Affordable.

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Watch the Deficit, Not the Debt

Narayana Kocherlakota is a Bloomberg View columnist. He is a professor of economics at the University of Rochester and was president of the Federal Reserve Bank of Minneapolis from 2009 to 2015.
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I’m often asked: What level of government debt can the U.S. sustain? The answer is that it can handle a lot more. What’s much more important is its longer-term ability to reduce the federal budget deficit -- and eventually run a surplus.

Before I explain, let’s define some terms. Debt refers to the value of all securities issued by the Treasury and held by the public (including the Federal Reserve). I’ll define the deficit to be the difference between government revenue and expenditures, other than interest on the debt (this is sometimes called the primary deficit). I’m not ignoring interest on the debt -- I’m just treating it separately. 

For a government’s debt to be sustainable in the long run, it must grow no faster than total economic output (as measured by, say, gross domestic product). So if the interest rate on government debt is 5 percent per year, and GDP grows at 4 percent per year, the government must run a surplus large enough to cover 1 percentage point of its interest cost if it wants to keep its ratio of debt to GDP stable. (Both my interest rate and growth rate figures are nominal -- that is, I’m not netting inflation out of either.)

How big a burden would this be? Right now, debt is about 75 percent of GDP, so the surplus needed to cover the 1 percentage point in interest cost would be 0.75 percent of GDP. If the debt were a lot larger, say 250 percent of GDP, the required surplus would be 2.5 percent of GDP -- meaning that companies and households would have to pay this net amount to the government every year. There’s no intrinsic reason why this would be unaffordable, particularly given that much of the interest on the debt would actually be paid back to Americans. 

None of this suggests that the U.S. government doesn’t have a budget problem. But the issue is the deficit, not the debt. The nonpartisan Congressional Budget Office (CBO) estimates that, largely because of added Medicare and Social Security costs related to the aging of the population, the (primary) deficit will rise to about 1.5 percent of GDP in 2040. This means that the government’s debt burden is likely to be growing at an unsustainable rate, regardless of its level.

The good news is that we have time to fix this politically challenging problem. The CBO estimates that if taxes and spending evolve according to current law, the level of the debt will be only slightly above the level of GDP in 2040. Given this estimate, my earlier analysis suggests that the debt will remain manageable as long as the government can take steps to turn its deficit into a sufficiently large surplus in, say, the next half-century.

Looking at debt this way has important implications for policy in the shorter run. If it desires, the U.S. government has ample capacity to expand the national debt to finance new investment in physical or human capital -- for example, in better roads and schools. To prevent that debt from getting out of control, our elected officials must figure out how to raise taxes or cut spending in the longer run, to turn a persistent demographically driven deficit into a persistent surplus.

This column does not necessarily reflect the opinion of the editorial board or Bloomberg LP and its owners.

To contact the author of this story:
Narayana Kocherlakota at nkocherlako1@bloomberg.net

To contact the editor responsible for this story:
Mark Whitehouse at mwhitehouse1@bloomberg.net