We in the United States know that we have a deficit problem, but when we hear news of the ongoing crisis in Europe, we feel a little better. At least we’re in better shape than Greece, Italy, and the other Eurozone basket cases. Aren’t we?
Think again. By one key measure of fiscal health, the structural primary balance (SPB), we are in worse shape than any EU country. In fact, among the members of the OECD, only Japan is deeper in deficit as the following chart shows.
Not just Greece and Italy, but even the Portugal, Ireland, and Spain, the other derisively styled “PIIGS,” score better better than the United States on this chart. That does not mean that their economies are in better shape overall. They have a lot of problems that we do not, which we will come back to later. What their structural primary balances do show is how far they have come in making the fiscal adjustments needed to make their budgets sustainable in the long run . The United States has barely started those adjustments, and Japan has not even thought about them. Let’s look more closely.
Just what is the structural primary balance?
The budget measure that usually makes the headlines in the United States—a deficit of 8.7 percent of GDP for fiscal 2011—is the federal government’s current balance.That is the difference between the government’s total spending and its total income in a given year, expressed as a percentage of the GDP that the economy actually produced. The structural primary balance differs from the current balance in two main ways.
First, the term “structural” means that it is adjusted to remove the part of the deficit or surplus that is attributable to the state of the business cycle. Right now, partway through an incomplete recovery from a deep recession, the U.S. economy is operating well below its potential level. When output drops below its potential, tax revenues fall, unemployment benefits rise, and certain other automatic stabilizers move the current balance toward deficit even if there are no changes in policy. Similarly, during a boom, when output is above its natural level, automatic stabilizers cause the balance to move toward surplus. The structural balance is the surplus or deficit that would prevail, with given policies, if GDP were right at its potential level. Some economists prefer the term cyclically adjusted budget balance.
Second, the “primary” part refers to the fact that the SPB, on the spending side, considers only program expenditures. Program expenditures include all government purchases of goods and services and all entitlement outlays, but not interest on government debt. The logic is that policies governing program expenditures, along with tax policies, are causes of budget imbalances, whereas interest on the government’s accumulated debt is a result of past policy imbalances.
For completeness, we should add that the OECD methodology on which the chart is based makes two other adjustments to facilitate international comparisons. One is to include all levels of government in order to allow for differences in the centralization of government from country to country. That adjustment is less important for the topic at hand than it might seem. The U.S. federal government accounts for nearly all of the total government deficit, while most states operate under balanced budget rules. Also, the OECD data adjust for the effects of one-off budget operations like tax amnesties or privatization revenues. Those are important for some countries, but much less so for the United States. The OECD uses the term underlying primary balance to refer to its version of the SPB.
Some basic budget arithmetic
To understand why the SPB is a key indicator of long-run fiscal sustainability, we need to review some basic budget arithmetic. In order to be sustainable, the government’s debt must not grow endlessly as a percentage of GDP. If it did, eventually it would get to a point where interest payments alone used up all available tax revenue. Well before that happened, the government would face the stark choice of either defaulting on its debt outright or defaulting indirectly through hyperinflation.
However, as long as the economy is growing, sustainability does not require that the government stop borrowing altogether. It can issue new debt without increasing the debt-to-GDP ratio up to the point where the rate of growth of the debt equals the rate of growth of GDP.
To take the simplest case, consider a government that has debt equal to 100 percent of GDP. If nominal GDP grows at 5 percent, and the government finances a current deficit equal to 5 percent of GDP with new borrowing, the debt-to-GDP ratio will not change. If it has less debt to start with, the maximum borrowing consistent with a constant debt-to-GDP ratio is lower. If we assume an initial debt of 50 percent of GDP and leave the rate of GDP growth at 5 percent, the current deficit must be held to 2.5 percent of GDP to keep the debt-to-GDP ratio from growing. More generally, if the debt-to-GDP ratio is D and the rate of growth of nominal GDP is Q, the maximum permissible deficit is Dtimes Q.
Looking at the primary deficit instead of the entire deficit simplifies the calculation of the maximum borrowing consistent with a constant debt-to-GDP ratio. The reason is that for most countries, the long-run average rate of growth of nominal GDP tends to be about equal to the average nominal rate of interest on government debt. (You can do the calculation in real terms if you prefer, by subtracting the rate of inflation from both the interest rate and GDP growth.) If that is the case, the debt will remain constant as a share of GDP as long as the primary budget is in balance, regardless of the initial level of the debt.
In practice, the average rate of interest is not always exactly equal to the rate of GDP growth, but the difference tends to be small when averaged over a long period. To the extent that the two are different, the interest rate tends to average slightly higher than the rate of growth. When that is the case, the country needs a slight surplus on the primary budget balance to keep the debt-to-GDP ratio constant.
For example, from 1988 to 2007, the relatively stable 20-year period leading up to the recent financial crisis, nominal GDP in the United States grew at an average rate of about 5.6 percent and the average rate of interest on federal debt held by the public was about 6 percent. If those numbers were to prevail in the long run, the structural primary balance would have to be in surplus by 0.4 percent of GDP in order to keep the debt-to-GDP ratio from growing. For some shorter periods, as in 2004 through 2006, the rate of growth has slightly exceeded the rate of interest. When that happens, the debt-to-GDP ratio can be held constant with the primary balance slightly in deficit. These differences of a fraction of one percent one way or another do not significantly undermine the usefulness of the SPB as a measure of fiscal sustainability.
Finally, we need to take into account the possibility that a country may not want just to hold its debt-to-GDP ratio constant over time, but actually to reduce it. In the case of the EU, budget rules require that countries have a debt-to-GDP ratio of 60 percent or less. A dozen countries, including France and Germany, now exceed that limit. To get their debts back down to the 60 percent mark, those countries will have to keep their SPB well in the surplus range. At least one country has already done so. From 1996 to 2011, Sweden reduced its debt-to-GDP ratio from 84 percent to 49 percent by keeping its SPB in surplus by an average of just under 2 percent of GDP.
The United States, of course, is not subject to EU rules, but many economists think it would be desirable to reduce the net federal debt from its current level of nearly 80 percent of GDP. Doing so will take even greater spending cuts or revenue increases than would be needed just to stabilize the ratio.
Looking for patterns in fiscal policy
We have seen, then, that the SPB must be held at or close to long-run balance to make the debt sustainable and in surplus to reduce the debt over time. However, that does not mean that sustainable policy requires the SPB to be unchanged from year to year. There are three patterns for the SPB that are consistent with the long-term goal of holding the debt-to-GDP ratio constant over time or gradually reducing it.
- Under a cyclically neutral pattern, the government would hold the SPB constant year after year, regardless of the state of the business cycle. Automatic stabilizers would produce moderate current deficits during recessions offset by current surpluses during expansions. As discussed in this earlier post, Chile has achieved excellent fiscal health by following the cyclically neutral pattern.
- Under a countercyclical policy, the government would undertake discretionary fiscal stimulus in the form of tax cuts or spending increases during recessions, which would move the SPB toward deficit. The stimulus would be offset with discretionary tax increases or expenditure cuts during expansions, leaving the SPB in balance or slightly in surplus on average over the cycle. That is the pattern Sweden has followed to get its debt under control. Such a policy has the potential to improve economic performance by moderating excessive cyclical booms and busts, but it requires a high level of political maturity and budget discipline.
- In theory, a country could follow a third pattern under which the current budget would be kept in balance each and every year. Such a policy would require procyclical tax increases or expenditure cuts during recessions, moving the SPB toward surplus and making the downturn more severe. It would then call for tax cuts or expenditure increases during expansions, adding fuel to the upturn. Proposals to amend the Constitution to require an annually balanced budget are a recurrent feature of U.S. political life. However, for reasons explained in this earlier post, mainstream economists tend see such proposals as counterproductive.
How the United States has gotten into its budget mess
The United States has gotten itself into its present budget mess by not following any of the sustainable patterns just outlined. Instead, it has followed an unbalanced discretionary policy that cuts taxes and increases expenditures to stimulate the economy during recessions, and then cuts taxes and increases spending again for short-term political gain during periods of prosperity. That pattern is evident in the following chart.
The chart shows a healthy surplus of the structural primary balance—1.7 percent of GDP, on average–from 1994 to 2001. Over that period, net government debt, by the OECD’s measure, fell from 54.4 percent of GDP to 34.6 percent. Countercyclical considerations could justify the sharp reduction in the surplus during the brief and mild recession of March to November 2001, but after that, things went badly off course.
Instead of moving back into surplus as the economy recovered, the SPB moved strongly into deficit during the cyclical expansion of 2002 to 2007. Two unfunded wars, substantial tax cuts, and new expenditure programs like Medicare Part D moved the SPB into an average deficit of 2.4 percent of GDP in those years, a swing of more than 4 percent of GDP from the surpluses of the 1990s. By 2007, the debt-to-GDP ratio had risen back to 48 percent of GDP.
The increased debt and deficit left the government with reduced room for maneuver when the economy again fell into recession at the end of 2007. Nevertheless, faced with an alarming global crisis, the government undertook vigorous stimulus measures. In 2008, the last year of the Bush administration, a tax rebate and other programs increased the structural primary deficit to 4.6 percent of GDP. Further stimulus measures during the first two years of the Obama administration sent it soaring to over 7 percent.
We are now well into the third year of a tepid cyclical recovery. Real GDP has been above its pre-recession peak for a year already. Most of the money from the 2009 fiscal stimulus has been spent, although some countercyclical tax cuts remain in force. And still, the OECD expects the United States to show a structural primary deficit of 5 percent of GDP for 2012. We are not on a sustainable policy trajectory.
Where to next?
Discussion of what lies ahead focuses mostly on two scenarios.
One scenario is that of the dreaded fiscal cliff, a combination of mandatory spending cuts and tax increases that would amount to an adjustment of about 4 percent of GDP in 2013. That would reverse most of the slippage of 2002 to 2007 in a single year. Many observers think that path to adjustment is too strongly front-loaded, although it is not quite as stringent as what Greece has gone through. According to the OECD, Greece will have moved from a structural primary deficit of 10.1 percent to a structural primary surplus of 3.2 percent just from 2009 to 2012. That is the equivalent of four fiscal cliffs in a row. Theoretically, the adjustment is enough to put Greece on the path to long-run fiscal sustainability, but in the short run, it has meant rioting in the streets.
True, the United States today is not in quite as bad a fiscal condition as Greece was in 2009. Still, the CBO forecasts that the cliff would put the U.S. economy back into recession. Furthermore, it would not fully erase the 5 percent structural primary deficit as measured by the OECD. For the United States to achieve the 3 percent structural primary surplus that Greece is aiming for would require two consecutive fiscal cliffs.
The second scenario is that Washington’s warring factions will reach a comprehensive budget deal during the post-election session of Congress—a deal that is not so strongly front-loaded and would therefore pose less threat of recession. A recent New York Times article tells us that negotiators are aiming at a package of revenue increases and spending cuts that would total $4 trillion over ten years. Such a deal would be very welcome—but even that might not be enough.
What would be enough? The most detailed calculations I have seen recently are those in an update of the Simpson-Bowles plan (or Bowles-Simpson, if you prefer) that has just been released by the Center on Budget and Policy Priorities. The CBPP version of Simpson-Bowles foresees a total of $6,257 billion in spending cuts and tax increases over the ten years from 2013 to 2022. Of that, about $1.5 trillion of spending cuts have already been enacted, leaving about $4,750 billion to go. That is significantly more ambitious than the hypothetical post-election deal outlined by the New York Times,which aims for $4 trillion of cuts including those that have already been made.
The CBPP analysis allows us to project the debt-to-GDP ratio and the primary budget balance over a ten-year time horizon, as shown in the next chart. A world of caution: The primary balances shown there are only roughly comparable to the OECD numbers given earlier. First, they are estimates of current primary balances for each year, not the structural primary balances. Second, they use somewhat different assumptions both for baseline policy and economic growth than those used by the OECD. Even with those caveats, the results offer a dramatic contrast to the large structural primary deficits of our earlier charts. If you want to know what an economically adequate fiscal consolidation plan would look like, this is as good a blueprint as you will find.
The big question is whether any such plan is politically feasible. There is room for doubt. In last week’s first presidential debate, the candidates paid no more than the most lukewarm lip service to Simpson-Bowles.
GOP candidate Romney rightly characterized President Obama’s failure to embrace the plan when it first appeared as a failure of leadership. However, he refused to endorse it himself. Here is the key segment, taken from CNN’s transcript of the debate:
21:31:34: MODERATOR JIM LEHRER: Governor, what about Simpson-Bowles? Do you support Simpson-Bowles?
21:31:34: ROMNEY: Simpson-Bowles, the president should have grabbed that.
21:31:35: LEHRER: No, I mean, do you support Simpson-Bowles?
21:31:36: ROMNEY: I have my own plan. It’s not the same as Simpson-Bowles. But in my view, the president should have grabbed it. If you wanted to make some adjustments to it, take it, go to Congress, fight for it.
21:31:48: OBAMA: That’s what we’ve done, made some adjustments to it, and we’re putting it forward before Congress right now, a $4 trillion plan . . .
The Romney plan and the President’s adjusted version of Simpson-Bowles differ from each other and from the CBPP’s version in the way they divide budget adjustments between spending cuts and revenue increases. According to the CBPP, the Simpson-Bowles plan envisioned a ratio of spending cuts to tax increases of something between 1-to-1 and 1.4-to-1, depending on how you treat interest savings. President Obama suggested during the debate that he was aiming for a 2.5-to-1 ratio in his modified plan. Romney’s plan, although notoriously short on details, purports to achieve fiscal adjustment entirely through spending cuts.
The trouble is, no plan that is so heavily loaded toward spending cuts is likely to pass the Senate, and no plan that includes significant revenue increases is likely to pass the House, at least as those bodies are presently constituted. That leaves us with the prospect of continued political gridlock unless one party or the other takes over all three branches of government (unlikely) or both parties give up political posturing and get down to realistic compromise (only slightly more likely).
Meanwhile, if politicians in Washington do nothing, budget realities will continue to unfold according to their inexorable arithmetic. The structural primary balance will remain deeply in deficit and the debt-to-GDP ratio will continue to rise.
Does that make the United States the Greece of North America, with gasoline bombs in the street and laid-off civil servants digging for food in the dumpsters? Hopefully, not. The United States has many economics strengths compared with Greece. Despite what we hear from some commentators, our labor and product markets are less tangled in bureaucratic red tape. Despite the ugly realities of pay-to-play, SuperPacs, and the rest, our political system is arguably less corrupt. Above all, we have our own central bank, as much on the defensive as it might be, and our own sovereign currency.
Still, each year that we fail to make the needed fiscal adjustments, we are squandering those advantages. Greece caused itself much unnecessary pain by waiting too long to face up to fiscal realities. Will we do the same?