Is U.S. Fiscal Policy Near the Tipping Point?

Of the various critiques of the empirical work presented by David Greenlaw, James Hamilton, Peter Hooper, and Frederic Mishkin, Ryan Avent nails it:

I was immediately concerned by the data sample: 20 advanced economies over 12 years. What's particularly distressing is that just over half of the sample countries are members of the euro zone. In choosing to study advanced economies, the authors specifically note the problem of "original sin" in studies of emerging markets—that countries which borrow in foreign currencies are subject to different debt dynamics—only to then use a sample in which most of the chosen economies are unable to print their own money.

For more on why this matters – see Paul Krugman. But to be fair, I am intrigued by the author’s dynamic debt modeling and this:

we calculate the level of the primary government surplus that would be necessary to keep debt from continually growing as a percentage of GDP. We argue that if this required surplus is sufficiently far from a country’s historical experience and politically plausible levels, the government will begin to pay a premium to international lenders as compensation for default or inflation risk.

The authors rightfully worry about the U.S. polarized political system and our political will to increases taxes enough to cover spending and pay down the debt slowly over time. I have to seriously question, however, why an 80% percent debt/GDP ratio is the tipping point. Let me explain with a simple and perhaps pessimistic version of their model, which really harkens back to Domar’s modeling and Sargent and Wallace’s unpleasant arithmetic. Let’s assume that the real interest rate (r) = 3% and the long-run growth rate (g) = 2% so the present value of primary surpluses expressed as a percent of GDP (s) is given by s/(r – g) which is 100 times the primary surplus ratio given our unpleasant assumptions. How hard would it be for U.S. fiscal policy to have taxes as a share of GDP to exceed government spending as a share of GDP by say 1 percent so we could readily handle the current level of debt in the long-run? I’ve been looking over government spending and revenue figures as shares of GDP over the past 60 years. I prefer to do this as overall government spending and revenues (Federal, state, and local) as we know the Federal government could push certain responsibilities such as Medicaid off to the states if Ryan Republicans have their way or could assist cash strapped states with more Federal revenue sharing if I had my way. Recall that we did manage to pay down the massive Federal debt after World War II despite the fact that we had a larger defense budget as a share of GDP than we even saw under President Reagan or Bush43. OK, we have higher state and local government purchases now than we did in the 1950’s and transfer payments as a share of GDP have risen over time. But notice that in the late 1990’s, we did see total taxes as a share of GDP reach 31%. So can we get back to that level and keep spending at 30% of GDP? Well we did have government purchases drop below 18% of GDP in the 1990’s even as state and local purchases being 11.5% of GDP and nondefense Federal spending being 2.5% of GDP by telling the Pentagon that they get less than 4% of GDP. Oh, I know Republicans hated the decline of the military industrial complex but I would argue this is just smart policy. So the trick on the spending side will be to limit government spending on health care to 6% of GDP if we maintain Social Security benefits at 6% of GDP. While that will be a real challenge, the other challenge will be to find some political agreement on how to raise taxes as a share of GDP. We Democrats should admit that we are loathed to increase the tax burden on the working class even as that is really the Republican’s secret desire. And we know the Republican agenda is to insure that their rich political masters see an even less tax bite than they face today. But if we can get past this class warfare, avoiding fiscal default is something we know how to do.