The projections, as I’ve written here, are made up of two economically impossible arguments. One is that there will be a big economic rebound, restoring near-full employment by 2013 or so. We’re already off that track, as some of us warned from the beginning. Of course, a recovery would reduce the deficit even if nothing were done. But CBO then recreates the exploding debt by assumptions, which include steady growth and low inflation, but sharply higher health-care costs and much higher short-term interest rates. These lead the projected debt to compound skyward, soon surpassing all previous records in relation to GDP.
Is this possible? No it is not. The Federal Reserve would never raise the short-term interest rate as CBO projects, without a prior increase of inflation, which CBO assumes will not occur. If they did, the economy would collapse! And if they don’t, the debt does not compound out of control. I have presented these simple numbers here. For what it’s worth, if you believe the capital markets signal anything, they signal their disbelief in doomsday forecasts, in the long-term interest rate on US government bonds, every single day.
If you follow his links, you eventually get to this paper (PDF), which is a little bit technical and mathy, but not hard to follow. The heart of his argument is summed up in a few paragraphs:
Next, let’s apply the same analysis to the United States, using the long-term CBO baseline projections…. The CBO appears to call for a real interest rate on US public debt to rise from present negative values to around 3 percent—that is to say, the CBO expects average nominal interest rates on the US debt to run about 5 percent and for the inflation rate to run about 2 percent. A real growth rate of around 2.5 percent is also expected, though I’ll modify that to 3 percent to match the long-term average from 1962 through 2010. The starting point is a debt-to-GDP ratio of .74; let’s assume the primary surplus is about -5 percent of GDP (and that it stays at that high level, indefinitely)….
It’s worth noting that the big primary deficit is not the dominant source of “unsustainability.” If I raise the projected (permanent) primary deficit from 5 to (say) 7 percent of GDP, [n]ow the increase [in total debt] reaches
eight times GDP rather than six, but the pattern is the same. Similarly, if I lower the primary deficit, to any value greater than zero, the path remains unsustainable. Because the growth rate and the real interest rate are assumed to be about equal, my modified CBO baseline requires a primary budget balance for sustainability. So long as interest rates exceed growth rates, any primary deficit is “unsustainable.”
But are the assumptions reasonable? In particular, how reasonable is it to assume a 3 percent real interest rate on US public debt? Buiter just asserts that governments in the advanced countries will face positive real interest rates on their public debt. He does not explain why this should be so — especially for the United States.
In economic terms, it normally should not be so for a sovereign borrower who controls her own currency and therefore cannot default. Why not? Because to an investor safety is valuable, and because under capitalism making money ought to require taking risk. There is no reason why a 100 percent–safe borrower should pay a positive real rate of return on a liquid borrowing! The federal government doesn’t need to compensate for risk. It isn’t trying to kill off a high and intractable inflation. It also doesn’t need to lock in borrowing over time; it pays the higher rate on long bonds mainly as a gift to banks. Moreover, it controls both the short-term rate and the maturity structure of the public debt, and so can issue as much short debt at a near-zero rate as it needs to.
The paper is a short and relatively straightforward 5 pages, and if you’ve got time it’s worth the read. But if even this is TL;DR, the takeaway is fairly simple: the CBO’s projections are based on an unrealistically high real rate of return on public debt, even thought the government itself essentially controls those interest rates. Tweak the interest rates in the CBO’s model, and all of a sudden there is no exploding debt. Debt levels off at a high but sustainable level, giving us plenty of time to carefully consider any policy or budget changes we feel are warranted without playing chicken with the debt ceiling and risking a collapse of market confidence in the value of U.S. debt (which, as Galbraith notes, flirts with violating the 14th Amendment).