The outlook for the U.S. federal debt
The current debt-to-GDP ratio is close to its level at the end of World War II. In addition, the CBO projects a persistent long-run primary deficit and a low rate of GDP growth compared with interest rates, an outlook that points to a steady increase in the debt ratio. In this commentary, Meisenbacher and Wilson argue that the U.S. is facing a daunting challenge: balancing the primary budget, which was a key factor in the decline of the debt-to-GDP ratio after World War II, would likely require major reforms to spending programs or large increases in tax revenue.
Without major reforms to mandatory spending programs such as Social Security and Medicare, or large tax increases, the primary deficit is expected to persist. This leaves the rate of economic growth relative to interest rates as the crucial factor determining the path of the debt-to-GDP ratio over the next few decades. Current projections of GDP growth are relatively low—lower than after WWII.
The Long-Run Fiscal Outlook in the United States
By: Brigid Meisenbacher, Daniel J. Wilson – Federal Reserve Bank of San Francisco
Can deficits finance themselves?
In this paper, Angeletos et al. analyze how fiscal deficits are financed in environments with two key features: (i) nominal rigidity and (ii) a violation of Ricardian equivalence due to finite lives or liquidity constraints. In such environments, deficits contribute to their own financing via two channels: a boom in real economic activity, which expands the tax base, and a surge in inflation, which erodes the real value of nominal government debt. The authors use a New Keynesian model with overlapping generations of perpetual-youth consumers. When the survival probability is equal to 1, their model reduces to the standard permanent-income representative-agent (PIH) benchmark. When the survival probability is less than 1, then their model has two key properties: (i) consumers discount future disposable income more heavily than in the PIH benchmark, and (ii) they have a larger short-run propensity to consume. These properties are similar to quantitative heterogeneous-agent models and are the main factors that contribute to their results. Finally, fiscal policy is represented by a rule for how tax revenue responds to changes in aggregate income and in public debt, while monetary policy is represented by a rule for how nominal rates adjust based on the state of the economy. They find:
- Pushing the fiscal adjustment further into the future helps generate a larger and more persistent boom, leading to more self-financing.
- Full self-financing is possible in the limit as fiscal adjustment is delayed more and more: the government can run a deficit today, refrain from tax hikes or spending cuts in the future, and nevertheless see its debt converge back to its initial level.
Can Deficits Finance Themselves?
Authors: George-Marios Angeletos, Chen Lian, Christian K. Wolf
From: Northwestern University, UC Berkeley, MIT
