May 22 , 2008
Will Debt Defeat Obama?
Obama has had a very successful first hundred days in office. He has achieved a good start on much of his agenda, and although the economy remains in a deep recession, there are clear signs that we are turning the corner. The stock market, which usually turns up several months before a recession ends, has surged almost 30% in the last six weeks. Many experts now predict the downturn will end this summer, and growth will return by the second half of this year.
But Republicans are not so fast to give credit to Obama’s aggressive policy responses. These critics are predicting doom, primarily in the form of a rapid upturn in inflation brought on by excessive government deficit spending. The current fiscal year, ending in September 2009, is projected to have a budget deficit of 1.8 trillion dollars, a new record. This budget was actually Bush’s budget, and put in place before Obama took office. But Obama has pushed Bush’s deficit of about 1.4 trillion dollars higher by another 400 billion. Next year, the deficit is supposed to shrink, but only down to 1.25 trillion dollars before hopefully descending down to 550 billion in 2012. This year’s deficit is so large due to the bank and auto bailouts of Bush, Obama’s stimulus package, and the huge fall in tax revenues due to the declining economy.
Although the critics are right that these deficits are huge and troubling, they are wrong about the ultimate consequences. The American economy is so large, that the only way to make sense of these deficit and debt numbers is by thinking of them in terms of a percentage of the total economy, what is called debt to GDP ratio, and seeing the annual deficits as a percentage of the economy.
This year, the deficit amounts to 13% of GDP, and next year’s is to be about 8.5%. In comparison, the largest deficit of the last 60 years was 1983, at 6% of GDP. According to the strict criteria that governs the Euro currency, Euro-zone countries must keep their annual deficits below 3% of GDP. The current deficits represent a massive level of spending, but in my opinion, a necessary level.
To get a sense of whether the deficits are too high, we must also look at where the total debt burden sits on the economy. In these two years, we are going to run the public debt to GDP ratio up from 40% to 60% of GDP. This is major change. For perspective, in 1945, this number exceeded 110%. In 1980 the debt to GDP ratio had fallen to below 30%, but Reagan and Bush then took it back up to 50%. Under Clinton, not only did the ratio fall again, but Clinton actually paid back some of the debt by running large surpluses in his last three years, pushing the burden down to 35%.
Bush changed this track, and began to run large deficits driven by tax cuts and very rapid growth in spending. By the end of fiscal 2008, debt to GDP had grown back to 40%. With the back to back massive deficits of fiscal 2009 and 2010, the US will run the debt to GDP ratio up to 60%. According to the Republicans, this shift will spell doom for America.
The Republicans are dead wrong, and setting themselves up for political irrelevancy by staking everything on the hopes that the economy will worsen rather than heal. While it is true that massive deficit spending and low interest rates will cause inflation in a fully-employed economy, it will do no such thing when the economy is in a deep recession with 10% unemployed and idle factories across the country. The key will be whether this potent fiscal and monetary stimulus can be wound down in the correct fashion to avoid either a burst of inflation or a return to economic contraction. If Bernanke at the Federal Reserve and Obama do their jobs, the US will come through this intact.
What is the long-term consequence of the added debt burden of these two years? The short answer is that the government will have to pay interest on an extra two trillion dollars of debt each year that it would not otherwise need to do. Assuming 5% interest rates for the US, this means an extra 100 billion dollars in interest payments, money that could have been used to fund extra government services or lower taxes. So we will see a permanent reduction in living standards by that amount. Is that a reasonable price to pay to avoid an even worse and longer recession or depression than we currently face? Yes it is the right answer, which is why Warren Buffet and George Soros and Ben Bernanke all believe that the current policies are correct and appear to be working.
Ultimately, what will determine the fiscal health of the United States is getting control of medical costs, and ensuring that we have a rapidly growing economy which can better afford to pay for all those things the citizens want from the government.
Comments can reach me at Nali@socal.rr.com
