How Bad Is the Debt Problem?

James Kwak has a lengthy analysis of our debt problem that’s worth your time. In his analysis he updates the CBO Extended Baseline and Alternative scenarios with the new developments of the last couple of monhs and adds some &147;Realistic Scenarios” of his own. He remarks:

So the bottom line is: If we extend the Bush tax cuts, we have very big deficit problems over the next ten years and the next twenty-five years. If we let them expire, there is no ten-year problem. That’s the same as in my earlier post, and I don’t think that’s controversial to anyone who understands the numbers.

What’s more controversial is my claim that if we let the tax cuts expire, there is a twenty-five year problem, but it’s not a huge one. Many other people argue that even if we let the tax cuts expire, we still have to cut Social Security and Medicare. On my reading, the problem is a national debt at 69% of GDP and growing steadily. If we have another financial crisis, or we start losing our status as the reserve currency, that could be a serious problem. My opinion is we should do something about it. But it’s not necessarily the end of the world.

I think the problem is more serious than Dr. Kwak apparently does for several reasons. First, his accounting for puiblic debt, like the CBO which he follows, does not include intragovernmental debt. Once you’ve included intragovernmental debt into the reckoning the public debt nears 100% of GDP rather than 69%. 69% is worrisome enough but 100% or more is disastrous.

Second and more importantly, his analysis is not robust: it is highly dependent on his assumptions and contrary to his claim that his assumptions are conservative to my eye they appear hopelessly optimistic. So, for example, he estimates an average 2.1% growth rate in real GDP, approximately the long term average growth rate. This year we will fall far short of that and IMO we are likely to do so for the foreseeable future. As evidence I’d submit that a) the current real GDP growth rate is far below 2.1%; b) when you account for the two consecutive bubbles we’ve experienced the real GDP growth rate has been below 2.1% for some time; c) to achieve an average 2.1% growth rate when you have growth rates significantly below that in some years means that you’ve got to have significantly higher growth rates in other years; d) there are no prospects whatever for growth rates significantly over 2.1% in coming years, not at least without serious structural changes; e) levels of public debt as high as the one we have are associated with lower rates of growth and f) just this morning PIMCO’s Bill Gross noted:

There are no double-digit investment returns anywhere in sight for owners of financial assets. Bonds, stocks and real estate are in fact overvalued because of near zero percent interest rates and a developed world growth rate closer to 0 than the 3 – 4% historical norms. There is only a New Normal economy at best and a global recession at worst to look forward to in future years.

I intend to return to Mr. Gross’s article in a later post. However, zero growth rates and near zero inflation means negative real growth rates.

Finally, look at the deficit and debt from a cashflow standpoint. We’re already paying a half trilllion a year in interest on the debt. At our present level of debt tiny changes in the interest rate we’re paying can push that up very rapidly.

Update

Here’s a very interesting muli-country analysis of public debt. Take particular note of the debt to GDP and interest to GDP ratios illustrated graphically in the report.