Will Faster GDP Growth End the Debt Debate?

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Obama talks budget cuts (Kevin Lamarque/REUTERS)

Washington is absorbed with how much it has to cut in order to get our financial house in order. And the conclusion by many is that President Obama’s proposed budget, which lowers the amount of debt we are set to take on in the next decade by $1 trillion, doesn’t cut enough. Former Bush staffer and a former member of the Financial Crisis Inquiry Commission, one of the dissenters, republishes this chart from a Congressional Budget Office report showing a resulting large budget deficit that follows right off the page. Hennessey’s take away, “The long-term budget problem starts now.”

But the politicians and policy wonks like Hennessey may be forgetting a key piece of the debt puzzle: growth. Yes, spending and taxes matter. And those are the debates we are having. But the growth rate of the economy is also a key determinate of how large our deficit is, perhaps even more so than the other two. And that part of the equation is starting to look at lot better. It turns out if you assume a slightly higher GDP growth rate, you don’t have to cut nearly as much out of the budget as you think to get back to essentially a balanced tally, and well out of the government goes broke scenario. Here’s why:

Why does GDP matter to the debt equation? Faster GDP growth boosts tax revenues for the government because individuals and companies produce more income, and therefore, hopefully, pay more to Uncle Sam. It also lowers the amount of money the government has to pour into such social safety programs as unemployment and food stamps. Mark Zandi, of Moody’s Economy.com, says a back of the envelope calculation is that for every extra dollar of GDP, the government’s tax take rises by $0.35.

The reason this all matters now is that all of a sudden, after three years of doldrums, a growing number of economists think our growth picture is looking up. This week, the Federal Reserve increased its estimate for what the economy would grow in 2011. The US central bank thinks the GDP could rise as fast as 3.9% this year. That’s up from the 2.7% estimate that the government made a year ago, which is the figure that was used to compute that the deficit in 2011 would reach nearly $1.6 trillion, our worst ever.

So how much does faster GDP growth matter to the deficit? It depends what time frame you’re talking about.  The 1.2 extra percentage points of growth this year will lower the deficit by an estimated $60 billion, or to $1.54 trillion. So not much. But if you assume that the higher growth will continue for some time then even a little bit of extra growth matters, a lot in fact.

On our current path, the next ten years of budget deficits are supposed to add around $7 billion to our national debt, which would grow to nearly $18 billion. (Please Note: I am just talking about debt held by public, not our total debt, which includes Social Security and other transfers. The CBO excludes, and has under both Republican and Democrat leadership, so I think I am on solid ground. No need to correct me.) But here’s what’s got most people freaked out. On that path, government debt as a percentage of GDP would equal 76%, and it would continue to grow. That would be up from 40% in 2008, and double the 40-year average of 36%. Some say this will crimp growth. Others say this will bankrupt the government. To say the least, it’s worrisome.

But if the economy instead grew just 0.1% better a year than expected over next ten years, it starts to be a different story. On that path, by 2021 the debt to GDP percentage is still a troubling 74%, but it would be dropping rather than rising at that point. Assume the GDP grows an extra 1.1 percentage points a year, and our nation’s budget deficit nearly disappears. That troubling debt to GDP ratio comes in at 55% at 2021, lower than it is today, and on a path that is dropping sharply.

How likely is it that the economy will grow an extra 1.1 percentage points a year in the next decade. Well, I went back and looked at the CBO’s budget report from 1991 – a time when we were similarly dismayed about our economic future. Back then, the CBO estimated that the economy would grow by an average of 2.6% a year for the next five years. Instead, the economy ended up growing 3.7% a year through much of the 1990s. If more politicians realized that, perhaps we would be talking a little less about cuts, and more about growth.

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