The Truth about Prospects for Cutting The National Debt

Given the bitter and stalemated debate in Washington about the debt ceiling and the national debt, it’s a good time to take a close look at the issue to see whether it’s really as bad as our political leaders would have us believe.  Or is it possible that it’s even worse? 

Most economists talk about the national debt as a fraction of our Gross Domestic Product, or “GDP.”  The reason it’s getting so much attention now is that the national debt is about to exceed our GDP, the point in economists’ minds where a nation’s ability to deal with its debt is called into question.  The following is a chart of our national debt relative to our GDP, dating back to 1929 and projecting forward (using Congressional Budget Office projections) to the year 2021 – ten years from now.  (All of the debate in Washington right now is focused on this ten-year projection.)

National Debt as Fraction of GDP

As you can see, the national debt has been here before, quickly soaring to 120% of GDP during World War II, driven by the massive war effort.  But once the war was over, spending fell to a fraction of its war-time level and a post-war economic boom cut that figure to 32% by 1974.  Then it began slowly rising again.  Not so coincidentally, the U.S. had its last trade surplus in 1975.  Since that time, deficit spending has been used to offset the negative economic effects of the steady outflow of money from the U.S. 

So, as a fraction of GDP, it isn’t such an ugly picture after all.  We’ve been there before and we recovered.  We can do it again, right?  Maybe not.  The problem is that it isn’t the GDP that will have to pay back the debt.  It’s the American citizens.  In other words, it’s you.  While lawmakers and economists may conclude that we merely need to raise revenues to some larger fraction of the GDP, every dollar of that revenue will be paid by you and me.  If it’s revenue generated by taxes on business profits, those taxes will be passed along to consumers in the form of higher prices.  One way or the other, you’re going to pay.  Therefore, what really matters is the national debt expressed in per capita terms (that is, divided by the population).  Here’s a chart of the national debt per capita over the same time frame:

National Debt Per Capita

Yikes!!  Looks a little scarier now, doesn’t it?  Right now, every man, woman and child owes about $44,000 on the national debt – about $176,000 for every family of four.  By 2021, those figures rise to $78,500 and $314,000 respectively. 

But, to be honest, much of what you’re seeing here is merely a measure of inflation.  Personal incomes have also increased a lot over this same time frame and, if the CBO is to be believed, will continue to grow at the same pace.  I have serious doubts about that, but let’s suppose the CBO is right.  The following chart shows the national debt relative to your ability to pay it; that is, as a fraction of personal income.

National Debt as Fraction of PI

Now it looks like the first chart of the national debt as a fraction of the GDP, but a little worse.  The debt already exceeds the average personal income.  And, using the CBO projections, it’ll exceed personal income by 30% by 2021.  And that’s if the CBO projections, a bit rosy in my opinion, are correct.  What if, instead of growing by an annual rate of 3%, GDP grows by only 2.5%?  And what if personal income rises at a rate of only 2.5% (just keeping pace with GDP growth), instead of the CBO’s average projected rate of increase of 3.65% which, in my opinion, is wildly optimistic given the current state of unemployment.  If that were to happen, the per capita national debt would soar to nearly 150% of personal income by 2021. 

OK, back to the debt ceiling/deficit reduction negotiations in Washington.  Two scenarios that have been discussed involve cutting the deficit by $2 trillion over the next ten years and the other scenario – the one the president was pushing for – the “big deal” – would cut it by $4 trillion.  Just exactly what would that do to the trajectory of the national debt?  Here’s how it would look under the first scenario, assuming that the $2 trillion reduction is spread evenly over those 10 years:

2 trillion cut from debt

It goes a long way toward slowing the growth in the debt as a fraction of personal income, but it continues to grow.  What if the president got his way, and the debt was cut by $4 trillion over 10 years? 

4 trillion cut from debt

Yeah, it helps, but barely.  As a fraction of personal income, the national debt does begin to decline ever so slightly but, by the end of that ten-year period, you can see that it starts ticking up again.  And, make no mistake, cutting $4 trillion from the deficit, whether it’s done entirely by spending cuts, tax increases or some combination of the two, is going to be a tremendous hardship and will likely drive the economy into recession, which would really send the debt skyrocketing again.  And that’s exactly what Federal Reserve Chairman Ben Bernanke has warned of in the last couple of days.  The point I’m trying to make is that we can never “get there from here.”  We can never make any serious headway on the national debt by focusing only on spending and taxes.  If anything, it’s likely to make matters much worse. 

But there’s an alternative.  What if we focused on restoring a balance of trade instead of on spending and taxes?  Our trade deficit is currently $600 billion per year.  What if, through the use of tariffs, we were able to eliminate it?  The results would be:

  • GDP would be boosted by $1.2 trillion per year.  Why twice the trade deficit?  Because imports are a subtraction from GDP.  Eliminate those imports, and GDP rises by $600 billion.  Now, manufacture those products domestically, and GDP rises by another $600 billion.
  • Revenues from tariffs would easily bring in an additional $400 billion per year, assuming an average tariff of 20% on $2 trillion worth of imports.
  • Revenues from the increase in GDP would bring in approximately another $200 billion, using the CBO average rate of about 17% of GDP.

Even if spending isn’t cut at all, here’s the effect on the national debt projection (again, expressed as a fraction of personal income):

trade balanced

With a balance of trade restored, now we’re making real progress on the national debt, and with no pain – no spending cuts and no increase in tax rates.  And isn’t it interesting that, under this scenario, the projected rate of decline in the national debt mirrors the rate in decline following World War II, when the U.S. still had a positive balance of trade?  This lends credibility to the projection. 

In summary, the approach to reducing the deficit and the debt now being negotiated in Washington barely has any hope of slowing the rise in the national debt at all and, in all likelihood, will actually make it worse by driving the ecnomy into recession, reducing revenues and increasing the need for more safety net spending.  It’s simply impossible to make headway on the national debt without first addressing our enormous trade deficit.

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3 Responses to The Truth about Prospects for Cutting The National Debt

  1. Tim says:

    How do we get the politicians to see this which is the real problem. I say we do the trade balance and cut government spending. Americans do not need the government giving our country away. Then cut taxes and watch even more growth.

    • Pete Murphy says:

      Not only that, but I left the CBO’s forecast for personal income unchanged. In all likelihood, the growth in personal income would blow away the CBO projection when all of those manufacturing jobs come back home. That’d boost revenue even more, paving the way for the tax cuts you talked about.

  2. Mark Hall says:

    Pete:

    If you should suddenly disappear or have an unfortunate accident, we can assume that one of our “free market at ALL costs” economists, politicians or corporate leaders read this post.

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