US debt ratio will decline when GDP growth recovers

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I disagree with the economic pessimists who believe that persistently slow growth in the US will be the norm for years to come. Yes, huge federal government deficits and debt are a major drag. It’s also true that budget surpluses aren’t likely to materialise to shrink the $17 trillion-plus (R180 trillion) national debt, even if growth resumes.

Nevertheless, there is a strong possibility that government debt relative to gross domestic product (GDP) will fall appreciably, as it did after World War II.

The debt-to-GDP ratio dropped from 122 percent in 1946 to 43 percent 20 years later. The ratio fell even further in the late 1960s and 1970s as inflation, caused by rapidly rising federal spending on Vietnam and Great Society programmes, pushed taxpayers into higher tax brackets and filled government coffers. Higher corporate tax revenues also resulted from under-depreciation and inventory profits.

A more recent example of a reduction of the federal debt-to-GDP ratio came in the 1990s under President Bill Clinton. Robust nominal growth of 5.5 percent a year caused deficits to shrink so much that small surpluses existed in fiscal years 1998 to 2001. Federal tax receipts rose 7 percent on average, faster than nominal GDP, and outlays grew slower, at 3.6 percent. The dotcom bubble lifted individual income tax receipts at an 8 percent annual rate and corporate taxes by 8.3 percent a year.

On the outlays side, national defence spending fell 0.2 percent a year as the Cold War ended. Medicare spending jumped 7.2 percent annually but was only 7.8 percent of outlays in the 1990s. Social Security spending climbed 5.1 percent a year, less than social-insurance receipts.

In contrast, in the 2000-2012 years, nominal GDP growth slowed to 3.9 percent while anti-recessionary tax cuts and rebates shrank federal receipts’ annual growth to 1.6 percent. Outlays climbed at an average 5.8 percent rate, driven by Iraq and Afghanistan spending and by Medicare outlays. Not surprisingly, the resulting huge deficits drove gross federal debt-to-GDP to 103 percent in fiscal 2012.

The message is clear: rapid economic growth pushes down the federal debt-to-GDP ratio directly as the denominator rises. Rapid growth indirectly affects government debt, too, as taxpayers get pushed into higher tax brackets, corporate profits grow faster than the economy, and tax cuts and government spending on social-welfare programs are curtailed.

Conversely, slow economic growth, as in the 2000-2012 period, pushes up the ratio directly. It climbs even more as the weak economy spawns tax cuts and counter-cyclical outlays.

So the resumption of rapid economic growth is the answer to the federal debt problem. Of course, the 800-pound gorilla in the room is the need for greater social security and Medicare outlays for retiring post-war babies.

So far, Congress and President Barack Obama’s administration prefer gridlock to solving the looming entitlement spending explosion. The more time passes, the more disruptive the solution must be. I believe that Washington will do the necessary thing when there is no other choice.

Robert Gordon, the Northwestern University economics professor, isn’t the first to posit that everything worth inventing has been invented.

I believe that much of today’s new technology – the internet, biotechnology, semiconductors, wireless devices, robotics and 3D printers – is in its infancy. Collectively, they have the potential to rival the rapid growth and productivity-generating effect of the American industrial revolution and railroads in the late 1800s. Mass-produced vehicles and the electrification of factories and homes, which led to electric appliances and radio in the 1920s, offer yet more examples. Today, only a third of the world’s population is connected to the internet but 90 percent live within range of a cellular network.

Sure, productivity (output per hour worked) grew by only 1.5 percent from 2009 to 2012, but that’s normal after a severe recession. I expect it to return to a 2.5 percent annual growth rate – or more – after deleveraging is completed in another four years or so.

Rapid productivity growth offsets slower labour force advances. The decline in the labour force participation rate is likely to slow in coming years once normal economic growth resumes. The rate has fallen as baby boomers retire and discouraged workers drop out of the labour market or stay in college.

Once private-sector deleveraging is completed, real GDP growth will probably return to its long-run trend of about 3.5 percent, and perhaps more.

Productivity improvements and labour-force growth will likely resume. And the slow-growth-forever crowd will need to find a new theory.

* Gary Shilling is a Bloomberg columnist.


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