US Deficit What is behind the numbers

January 8, 2009

Barack Obama warned Americans that his new administration is inheriting a deficit of 1.2 trillion dollars and Americans could face trillion dollar deficits for some years to come. This remains to be seen and will be a function of how effective the stimulus package that is going to be presented to Congress in the coming weeks.The facts are that the US GDP is about 15 trillion dollars and its accumulated debt is about 10.6 trillion. This means at present the   gross debt to GDP ratio is about 70 %.
The gross deficit to GDP ratio is about 8 %. Remember that during the Second world war the deficit to GDP ratio exceeded 30 %.

Now lets examine the math involved in a successful deficit financed stimulus program. Let us be a bit optimistic and assume that in 2009 growth will be anemic or even negative until the third or fourth quarter but then the impact of the stimulus , bank and automotive bailouts and very low interest rates begin to kick in .

There is a reasonable possibility that the overall impact upon the GDP is such that growth for 2009 is mildly positive, say 1 %. This means that the deficit to GDP ratio rather than rising may stay stable or even fall slightly as the denominator begins to grow.
If the interest rates are kept lower than this 1 % rate then the debt to GDP ratio may also begin to stabilize. Over time it will actually   drop as smaller additions to the debt occur and larger growth rates in the GDP result from the return of a more normally expanding economy.It is a matter of simple arithmetic. The denominator the GDP grows larger and faster than the numerator so long as the total amount of the deficit shrinks over time and interest rates are kept below the growth rate in the economy.
If the economy begins to grow again at 3% per year within five years the GDP is   15.9 % larger, or about 17.4 trillion dollars. In five years time the deficit may well have fallen to 2/3 of its current size, so the deficit to GDP   ratio will shrink to 4 % from 8 %. Another few years along and deficit could well disappear altogether as the economy continues to grow and yield a growing flow of tax revenue.To achieve the target of a deficit that is 2/3 of the present one in five years time one would simply have to cut the deficit by 5% per year in the years that follow recovery, assuming that doing so would not cause a slowdown in the growth rate.5 % of 1 .2 trillion is of the order of 60 billion dollars.This would be a realistic target for budgetary reductions on an annual basis once the economy has begun to recover.

There should be no slowdown feedback from the cut so long as the growth rate is sufficiently positive to overwhelm it. As the economy   recovers   once confidence is restored and the banking system resumes functioning properly private market activity replaces government spending. There is therefore no cause for alarm in the proposed stimulus program.