Tax Analysts Blog

Debt Clock Ticking: How Much Time is Left?

Posted on Oct 15, 2010

Economists at Congressional Budget Office are doing their best to educate their bosses about the dangers of rising government debt. In a recent report they warn that debt crowds out private capital formation, that it increases the likelihood of inflation, that it increases the possibility of a fiscal crisis, that it reduces the ability to respond to the next financial crisis or major recession, and that the longer the delay the most painful (and economically harmful) will be the needed tax hikes and spending cuts,

But for my money the folks at the International Monetary Fund provide the most insight about the future effects of overgrown government debt. In September they simultaneously issued three [(1) (2) and (3)] papers. They are all excellent but most interesting is the third. It actually tries to estimate when each advanced economy will reach its debt limit. The authors estimate that the day of reckoning will occur when the gross U.S. debt reaches about 160 percent of GDP. We are now at about 90 percent, By my reckoning we will not reach the 160 level until the year 2027. That's less than two decades.

Commenting on this paper the latest issue of The Economist looked at it this way:

Nor are most rich countries anywhere close to the limits of what they can borrow. A new study from the IMF suggests that most advanced economies still have plenty of “fiscal space”. In America and Britain, for instance, the fund’s economists calculate that public debt will not reach its absolute limit until it hits 160% of GDP or more, far higher than its current levels. The wolf is not at the door.

Although this is an excellent paper, it is wrong to use the estimates as any guideline for policy or (as The Economist seems to do) some assurance that fiscal crisis is a comfortable distance in the future.

As the paper points out (and this is the really useful part), there are three factors--two economic, one political--that determine how soon we will reach our hard debt limit:
(1) the rate of economic growth--the higher, the more time we have
(2) interest rates - the higher, the less time we have
(3) government's willingness to reduce deficit when the debt gets large.

In order to make its estimates the IMF makes good guesses about (1) and (2) but there is obviously a great deal of uncertainty about growth and interest rates a decade from now. On (3) the authors have actually estimated a "primary balance reaction function"--that is, based on historical experience, how much governments reduce their deficits when debts get large. As you might expect, deficits get smaller when debt gets large but--get this--if the debt gets too large governments simply may not be able to respond adequately: even in the face of a humongous debt political pressure puts a limit on how much deficit reduction can take place.

Now here's the key point. As we move through time the three factors cited above start interacting with each in ways that are not good. More debt raises interest rates. More debt slows growth. Slower growth and higher interest rates increase debt. These interactions can create a snowball effect. When you combine this with government's natural reluctance to take painful measures, this can easily spell disaster--an out-of-control spiral. The IMF paper has not taken into account the negative growth effects of debt on economic growth (that will speed up the day of reckoning). It has only crudely taken into account the costs of an unexpected recession/financial crisis (like 2008-09 episode that increased debt by 27 percent of GDP on average in advanced economies).

Disaster may not be around the corner, but no government can gamble that it is two decades away. The lesson we learn from the IMF is that if we want to avert disaster we need to keep a sharp lookout on (1) expected growth (2) future interest cost and (3) political will.

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