Decreasing Federal Debt Load

There are at least two common misuses of economic statistics in public policy: the belief that the science of economics is capable of making long-term predictions with any degree of accuracy, and the use of absolute economic statistics without context or proportion. These mistakes are even made by those who ought to know better.

Economists should never commit their predictions to paper, where they can later be checked. In a September 1982 memo to Martin Feldstein, the Chairman of President Ronald Reagan’s Council of Economic Advisors, Princeton Economist Paul Krugman and presently a NY Times columnist, with colleague Larry Summers who became Secretary of Treasury in the last two years of the Clinton Administration, marshaled their MIT/Yale/Harvard educations to make a now embarrassing prediction. Inflation had just cooled from over 10% to just under 6% and these professional economists confidently concluded “…that it is reasonable to expect a significant reacceleration of inflation in the near future…Our very rough guess is that correction of … distorted relative prices will add at least 5 percentage points to future increases in consumer prices… This estimate is conservative…” This would have put inflation back to over 10%. The 1932 graduate in economics from Eureka College, Ronald Reagan, followed his own counsel. Contrary to learned predictions, inflation continued to drop and remained 5% and lower (mostly lower) for the rest of the decade.

One measure of the maturity of a science is its ability to make accurate predictions. Astronomers can tell us the position of the moon will be centuries in the future with great precision. Other sciences are less mature. Meteorologists are largely constrained in their predictions by limited measurements of the present state of the atmosphere for predictions. Meteorologists can perhaps make predictions up to a week or so before the use of climatology is just as accurate.

What made the Krugman-Summers prediction so disappointing is that one could have made a more accurate prediction using the simple assumption that, in the short term, current trends would continue. Even the simpler assumption that things would not change from their current state — persistence — would have been more accurate. Modern scientists are usually able to bound the accuracy of their predictions, specifying increasing uncertainty as the prediction horizons increase. This is discipline and humility is too often lacking from economic predictions.

Last year, the government predicted a $426 billon budget deficit for 2005. We are now in 2005, additional data have come in, and this week the budget deficit estimate for this year was just reduced by $94 billion. This means that while pundits argue about the budget deficits years in the future, there is a demonstrable 22% error in budge deficit estimates less than a year old. The predictions of $500 billion deficits as a result of the Bush tax cuts never materialized. If the deficit predictions had been underestimates, one can be sure that this information would be ammunition in Liberal punditry against the Bush Administration. The rapid decrease in the budget deficits, will, of course, be duly reported, but will certainly escape notice of all but the most attentive.

Even when predictions are accurate or even when economic statistics of the past are presented, context is often not provided. Since the economy grows over time, the absolute value of economic statistics will continually dwarf those of the past. During good times, the absolute amount of dollar growth in the economy will be larger than that of the past, just as the dollar amount of declines will be larger. Relative values are to providing context. Fortunately, for inflation and unemployment relative numbers are usually given. We concern ourselves less with the absolute price or employment level, but with inflation and unemployment rates. Such is not typically the case, when budget deficits are the cited.

The true measure of budget deficits is relative debt load and whether this load is increasing. By analogy, which is a preferable economic situation for an individual: a $100,000 mortgage with a $100,000 income or a $150,000 mortgage with a $200,000 income? Most would choose the latter, because the debt is smaller in comparison with the ability to pay. One normalization of federal debt is the debt-to-Gross-Domestic-Product (GDP) ratio. In 1946, in the aftermath of World War II, the total US debt was $223 billion, tiny compared to the nearly $8 trillion present debt. However, the GDP was far smaller. In 1946, the debt-to-GDP ratio was 121%, a tremendous burden on the economy. In 2005, the debt-to-GDP ratio is just under 65%. This value puts the US pretty much in the middle of debt-to-GDP ratio for the largest modern economies. The European Union, as whole, has the debt-to-GDP ratio of 79%, with the values for France and Germany of 74% and 72% respectively. The United Kingdom’s debt load is smaller than that of the US at 46%.

Relative Debt Load
When there is a budget surplus and the economy is growing, it is clear that the debt load is decreasing. It is also possible for the debt to be growing, but if the economy is growing even faster, the debt load decreases. It is even, in principle, possible to have a budget surplus, but if the economy is contracting faster than the debt, then the debt load actually increases. For perspective, the attached figure shows the relative debt load with time. Recent budget numbers suggest that debt load increases are moderating. Indeed, last year’s projection predicted the 2006 budget deficit to be $390 billion. Given the recent $94 billion reduction in the current 2005 budget deficit, we will likely also see a downward adjustment for the 2006 budget deficit. Indeed, if the growth rates continue as projected, always an uncertain prospect, the budget deficit would have to be $441 billion in order for the debt load to increase in 2006. At the risk of making a reckless and irresponsible one-year projection, 2006 will see a decrease in the US government’s debt load. The only consolation in venturing such a prediction is that it would be harder to be more wrong than Krugman and Summers turned out to be.

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