher than the interest rate [correction–more than half was due to GDP growth minus the interest rate. But still, a lot was due to the primary surpluses]. (In fact, GDP growth averaged 3 to 4 percentage points higher than the interest rate from the end of the second World War to 1970. By the way, I calculated the interest rate by simply taking the ratio of interest paid in a given year to the debt outstanding at the end of the previous year.) The other half of the sharp drop was due to all those primary surpluses–the U.S. genuinely ran a responsible fiscal policy, even in the 1960s.
The 1970’s were a decade in which we inflated away some of our debt. We ran primary deficits. Real GDP growth was sluggish. But nominal GDP growth exceeded the interest rate by nearly 5 percentage points per year. Bondholders got shafted, and this was not sustainable. In fact, in the 1980’s, the “bond market vigilantes” (an expression coined by Edward Yardeni, a Wall Street Fed-watcher of the period) got their revenge, and nominal interest rates actually exceeded the growth rate in nominal GDP. This differential widened in the first half of the 1990’s, as bond investors continued to price for more inflation than actually transpired.
The Reagan deficits of the early 1980’s, along with the bond market vigilantes, caused the ratio of debt to GDP to rise from a low of about 26 percent of GDP to 40 percent by 1985, and then for the next decade the bond market vigilantes kept the debt ratio climbing, to 49 percent of GDP in 1995. For the rest of the 1990’s, the Clinton economy generated primary surpluses in the government budget, and so the debt to GDP ratio fell to 33 percent by the time President Clinton left office.
President Bush’s fiscal policies caused the debt ratio to edge up to 36 percent by 2007, and then the recession and the policy reactions of Bush and Obama sent it up to 53 percent currently. The CBO projection is for a 90 percent ratio by 2020.
My reading of this history is that one should not be optimistic that we can simply shrink the ratio of debt/GDP by growing the denominator. A lot of the reduction that took place between 1947 and 2000 was due to running primary surpluses. If we are going to do that again, we will have to do so in spite of the fact that military spending is a much smaller share of GDP (so that arithmetically there is less room to cut) and in spite of the way that Social Security and Medicare are going to be affected by demographics and health care spending trends.
The “erosion factor” of the nominal interest rate minus the GDP growth rate, has been negative at times–particularly in the 1970’s. However, you cannot fool bond investors forever, and the best guess is that over long periods the erosion factor will average zero. In other words, we are unlikely to be bailed out by a negative erosion factor. In fact, if investors lose confidence, the erosion factor could become very high, very quickly.
*[For those of you who like algebra, let D = debt, P = primary deficit, i = interest rate, and g = growth rate of nominal GDP, and d = growth rate of debt.
We are interested in d-g, the growth rate of debt minus the growth rate of GDP. If that is positive, the ratio of debt to GDP is rising, and conversely.
d = P/D + i, that is the debt grows at the interest rate plus the ratio of the primary deficit to the initial debt. Subtracting g from both sides of this, we have:
d – g = P/D + (i-g)
On the right-hand side are the two components that I am looking at. P/D is the ratio of the primary deficit to the current debt. (i-g) is the “erosion factor,” of the nominal interest rate minus the growth rate of GDP.]