The Failure of the Austerity Strategy Imposed on Greece, With Some Suggestions on What To Do (and What Not To Do) Now

Greece - GDP 2008-2014 Projection vs Actual

A.  Introduction

It appears likely now that Greece will continue, at least for a few more months, with the austerity program that European governments (led by Germany) are insisting on.  In return, Greece will receive sufficient “new” funding that will allow it to pay the debt service coming due on its government debt (including debt service that was supposed to have been paid in June, but was not), as well as continued access to the liquidity lines with the European Central Bank that allow it to remain in the Eurozone.  But it is not clear how long Greece can continue on this path.

The measures being imposed by the Eurozone members are along the same lines as have been followed since the program began in 2010:  Primarily tax increases and cuts in government spending.  The most important measures (in terms of the predicted impact on euros spent or saved) in the new program are increases in value-added taxes and cuts in government pensions.  This has been a classic austerity strategy.  The theory is that in order to pay down debts coming due, a government needs to increase taxes and cut how much it has been spending.  In this way, the theory goes, the government will reduce its deficit and soon generate a surplus that will allow it first to reduce how much it needs to borrow and then start to reduce the debt it has outstanding.

The proponents of this austerity strategy, with Germany in the lead, argue that in this way and only in this way will the economy start to grow.  Others argue that austerity in conditions such as where Greece finds itself now will instead cut rather than enhance growth, and in fact lead to an economic decline.  The priority should instead be on actions that will lead to growth by raising rather than reducing demand.  Once the economy returns to full employment, one will be able to generate the public sector savings which will allow debt to be paid.  Without growth, the situation will only get worse.

One does not need to argue these points in the abstract.  Greece is now in its sixth year of the austerity program that Germany and others have insisted upon.  One can compare what has in fact happened to the economy to what was expected when the austerity program started.  The Greek program is the work of a combined group (nicknamed the “Troika”) made up of the EU, the ECB (European Central Bank), and the IMF.  The IMF support was via a Stand-By Arrangement, and for this the IMF prepares and makes available a Staff Report on the program and what it expects will follow for the economy. The EU and the ECB co-developed these forecasts with the IMF, or at least agreed with them.  This can therefore provide a baseline of what the Troika believed would follow from the austerity program in Greece.  And this can be compared to what actually happened.

The “projected” figures are therefore calculated from figures provided in the May 2010 IMF Staff Report for the Stand-By Arrangement for Greece.  What actually happened can be calculated from figures provided in the IMF WEO Database (most recently updated in April 2015).  I used the IMF WEO Database for the data on what happened as the IMF will define similarly in both IMF sources the various categories (such as what is included in “government” or in “public debt”).  Hence they can be directly compared.

This blog post will focus on a series of simple graphs that compare what was projected to what actually happened.  Note that the figures for 2014 should all be taken as preliminary. The concluding section of the post will review what might be done now (and what should not be done now).

As will be seen, the program failed terribly.  I should of course add that Germany and the Troika members do not believe that this failure was due to a failure in the design of the program, but rather was a result of the governments of Greece (several now) failing to apply the program with sufficient vigor.  But we will see that Greece actually went further than the original program anticipated in cutting government expenditures and in increasing taxes.  To be honest, I was myself surprised at how far they went, until I looked at the numbers.

Austerity was applied.  But it failed to lead to growth.

B.  The Path of Real GDP

To start with the most basic, did the austerity strategy lead to a resumption of growth or not?  The graph at the top of this post shows what was forecast to happen to real GDP in the Troika’s program, and what actually happened.  The base year is taken as 2008. Output had peaked early in that year before starting to turn down later in the year following the economic and financial collapse in the US.  (Note:  For 2008 as a whole, real GDP in Greece was only slightly below, by 0.4%, what it was in 2007 as a whole.)

The IMF Stand-by Arrangement for Greece was approved in mid-2010, with output falling sharply at the time.  The IMF then predicted that Greek GDP would fall further in 2011 (a decline of 2.6%), but that with adoption of the program, would then start to grow from 2012 onwards.

That did not happen.  The situation in 2010 was in fact already worse than what the IMF thought at the time, with a sharper contraction already underway in 2009 than the estimates then indicated and with this then continuing into 2010 despite the agreement with the Troika.  National estimates for aggregates like GDP are always estimates, and it is not unusual (including for the US) that later, more complete, estimates can differ significantly from what was initially estimated and announced.

Going forward, GDP growth was then far worse than what the IMF thought would follow with the new program.  GDP fell by 8.9% in 2011, rather than the 2.6% fall the IMF predicted.  GDP then fell by a further 6.6% in 2012 and a further 3.9% in 2013.  The widening gap between the forecast and the reality is especially clear if one shifts the base for comparison to 2010, the start of the IMF supported program:

Greece - GDP 2010-2014 Projection vs Actual

Growth appears to have returned in 2014, but by just 0.8% according to preliminary estimates (and subject to change).  But with the turmoil so far in 2015, everyone expects that GDP is once again falling.  The austerity strategy has certainly not delivered on growth.

C.  Real Government Expenditures, Taxes, the Primary Balance, and Public Debt

Advocates of the austerity strategy have argued not that the austerity strategy failed, but rather that Greece did not apply it with sufficient seriousness.  However, Greece has in fact cut government expenditures by substantially more than was called for in the IMF (and Troika) program:

Greece - Govt Expendite 2008-2014 Projection vs Actual

By 2014, real government expenditures were 17% below what the IMF had projected would be spent in that year, were 27% below where they had been in 2010 at the start of the program, and were 32% below where they had been in 2008.  Real government expenditures were in each year far less, by substantial margins, than had been called for under the initial IMF program.

It is hard to see how one can argue that Greece failed to cut its government spending with sufficient seriousness when government spending fell by so much, and by so much more than was called for in the original program.

Taxes were also raised by substantially more than called for in the initial IMF program:

Greece - Govt Revenue 2008-2014 Projection vs Actual

 

Tax effort and effect is best measured as a share of GDP.  The IMF program called for government revenues to rise as a share of GDP from 37% in 2009 and an anticipated 40.5% in 2010, to a peak of 43% in 2013 (a rise of 2 1/2% over 2010) after which they would fall.  What happened is that taxes were already substantially higher in 2009 (at almost 39% of GDP) than what the earlier statistics had indicated, and then rose from 41% of GDP in 2010 to a peak of 45% in 2013 (a rise of 4% over 2010).

Taxes as a share of GDP have therefore been substantially higher throughout the program than what had been anticipated, and the increase from 2010 to the peak in 2013 was far more than originally anticipated as well.  It is hard to see how one can argue that Greece has not made a major effort to secure the tax revenues that the austerity program called for.

With government spending being cut and government revenues rising, the fiscal deficit fell. For purposes of understanding the resulting government debt dynamics, economists focus on a fiscal deficit concept called the “primary balance” (or “primary deficit”, when in deficit).  The primary balance is defined as government revenues minus government expenditures on all items other than interest (and principal) on its debt.  It will therefore measure the resources available to cover interest (and principal, if all of interest can be covered).  If insufficient to cover interest coming due, then additional net borrowing will be necessary (thus adding to the stock of debt outstanding) to cover that interest.

With expenditures falling and revenues rising, the government’s primary balance improved sharply over the program period:

Greece - Primary Balance 2008-2014 Projection vs Actual

The primary balance improved from a deficit of 10.2% of GDP in 2009 to 5.2% of GDP in 2010, and then rose steadily to a primary surplus of 1.2% of GDP in 2013 and an estimated 1.5% of GDP in 2014 (where the 2014 estimate should be taken as preliminary). A rise in the primary balance of close to 12% of GDP in just five years is huge.

However, the primary balance tracked below what the IMF program had called for.  How could this be if government spending was less and government revenues higher?  There were two main reasons:  First, the estimates the IMF had to work with in 2010 for the primary deficit in that year and in the preceding years were seriously wrong.  The primary deficit in 2010 turned out to be (based on later estimates) 2.8% points of GDP higher than had originally been expected for that year.  That gap then carried forward into the future years, although narrowing somewhat (until 2014) due to the over-performance on raising taxes and reducing government expenditures.

Second, while the path of government expenditures in real terms was well below that projected for the IMF program (see the chart above), the decline in government expenditures as a share of GDP was less because GDP was so much less than forecast. If, for example, government expenditures are cut by 20% but GDP also falls by 20%, then government expenditures as a share of GDP will not change.  They still did fall as a share of GDP between 2009 and 2014 (by 7.7% points of GDP), but not by as much as they would have had GDP not collapsed.

Finally, from the primary balance and the interest due one can work out the path of government debt to GDP:

Greece - Govt Debt to GDP 2008-2014 Projection vs Actual

The chart shows the path projected for public debt to GDP in the IMF program (in blue) and the path it actually followed (in black).  Despite lower government expenditures than called for in the program and higher government revenues as a share of GDP, as well as a significant write-down of 50% on privately held government debt in 2012 (not anticipated in the original IMF program), the public debt to GDP ratio Greece now faces (177% as of the end of 2014, and rising) is well above what had been projected in the program (153% as of the end of 2014, and falling).

Why?  Again, the primary reason is that GDP contracted sharply and is now far below what the IMF had forecast.  If debt followed the path it actually did take but GDP had been as the IMF forecast, the debt to GDP ratio as of the end of 2014 would have been 131% and falling (the path shown in green on the chart).  This would have been well less than the 153% ratio the IMF forecast for 2014, due both to private debt write-off and to the fiscal over-performance.  Or if debt had followed the path projected in the IMF program while GDP took the path it in fact did take, the debt to GDP ratio would have been 207% in 2014 (the path in red on the chart) due to the lower GDP, or well above the actual ratio of 177% in that year.

One cannot argue that Greece failed to abide by its government expenditure and revenue commitments sought in the IMF program.  Indeed, it over-performed.  But the program failed, and failed dramatically, because it did not recognize that by implementing such austerity measures, GDP would collapse.  The program was fundamentally flawed in its design.

D.  Other Measures

While the fiscal accounts are central to understanding the Greek tragedy, it is of interest to examine two other variables as well.  First, the path taken by the external current account balance:

Greece - Current Acct 2008-2014 Projection vs Actual

For countries who have their own currency, but who borrow in a foreign currency, crises will normally manifest themselves through a balance of payments crisis.  This is not central in Greece as it does not have its own currency (it is in the Eurozone) and almost all of its public borrowing has been in euros.  Still, it is of interest that the current account balance of Greece (exports of all goods and services less imports of all goods and services) moved from a massive deficit of over 14% of GDP in 2008 to a surplus in 2013 and 2014. Relative to 2010, Greek exports of goods and services (in volume terms) were 12% higher in 2014, while Greek imports were 19% lower.

The IMF had projected that the external current account would still be in deficit in those years.  This shift was achieved despite Greece not being able, as part of the Eurozone, to control its own exchange rate.  The rate relative to its Eurozone partners is of course fixed, and the rate relative to countries outside of the Eurozone is controlled not by events in Greece but by policy for the Eurozone as a whole.  Rather, Greek exports rose and imports fell because the economy was so depressed that domestic producers who could export did, while imports fell in line with lower GDP (real GDP was 17.5% lower in 2014 than in 2010).  Lower wages were central to this, and will be discussed further below.

Finally, with the economy so depressed, unemployment rose, to a peak of 27.5% in 2013:

Greece - Unemployment Rate 2008-2014 Projection vs Actual

While the preliminary estimate is that unemployment then fell in 2014, most observers expect that it will go up again in 2015 due to the economic turmoil this year.  And youth unemployment is at 50%.

E.  What Can Be Done

I do not know Greece well, and certainly not enough to suggest anything that would be close to a complete program.  But perhaps a few points may be of interest, starting first with some things not to do (or at least are not a priority to do), and then some things that should be done (even if unlikely to happen):

1)  What not to do, or at least not worry about now:

a)  Do not continue doing what has failed so far:  While it should be obvious, if a particular strategy has failed, one should stop pursuing it.  Keeping the basic austerity strategy, with just a few tweeks, will not solve the problem.

b)  Do not make the austerity program even more severe:  Most clearly, the austerity program has savaged the economy, and one should not make things worse by tightening it even further.  Yet that is the direction that things appear to be heading in.

Negotiations are now underway as I write this between the Government of Greece and the Troika on the extension of the austerity program.  A focus is the government’s primary balance.  The original IMF program called for a primary surplus of 3% of GDP in 2015, and that has been still the official program goal despite all the turmoil between 2010 and now. The IMF program (as updated in June 2014) then envisioned the primary surplus rising to 4.5% of GDP in 2016 and and again in 2017.  Germany wanted at least this much, if not more.

Even the official Greek proposal to the Troika of July 10 had the primary surplus rising over time, from 1% of GDP in 2015, to 2%, 3%, and 3 1/2% in 2016, 2017, and 2018, respectively.  With the chaos this year, few expect Greece to be able to achieve a primary surplus target of even 1% of GDP (if one does not ignore payment arrears).  And while the IMF estimate from this past spring was that the primary surplus in 2014 reached 1.5% of GDP (reflected in the chart above), this was a preliminary estimate, and many observers believe that updated estimates will show it was in fact lower.

With even the Greek Government proposal conceding that an effort would be made to reach higher and higher primary balance surpluses, the final program as negotiated will almost certainly reflect some such increase.  This would be a mistake.  It will push the economy down further, or at least reduce it to below where it would otherwise be had the primary surplus target been kept flat.

c)  Do not negotiate over the stock of debt now:  There has been much more discussion over the last month on a need to negotiate now, and not later (some assert), a sharp cut to the stock of Greece’s public debt outstanding.  This was sparked in part by the public release on July 14 by the IMF of an updated debt sustainability analysis, which stated bluntly that the level of Greek public debt was unsustainable, that it could never be repaid in full, and that therefore a reduction in that debt will at some point be inevitable through some system of write-offs.

There is no doubt that Greek public debt is at an unsustainable level.  Some portion will need to be written down.  But I see no need to focus on that issue now, with the economy still deeply depressed and in crisis.  Rather, a moratorium on debt service payments (both principal and interest) should be declared.  The notional debt outstanding would then grow over time at the rate of interest (interest due in effect being capitalized).  At some future point, when the economy has recovered and with unemployment at more normal levels, there can be a negotiation on what to do about the debt then outstanding.  One will know only at that point what the economy can afford to pay.

Note that such a moratorium on debt service is fully and exactly equivalent to debt service payments being paid, but out of “new” loans that cover the debt service due.  This has been the approach used so far, and the current negotiations appear to be calling for a continuation of this approach.  Such “new” lending conveys the impression that debt service continues to be paid, when in reality it is being capitalized through the new loans. Little is achieved by this, and it wastes scarce and valuable time, as well as political capital, to negotiate over such issues now.

d)  Structural reforms can wait:  There is also no doubt that the Greek economy faces major structural issues, that hinder performance and productivity.  There are undoubtedly too many rules and regulations, inefficient state enterprises in key sectors, and codes that limit competition.  They do need to be reformed.

But there is a question of whether this should be a focus now.  The economy is severely depressed, with record high unemployment (similar to the peak rates seen in the US during the Great Depression).  Measures to improve productivity and efficiency will be important to allow the full capacity level of Greek GDP eventually to grow, but the economy is currently operating at far below full capacity.  The priority right now should be to return employment to close to full employment levels.

One needs also to recognize that many of the measures that would improve efficiency will also have the immediate impact of reducing rather than raising employment.  Changing rules and regulations that will make it easier to fire workers will have the immediate impact of reducing employment, not raising it.  Certain state enterprises undoubtedly should be privatized, and such actions can improve efficiency.  But the immediate impact will almost certainly be cuts in staffing, not increases.

Structural reforms will be important.  But they are not the critical priority now.  And far more knowledgeable commentators than myself have made the same point.  Former Federal Reserve Board Chairman Ben Bernanke made a similar point in a recent post on his blog, although more diplomatically and speaking on Europe as a whole.

2)  What should be done:

Finally, a few things to do, although it is likely they will not be politically feasible.

a)  Allow the primary balance to fall to zero, and then keep it there until the economy recovers:  As discussed above, the program being negotiated appears to be heading towards a goal of raising the primary surplus to 3 1/2% of GDP or more over the next few years.  The primary balance appears to have been in surplus in 2014 (the preliminary IMF estimate was 1.5% of GDP, but this may well be revised downwards), with a surplus also expected in 2015 (although the likelihood of this is now not clear, due to the chaotic conditions).  To raise it further from current levels, the program will call for further tax increases and government expenditure cuts.  This will, however, drive the economy down even further.

Keeping the primary balance at zero rather than something higher will at least reduce the fiscal drag that would otherwise hold back the economy.  Note also that a primary balance of zero is equivalent to a moratorium on debt service payments on public debt, which was discussed above.  Interest would then be fully capitalized, while no net amount will be paid on principal.

b)  Germany needs to take actions to allow Greece (and the Eurozone) to recover:  While I am under no illusion that Germany will change its domestic economic policies in order to assist Greece, the most important assistance Germany could provide to Greece is exactly that.

The fundamental problem in the design of the single currency system for the Eurozone system was the failure to recognize as critically important that Europe does not have a strong central government authority, with direct taxing powers, that can take action when the economy falls into a recession.  When a housing bubble bursts in Florida or Arizona, incomes in those states will be supported by US federal authorities, who will keep paying unemployment compensation; pensioners will keep receiving their Social Security and Medicare; federal transfers for education, highway programs, and other such government expenditures will continue; and if there is a national economic downturn (and assuming Congress is not controlled by ideologues opposed to any such actions) then stimulus measures can be enacted such as increased infrastructure spending.  And the Federal Reserve Board can lower interest rates to spur investment.  All of this supports demand, and keeps demand (and hence production and employment) from falling as much as it otherwise would.  This can then lead to a recovery.

The European Union in current form is not set up that way.  Central authority is weak, with no direct taxing powers and only limited expenditures.  Members of the Eurozone do not individually control their own currency.  If a member country suffers an economic downturn and faces limits on either what it can borrow in the market or in how much it is allowed to borrow in the market (by the limits set in the Fiscal Compact that Germany pushed through), it will not be able to take the measures needed to stabilize demand. Government revenues will decline in the downturn.  Any such borrowing limits will then force government expenditures to be cut.  This will lead to a further downward spiral, with tax revenues falling again and expenditures then having to be cut again if borrowing is not allowed to rise.  Greece has been caught in exactly such a spiral.

As was discussed some time ago on this blog, even Professor Martin Feldstein (a conservative economist who had been Chairman of the Council of Economic Advisers under Reagan) said such fiscal rules for the Eurozone could “produce very high unemployment rates and no route to recovery – in short, a depression”.  That is exactly what has happened in Greece.

The EU in its present form cannot, by itself as a central entity, do much to resolve this. However, member countries such as Germany are in a position to help support demand in the Eurozone, if they so wished.  But they don’t.  Germany had a current account surplus of 7.5% of GDP in 2014, and the IMF expects it will rise to 8.4% of GDP in 2015. Germany’s current account surplus hit $288 billion in 2014, the highest in the world (China was second, at $210 billion).  German unemployment is currently about 5%, but inflation is excessively low at 0.8% in 2014 and an expected 0.2% in 2015.  It could easily slip into the deflationary trap that Japan fell into in the 1990s that has continued to today.

To assist Greece and others in the Eurozone, Germany could do two things.  First, it could accede to the wage demands of its principal trade unions.  Germany’s largest trade union, IG Metall, had earlier this year asked for a general wage increase of 5.5% for 2015.  In the end, it agreed to a 3.4% increase.  A higher wage increase for German workers would speed the day to when they were in better alignment with those in Greece (which have been dropping, as we will discuss below) and others in the Eurozone.  Inflation in Germany would likely then rise from the 0.2% the IMF forecasts for 2015, but this would be a good thing.  As noted above, inflation of 0.2% is far too low, and risks dipping into deflation (prices falling), from which it can be difficult to emerge.  Thus the target set in the Eurozone is 2%, and it would be good for all if German inflation would rise to at least that.

Direct fiscal spending by Germany would also help.  It has the fiscal space.  This would spur demand in Germany, which would be beneficial for countries such as Greece and others in the Eurozone for whom Germany is their largest or one of their largest export markets.  Inflation would likely rise from its current low levels, but as noted, that would be good for all.

Of even greater direct help to Greece would be German support for EU programs that would provide direct demand support in Greece.  An example might be an acceleration of planned infrastructure investment programs in Greece, bringing them forward from future years to now.  Workers are unemployed now.  Bringing such programs forward would also be rational even if the intention was simply to minimize costs.  Unemployed workers and other resources are now available at cheap rates.  They will be more expensive if they wait until the economy is close to full employment, so that workers have an alternative. Economically, the opportunity cost of hiring workers now is extremely low.

A more balanced approach, where adjustment is not forced solely on depressed countries such as Greece but in a more balanced away between countries in surplus and those in deficit, would speed the recovery.  Far more authoritative figures than myself (such as Ben Bernanke in his blog post on Greece) have made similar arguments.  But Germany shows little sign of accepting the need for greater balance.

3)  What will likely happen:

With Germany not changing its stance, and with the Troika now negotiating an extension and indeed deepening of the austerity program Greece has been forced to follow since 2010 (in order to be allowed to remain in the Eurozone), the most likely scenario is that conditions will continue along the lines of what they have been so far under this program. The economy will remain depressed, unemployment will remain high, government revenues will fall in euro terms, and this will then lead to calls for even further government expenditure cuts.

One should not rule out that at some point some event occurs which leads to a more immediate collapse.  The banking system could collapse, for example.  Indeed, many observers have been surprised that the banking system has held up as well as it has. Liquidity support from the European Central Bank has been critical, but there are limits on how much it can or will be willing to provide.  Or a terrorist bomb at some resort could undermine the key tourism industry, for example.

Absent such uncontrollable shock events, there is also the possibility that at some point the Government of Greece might decide to exit the Eurozone.  This would also create a shock (and any such move to exit the Eurozone could not be pre-announced publicly, as it would create an immediate run on the currency), but at least some argue that following the initial chaos, this would then make it possible for Greece to recover.

The way this would work is that the new currency would be devalued relative to the euro, and by law all domestic transactions and contracts (including contracts setting wages of workers) would be re-denominated into the new currency (perhaps named the “new drachma” or something similar).  With a devaluation relative to the euro, this would then lead to wages (in euro terms) that have been reduced sharply and immediately relative to what they were before.  The lower wages would then lead to Greek products and services that are more competitive in markets such as Germany, leading to greater exports (and lower imports).  This is indeed how countries with their own currencies normally adjust.

It would, however, be achieved only by sharply lower wages.  It would also likely be accompanied by chaotic conditions in the banking system and in the economy generally in reaction to the shock of Eurozone exit.  Greece would also likely cease making payments of interest and principal on its government debt (payments that are due in euros).  This plus the exit from the Eurozone would likely sour relations with Germany and others in the Eurozone, at a time when the country needs help.

So far Greece has resisted leaving the Eurozone.  Given what it has accepted to do in the Troika program in order to stay in the Eurozone (with the resulting severely depressed economy), there can be no doubt that this intention is sincere.  Assuming then that Greece does stay in the Eurozone, what will likely happen?

Assuming no shocks (such as a collapse of the banking system), it would then be likely that the economy would muddle along for an extended period.  It would eventually recover, but only slowly.  The process would be that the high unemployment will lead to lower and lower wages over time, and these lower wages would then lead to Greek products becoming more competitive in markets such as Germany.  This is similar to the process following from a devaluation (as discussed above), but instead of this happening all at one point in time, it would develop only gradually.

The process has indeed been underway.  The key is what has happened to wages in Greece relative to where wages have gone in its trading partners.  One needs also to adjust for changes in labor productivity.  The resulting measure, which economists call nominal unit labor costs, measures the change in nominal wages (in euro terms here), per unit of effective labor (where effective labor is hours of labor adjusted for productivity growth).  While one cannot easily compare unit labor costs directly between countries at the macro level (it would vary based on employment composition, which differs by country), one can work out how much it has changed in one country versus how much it has changed in another country, and thus how much it has changed for one country relative to another.

Scaling the base to 100 for the year 2010 (the year the austerity program started in Greece), relative unit labor costs have fallen sharply in Greece relative to the rest of the Eurozone, and even more so relative to Germany (with the data computed from figures provided by Eurostat):

Greece and Eurozone Unit Labor Cost, 2010 = 100

Relative to 2010, nominal unit labor costs fell by 13% in Greece (up to 2013, the most recent date available).  Over that same period, they rose by 4% in the Eurozone as a whole and by 6% in Germany.  Thus relative to Germany, unit labor costs in Greece were 18% lower in 2013 than where they were in 2010.  This trend certainly continued in 2014.

The lower unit labor costs in Greece have led to increased competitiveness for the goods and services Greece provides.  Using the IMF WEO database figures, the volume of Greek exports of goods and services grew by a total of 12% between 2010 and 2015, while the volume of imports fell by 19%.  As noted in a chart above, the Greek current account deficit went from a large deficit in 2010 to a surplus in 2013 and again in 2014.  Greater exports and lower imports have helped Greek jobs.  And as seen in another chart above, Greek unemployment fell a bit in 2014 (although with the recent chaos, is probably rising again now).

This process should eventually lead to a recovery.  But it can be a slow and certainly painful process, and is only achieved by keeping unemployment high and wages falling.

Are Greek wages now low enough?  Changes in unit labor costs cannot really provide an answer to that.  As noted above, the figures can only be provided in terms of changes relative to some base period.  The base period chosen may largely be arbitrary.  The chart above was drawn relative to a base period of 2010, as that was the first year of the austerity program, but cannot tell us how much (and indeed even whether) wages were out of line with some desirable relative value in 2010.  And one can see in the chart above that Greek unit labor costs were rising more rapidly than unit labor costs in the Eurozone as a whole in the period prior to 2010, and especially relative to Germany.

Rebasing the figures to equal 100 in the year 2000 yields:

Greece and Eurozone Unit Labor Cost, 2000 = 100

The data is the same as before, and simply has been adjusted to reflect a different base year.  Relative to where they were in the year 2000, Greek unit labor costs in 2013 were below what they were for the Eurozone, but only starting in 2013:  They were higher for each year from 2002 to 2012.  And they were still above the change in Germany over the period:  German unit labor costs were 11% higher in 2013 than where they were in 2000, while Greek unit labor costs were 17% higher (but heading downwards fast).

Wages are therefore adjusting in Greece, and indeed adjusting quite fast.  This is leading to greater exports and lower imports.  Over time, this will lead to an economic recovery. But it will be a long and painful process, and it is difficult to predict at this point how long this process will need to continue until a full recovery is achieved.

Unless the depressed conditions in the country lead to something more radical being attempted, this is probably the most likely scenario to expect.

The recovery could be accelerated if Greece were allowed to keep the primary balance flat at say a zero balance (implying all interest on its public debt would be capitalized, and no net principal paid) rather than increased.  But this will depend on the acquiescence of the Troika, and in particular the agreement of Germany.  It is difficult to see this happening.

The Government Debt to GDP Ratio is Falling

Fed Govt Debt as Share of GDP, 2006Q1 to 2014Q3

The US federal government debt to GDP ratio is falling.  A few years ago, conservative critics (such as Congressman Paul Ryan) argued that if drastic action were not taken immediately to slash government expenditures, consequent rapidly rising federal government debt would stifle growth and spiral ever upwards.  Liberals (such as Paul Krugman) argued that the federal deficit and debt were far less of a concern than these critics asserted:  With the recovery of the economy, both would soon start to fall.  And the detailed projections from the Congressional Budget Office backed this up, with projected falls in the debt to GDP ratio for at least a few years.  There would be a rise later if nothing further is done, in particular on medical costs, but the question at issue here is whether the debt to GDP ratio could fall in the near term without drastic cuts in government expenditures.  Conservatives asserted it would not be possible.

But these were projections and assertions.  The chart above shows the actual data.  With the release this morning by the Bureau of Economic Analysis of its first estimate of 2014 third quarter GDP (growth at a fairly solid 3.5% real rate), one can now see that there has been a downward turn in the debt to GDP ratio.  The ratio peaked at 72.8% of GDP in the first quarter of 2014, and dropped to 72.2% as of the third quarter.

The federal government debt figure used here is the debt held by the public.  There are also various trust funds (most notably the Social Security Trust Fund) that formally hold government debt in trust, but this reflects internal accounting within government.  The figures come from the US Treasury, with quarterly averages taken based on an average of the amounts outstanding each day of the quarter.  This average is then taken as a share of nominal GDP for the quarter (nominal GDP since debt is also a nominal concept).  And since nominal GDP reflects the flow of production over the course of the quarter, taking the daily average debt outstanding over the course of the quarter will better reflect the debt burden than simply taking debt as of the end of the quarter and dividing this by GDP (although this is commonly done by many).

There was an earlier downward dip in the public debt to GDP ratio in the third quarter of 2013, but this was due to special circumstances surrounding the delay by Congress to approve a rise in the statutory government debt ceiling.  Various accounting tricks were used to delay recognition of items that would add to the formally defined government debt in order to keep under the ceiling, which artificially suppressed the debt to GDP ratio in that quarter.  This carried over into the fourth quarter, with the Republicans forcing a shutdown of the federal government from October 1 by not approving a new budget.  The dispute was not resolved until October 16, when deals were reached to raise the debt ceiling and to approve a budget.  The debt ratio then returned to its previous path.

The fall in the debt ratio in 2014 is more significant.  Accounting tricks are not now being used due to debt ceiling disputes, and the fall reflects the continued fall in the fiscal deficit coupled with reasonably sound growth.  The deficit is estimated to have totaled $483 billion in fiscal 2014 (which just ended on September 30), or 2.8% of GDP.  This is sharply down from the $1.4 trillion (or 9.8% of GDP) of fiscal 2009, in the first year of the downturn.  The fiscal deficit has fallen primarily due to the recovery, but also due to cuts in federal government expenditures under Obama since 2010.  While not nearly as drastic as Congressman Ryan and other conservatives had insisted would be necessary, government spending has still fallen under Obama, in contrast to the increases allowed in previous downturns.

Note that the government expenditure cuts that were done do not represent what would have been the desirable path in deficit reduction:  As discussed in an earlier post on this blog, it would have been far better to follow a fiscal path similar to that followed by Reagan and others in earlier downturns, with government spending allowed to grow so that the economy could have more quickly returned to full employment.  Once full employment was reached, one would then consider fiscal cuts, if warranted, to address any debt concerns.

The path followed has thus been far from optimal.  But it has shown that the alarms raised by the conservative critics, that the debt to GDP ratio could not fall without drastic government cutbacks (far more severe than that seen under Obama), were simply wrong.

We Have a Revenue Problem: Government Debt to GDP Would Fall Without the Bush Tax Cuts

Debt to GDP Ratio, FY1790 to 2038, no Bush Tax Cuts

A.  Debt to GDP Would Fall Without the Bush Tax Cuts

If the Bush tax cuts had not been extended at the start of this year for almost all households, the public debt to GDP ratio would be falling rapidly.  Even though health care costs are rising and Social Security payments will need to increase as baby boomers retire, the US would be generating more than sufficient tax revenues to cover such costs, if we simply had reverted to the tax rates that held prior to the Bush tax cuts.

The figures on this can be calculated from numbers provided by the Congressional Budget Office with its annual Long-Term Budget Outlook, which was published earlier this week.  Most of the attention paid to the report focussed on the base case projection by the CBO of the public debt to GDP ratio if nothing changes in current policy.   The ratio had risen sharply as a consequence of the economic collapse of 2008, in the last year of the Bush administration, and subsequent weak recovery.  But with the economy recovering and with other measures taken, the ratio is now projected to stabilize and indeed fall modestly for several years.  However, the ratio would then start to grow again in fiscal year 2019, and especially after 2023.  As the graph above shows, the CBO projects that, under current policy, the debt to GDP ratio would rise to 100% of GDP by fiscal 2038, reaching levels last seen at the end of World War II.

This has been interpreted by Republicans as a runaway spending problem, and have asserted this calls for further sharp cuts.  But the data issued by the CBO with its report allows one also to work out what the consequences were of allowing most of the Bush tax cuts (primarily – there were also some other tax measures) to be extended from January 1, 2013.  The Bush tax cuts had been scheduled to expire on that date.  They were instead extended and made permanent for all but the extremely rich (those households earning more than $450,000 a year, the richest 0.7% of the population).

Specifically, the CBO provided in the projections it had made last year (in 2012) what public revenues would have been if the tax cuts had expired, as scheduled, at the start of 2013.  The new report provides those figures for comparison, updated to reflect the new methodology for GDP that the BEA adopted in July.  One can combine those revenue projections with CBO’s current projections of non-interest expenditures, along with a calculation of what interest would then be on the resulting (lower) debt, to estimate what the fiscal deficit and debt to GDP figures would then be.

The resulting path of federal government debt to GDP is shown as the green line in the graph above.  The debt to GDP ratio plummets.  Instead of reaching 100% of GDP in fiscal 2038, it instead would fall to just 37% of GDP in that year.  And a simple extrapolation of that line forward would bring the debt all the way to zero in a further 24 years.

The extension of the Bush tax cuts for most households can therefore, on its own, more than fully account for the projected rise in the public debt to GDP ratio.  With tax rates as they had been under Clinton, there would be no debt issue.

B.  A Longer Term Perspective

The CBO report also provides data on the federal government debt to GDP ratio going back to the founding of the republic in 1790.  I have put the projected paths on a graph with the history to put them in that context.  The fall in the debt ratio that would follow if the Bush tax cuts had not been extended is similar to the falls seen in that ratio in the periods following the Revolutionary War, the Civil War, World War I, World War II, and during the Clinton years following the run-up during the Reagan and first Bush presidencies.

Public debt reached a peak of 106% of GDP in fiscal year 1946, at the end of World War II.  The ratio then fell steadily in the 1950s and 1060s, and was just 25% in 1981, at the end of the Carter presidency.  It fell during this period not because there were large budget surpluses, but rather because of generally strong economic growth.  This also shows that strong growth is possible even if the debt ratio is as high as 106%, undermining the argument made by the economists Carmen Reinhart and Ken Rogoff in a 2010 paper, that debt in excess of 90% of GDP will lead to a sharp reduction in growth.  Republican politicians had quickly jumped on the Reinhart and Rogoff conclusion, arguing that this work supported their views.  But aside from numerous counterexamples, such as the US after World War II, researchers later discovered that there had been a coding error in the spreadsheet Reinhart and Rogoff used to assemble their data.  More fundamentally, researchers showed that to the extent there is a relationship between high debt and slow growth, it is that downturns and slow growth lead to a rise in the debt to GDP ratio (as we saw in the US after the 2008 collapse), rather than that a high debt ratio leads to slow growth.

The debt ratio then rose sharply during the Reagan and first Bush presidencies, rising from 25% of GDP in fiscal 1981 to 48% in fiscal 1993.  This was the first such rise in the debt ratio in American history, aside from the times when the country went into war or at the start of the Great Depression.  During the Great Depression the ratio rose during the Hoover years from 15% in fiscal 1929 to 39% in fiscal 1933, and then to 43% in fiscal 1934.  But it is interesting that during the Roosevelt presidency, and in stark contrast to the common view that the New Deal was characterized by big increases in government spending, the ratio then stayed in the range of 40% to 44% until 1942, following the entry of the US into World War II.

The debt ratio then fell during the Clinton presidency, from 48% in fiscal 1993 to 31% in fiscal 2001.  But with the Bush tax cuts and then the 2008 collapse, the ratio rose to 52% in  fiscal 2009, and to 73% this year.   As noted above, the ratio would now start to fall again if the Bush tax cuts had not been extended, reaching a projected 37% in fiscal 2038.  But with most of the Bush tax cuts made permanent, the ratio (with the same government spending levels) is instead projected to rise to 100% in that year.

C.  Conclusion

The first step in addressing some problem is to understand the cause.  The cause of the current fiscal problems, which if not addressed would lead to a public debt rising to 100% of GDP by fiscal 2038, is the Bush tax cuts.

An earlier post on this blog looked at what the debt to GDP ratio would have been had the Bush tax cuts never been enacted (in 2001 and 2003) and the Afghan and Iraq wars had not been launched.  It found that even assuming the 2008 economic downturn would still have occurred, the public debt to GDP ratio would have risen only to about 35% by fiscal 2014, and would then start to fall.  That post also showed that even assuming the cost of the wars and with the Bush tax cuts in place from 2001 to 2013, phasing out the tax cuts starting in fiscal 2014 would have led the public debt to GDP ratio to fall until at least fiscal 2022 (the last year in the CBO figures then available).

The current post has made use of the CBO’s new long term projections, and finds that if the Bush tax cuts had not been extended at the beginning of 2013, the debt to GDP ratio would be on a sharp downward path to at least fiscal 2038.  The current conventional wisdom appears to be that rising health care costs and the increase in the number of retirees as the baby boom generation reaches 65 means that a rise in the debt to GDP ratio is inevitable, unless there are sharp cut-backs in Medicare and Social Security.

But that is not the case.  The debt ratio would be falling rapidly if it were not for the Bush tax cuts.

The Recovery From the 2008 Collapse That Could Have Been: The Impact of the Fiscal Cuts

GDP Recovery Path with Govt Growth at Historic Average, 2004Q4 to 2013Q2

A.  Introduction

Previous posts on this blog (including this older one from 2012) have discussed how the sluggish recovery from the 2008 economic collapse could have been avoided if one had allowed government spending to grow as it had during Reagan’s term.  This post will look in more detail at what the resulting path for GDP would have been if government spending had followed the path as it had under Reagan, or even had simply been allowed to grow at its normal historical rate.

The 2008 collapse was of course not caused by fiscal actions, but rather by the bursting of the housing bubble, and its consequent impact both in bankrupting a large share of an overly-leveraged financial system and in causing household consumption to fall as many homeowners struggled to repay mortgages that were now greater than the value of their homes.  Faced with the high unemployment resulting from this, an expansion of government spending would have supported the demand for output and hence for workers to produce that output.  And initially, fiscal spending did indeed grow.  This growth (along with aggressive action by the Fed) did succeed in turning around the steep slide of the economy that Obama faced as he took office.  But since 2009 government spending has been cut back, and as a result the recovery of GDP has been by far the slowest in any cyclical downturn of the last four decades.

This blog post will look at alternative scenarios of what the recovery path of GDP could have been, had government spending not been reduced.  Two primary alternatives will be examined.  In the first, government spending is allowed to grow from the point President Obama took office at a rate equal to its average rate of growth over the period 1981 to 2008.  In the second, government spending is allowed to grow from the onset of the recession (i.e. from the fourth quarter of 2007) at the same rate as it had during the Reagan years, following the downturn that began in the third quarter of 1981.

B.  Government Spending Growth at the Historic Average Rate

In the first scenario, real government spending on goods and services (as measured in the GDP accounts, and inclusive of state and local government as well as federal) is allowed to grow at a rate of 2.24% per year.  This is the average rate of growth for government spending over the 28 years from 1980 to 2008.  This was a modest growth rate, and spanned the presidencies of three Republicans (Reagan and the two Bushes) for 20 of the 28 years, and one Democrat (Clinton) for 8 of the 28 years.  The 2.24% growth rate was substantially below the growth rate of GDP of 3.04% over this same period (note this is for total GDP, not per capita).  As a result, real GDP grew by over 50% more over this period than government spending did.  But this modest pace of government spending growth was substantially more than the absolute fall in government spending during Obama’s term in office.

Note that this path for government spending is not some special rate faster than the historical average, as would normally be called for in a downturn when fiscal stimulus is needed because aggregate demand in the economy is less than what is needed for full employment.  Rather, it is just the historical average rate.  This should be seen as a neutral path, with government spending neither purposely stimulative, nor purposely contractionary.

This path for government spending is shown as the orange line in the following, where the path is superimposed on the graph presented in the earlier blog post of such paths of government spending in each of the downturns the US has faced since the 1970s:

Recessions - Govt Cons + Inv Expenditures Around Peak, 12Q before to 22Q after, with growth at avg historical rate

Maintaining government spending growth at the historical 2.24% rate would have led to government spending well below that seen during the Reagan years (in the recoveries from the July 1981 and January 1980 downturns), roughly where it was in the recoveries from the November 1973 and March 2001 downturns, and well above where it was in the recoveries from the July 1990 downturn (during the Clinton years) and of course the December 2007 downturn (under Obama).  Government spending in the current downturn (the brown curve in the graph) has fallen substantially during the period Obama has been in office.

The graph at the top of this post then shows what the GDP path would have been if government spending would have been allowed to grow at the historic average rate.  The impact will depend on the multiplier.  As was discussed in the earlier post on fiscal multipliers, the multiplier for the US in this period of high unemployment and short-term interest rates of close to zero will be relatively high.  But for the purposes here, we will run scenarios of multipliers of 1.5, of 2.0, and of 2.5.  This will span the range most economists would find reasonable for this period.

The results indicate that had one simply had government spending grow at its historic average rate, the economy would likely now be at or close to potential GDP, which is what GDP would be at full employment.  But because of the fall in government spending since 2009 rather than this increase, current actual GDP is over 6% below potential GDP, and unemployment is high.  (Potential GDP comes from the CBO estimates used in its May 2013 budget projections, but adjusted to reflect the methodological change made by the BEA in July 2013.  Due to these adjustments, including for the GDP deflators used, the potential GDP path is not as “smooth” as one would normally see.  But it will be close.)

Republicans have argued that we cannot, however, afford higher government spending, even if it would lead the economy back to full employment, as it would lead to an even higher public debt to GDP ratio.  But as was discussed in a recent post on this blog on the arithmetic of the debt to GDP ratio, it is not necessarily the case that higher government spending will lead to a higher ratio.  The Republican argument fails to recognize both that GDP will higher (due to the multiplier, and indeed a relatively high multiplier in the current conditions of high unemployment and close to zero short-term interest rates), and that a higher GDP will generate higher tax revenues due to that growth, which will off-set at least in part the impact on the deficit of the higher spending.

The resulting paths for the debt to GDP ratios by fiscal year, using a 30% marginal tax rate for the higher income, would be:

Public Debt to GDP with Govt Growth at Historic Average, FY2009 to FY2013

The impact of the higher government spending is to reduce the debt to GDP ratios over this period.  The higher government spending leads to a higher GDP, and this higher GDP along with the extra tax revenues generated at the higher output means the debt rises by proportionately less.  The ratios fall the most, as one would expect, the higher the multiplier.  If one is truly concerned about the burden of the debt, one should be supportive of fiscal spending in this environment to bring the economy quickly back to full employment.  The debt burden will then be less.

The debt to GDP ratios still rise over these years.  This serves to point out that the assertion made by the Republicans that the public debt to GDP ratio has risen so much during Obama’s term due to explosive spending under Obama is simply nonsense.  The debt to GDP ratios rose not due to higher government spending, but primarily due to the economic collapse and slow recovery, which has decimated tax revenues.  With higher government spending, the debt to GDP ratios would have been lower.

C.  Government Spending Growth at the Rate During the Reagan Years

The second set of scenarios examine what the path of GDP would have been had government spending been allowed to grow, following the onset of the downturn in December 2007, at the same pace as it had during the Reagan years following the onset of the July 1981 downturn.  The path followed is shown as the green line in the graph above on government spending around the business cycle peaks.

The resulting recovery in GDP during the current downturn would have been significantly faster:

GDP Recovery Path with Govt Growth at Reagan Rate, 2004Q2 to 2013Q2

If government spending had been allowed to grow under Obama as it had under Reagan, the economy likely would have reached full employment in 2011 (multipliers of 2.5 or 2.0), or at least by the summer of 2012 (multiplier of just 1.5).  That is, the economy would have been at full employment well before the election.

The deb to GDP ratios would also have been less than what they actually were:

Public Debt to GDP with Govt Growth at Reagan Rate, FY2008 to FY2013

Note that for these calculations I assumed that once the economy reached full employment   GDP (potential GDP), that government spending was then scaled back to what was then necessary to maintain full employment, and not over-shoot it.  Hence the curves for the 2.5 and 2.0 multipliers move parallel to each other (and are close to each other) once this ceiling has been reached.

D.  Conclusion

Fiscal spending was not the cause of the 2008 collapse.  Rather, the cause was the bursting of the housing bubble, and the resulting bankruptcy of a large share of the financial system, as well as the resulting reduction in household spending when many homeowners found that their homes were now worth less than their mortgages.

But following an initial increase in government spending, in particular as part of the fiscal stimulus package passed soon after Obama took office, government spending has been cut back.  The scenarios reviewed above indicate that had government spending merely been allowed to grow at its normal historical rate from when Obama took office (i.e. even without the special stimulus package), the US would by now be at or at least close to full employment.  And if government spending had grown as it had during the Reagan years, the economy would likely have reached full employment in 2011.

There is no need to introduce some special factor to explain why GDP is still so far below what it would be at full employment.  There is no need to assume that something such as “business uncertainty” due to Obama, or new and burdensome regulations, have for some reason led to this slow recovery in GDP.  Rather, the sluggish recovery of GDP and hence of employment can be explained fully by the policies that have kept government spending well below the historical norms.

An Increase in Government Spending Can Reduce the Debt to GDP Ratio: Econ 101

Most people realize that it is not the absolute value of the government debt that matters, but rather the ratio of that debt to GDP.  A larger economy can support a larger debt.  But most people will also think instinctively that an increase in government spending will necessarily lead to an increase in the government debt to GDP ratio.  It is not surprising that they should think so.  But it is wrong.

Whether the government debt to GDP ratio will rise or will fall when government spending increases will depend on economic conditions and other structural factors.  In conditions of high unemployment and where the Central Bank has driven the interest rates it can control essentially to zero, such as exist now in the US and Europe, an increase in government spending will increase the demand for goods and services, and hence will increase the demand for labor to produce those goods and services.

Employment and output will then rise. How much they will rise will depend on the multiplier, but as was discussed in a previous Econ 101 post on this site, in conditions of high unemployment and close to zero Central Bank controlled interest rates such as currently exist, the multiplier will be relatively high.  The higher incomes that then follow from the higher employment and output will also then lead to higher tax revenues, as a share of the higher incomes will be paid in taxes.

Hence the addition to the deficit and thus the public debt will be less than simply the increase in government spending, due to the higher tax revenues.  With GDP higher due to the greater demand and with the debt also possibly higher but not by as much, the debt to GDP ratio could fall.  And indeed, under conditions such as currently exist in the US and Europe, the debt ratio will almost certainly fall.

To see this, one can start with a simple numerical example.  Suppose one starts with a GDP equal to 100 units (it could be $100 billion), a public debt of 50 (or 50% of GDP, roughly where it was in the US in 2009), a multiplier equal to 2.0 (a reasonable estimate for the US in recent years), and a marginal tax rate on additional income of 30% (also a reasonable estimate for what it is for US federal government level revenues; it would be higher if one included state and local government revenues).

In these conditions, suppose government spending rises by 1 unit.  With a multiplier of two, GDP will then rise by 2 units.  Tax revenues will then rise by 0.6 units, when the marginal tax rate is 30% on the additional 2 units of GDP.  The government deficit, and hence the public debt, will rise by 0.4 units, equal to the extra 1 unit of government spending less the 0.6 units of additional tax revenue.  The resulting public debt will be 50.4, while GDP will then be 102, and the ratio of 50.4/102 is equal to 0.494.  Hence the debt ratio fell from 50% to 49.4% when government spending rose by 1.  Higher government spending led to a reduction in the debt to GDP ratio.  While the total debt rose, GDP rose by proportionately more, leading to a fall in the debt to GDP ratio.

Further numerical examples will help give a feel to what is going on:

Impact on Debt/GDP Ratio from a One Unit Increase in Government Spending
        Scenario: (a) (b) (c) (d) (e)
GDP: Y 100 100 100 100 100
Public Debt: D 50 70 30 50 50
multiplier: m 2.0 2.0 2.0 0.5 3.5
marginal tax rate: t 0.3 0.3 0.3 0.3 0.3
pre-change D/Y 0.500 0.700 0.300 0.500 0.500
Change in G 1 1 1 1 1
Change in Y 2 2 2 0.5 3.5
Change in D 0.4 0.4 0.4 0.85 -0.05
Resulting D/Y 0.494 0.690 0.298 0.506 0.483

Scenario (a) is the case just discussed.  With an initial public debt ratio of 50%, a multiplier of 2, and a marginal tax rate of 30%, a unit increase in government spending will lead the debt to GDP ratio to fall to 49.4%.  This is robust to different initial debt to GDP ratios:  The debt to GDP ratio will fall with higher government spending with an initial debt ratio of 70% (scenario (b), with the debt ratio where it was in FY2012) or at 30% (scenario (c), almost what the debt ratio had fallen to at the end of the Clinton administration, before the Bush tax cuts).

Under conditions where the economy is close to full employment, so that the multiplier will be relatively small, the debt ratio could rise with the higher government spending.  GDP will not rise by much, if at all, if the economy is already producing at or close to full employment levels.  The denominator in the ratio hence will not rise by much, if at all, while the numerator (the level of debt) will rise by the level of extra government spending, with only limited or no extra tax revenues to offset this since GDP has not increased by much.   Scenario (d) provides an example, with a multiplier of 0.5.  The debt ratio will rise from 50% to 50.6% in this example, when government spending rises by 1.

At the other extreme, a very high multiplier may lead to such a large increase in GDP that the extra tax revenues thus generated are greater than the increase in government spending, leading to an actual decrease in the deficit and hence the debt.  Scenario (e) presents an example, with a multiplier of 3.5.  Debt actually falls from 50 units to 49.95 units, despite the increase in government spending by 1 unit, and the debt to GDP ratio falls from 50% to 48.3%.

One will also get this result if the extra tax revenues generated for a given increase in GDP is sufficiently high.  The above examples assume a marginal tax rate of 30%.  More generally, if the marginal tax rate times the multiplier is greater than one (e.g. 30% times 3.5 = 1.05 in the example above), then the absolute value of the debt will fall with the higher government spending.

It may well be unlikely, however, that the multiplier will be as high as 3.5, even with the current high unemployment in the US and Europe.  Thus it is unlikely that the absolute value of the debt will fall with higher government spending, even in conditions of high unemployment.  But as was discussed above, with a reasonable estimate of the multiplier at around 2, one will see the debt to GDP ratio fall, under conditions such as now exist in the US and Europe.

For those with some mathematical expertise, it is straightforward to derive the specific conditions which will determine whether the debt to GDP ratio will rise or fall with an increase in government spending.  This requires some elementary differential calculus, and I will not go through the derivation here.  But the final result is that the debt to GDP ratio will fall if:

(t + D/Y) – (1/m) > 0

and the debt ratio will fall if the sum on the left is less than zero.  That is, the debt to GDP ratio will fall if the marginal tax rate (t), plus the initial debt to GDP ratio (D/Y), minus the inverse of the multiplier (m), is greater than zero (and will rise if the sum is less than zero). Thus if t=30%, D/Y=50%, and m=2 (so 1/m=0.5), with a sum then of 0.3 + 0.5 – 0.5 = 0.3, which is greater than zero, the debt to GDP ratio will fall.

The material above is straightforward.  There is nothing deep or complex.  It also just examines the immediate impact on the public debt to GDP ratio from an increase in government spending.  For a more elaborate look at the long-term impact, see the paper of Brad DeLong and Larry Summers published in 2012.  They show there that higher government spending will not only spur GDP in the short run under conditions such as exist now, but also that such spending will likely pay for itself in the long run through its long term positive impact on growth.

But this post simply focuses on the short term, and shows that counter to what many people might at first believe, higher government spending can lead to a fall in the public debt to GDP ratio.  All this result requires is the recognition that under conditions such as exist now, when unemployment is high and Central Bank controlled interest rates are close to zero, there will be a significant multiplier effect from an increase in government spending.  The resulting increase in GDP along with the extra tax revenues thus generated could very well then lead to a fall in the debt to GDP ratio.  Indeed, with the conditions and parameters such as now exist in the US and Europe, one should expect this result.