Pethokoukis, Economics, U.S. Economy

Please, debt levels do matter


OK, the CBO now projects the 2013 deficit will weigh in at $642B (4% of GDP) in 2013 and it will continue on a downward track (under current law) through 2015. Why: a) better economy, b) slowdown in the rate of medical inflation, c) higher taxes, and the d) sequestration.

Still, we are only stabilizing the important debt-GDP ratio, not putting it on a downward trajectory toward pre-recession levels — which means which we are also not fixing entitlements. And debt still matters..

Check out this case for expansionary austerity, via the econ team at Wells Fargo, using the 1990s US economic boom as an example:

Much has been made of the tax increases and budget cuts during the 1993–1995 period and the subsequent pick-up in economic growth. Here, the perspective is that both businesses and households saw the cuts in spending as less future borrowing and thereby less future taxes. Higher taxes meant paying the bills today and thereby reinforced the message that future taxes would not be raised to pay for spending today.

In both cases, reduced future taxes signaled a rise in the present value of real after-tax income for both households and businesses. Note the contrast with fiscal policy the past few years where outsized spending increases served as a signal that future taxes were going up, thereby lowering expected future after-tax income, in turn, providing a disincentive to investment and economic growth. This provides an explanation for the continued subpar pace of investment spending and job growth now in the fourth year of the economic expansion.

Is the expectations channel enough to completely offset the demand channel? I think this better works as a general  explanation of why keeping debt low is important rather than as a reason to dramatically cut spending during a downturn. (Also, what about the tech boom during that decade?  The “equipment and software” bit of GDP was adding a full percentage point during go-go years.)



3 thoughts on “Please, debt levels do matter

  1. As I have posted before (perhaps I need to do it again), the CBO has a track record of being overoptimistic and unreliable in their future forecasts. Obviously these indicate examples where it is in this case:

    re: “slowdown in the rate of medical inflation, c) higher taxes, and the d) sequestration.”

    Obviously they wish to overturn sequestration, and obviously may free market analysts explain that higher tax rates may not necessarily lead to higher tax revenue if they impact growth, or change timing. Some say temporary higher tax revenue the past few months has been due to people accelerating capital gains and other income before tax rates change.

    In addition, you confuse medical inflation with medical spending. Medical inflation=medical prices have continued rising steadily. What hasn’t grown quite as quickly is medical spending, which indicates it may be partly due to the slow economy and higher unemployment. In addition part of it may be due to things like high deductible insurance policies leading to shopping around. Unfortunately Obamacare will limit the highest allowed deductible next year, and introduces other changes that are favors for special interest groups (regulatory capture) which are likely to lead to increased medical costs, as this page details:

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