Full text of Economic Commentary (Federal Reserve Bank of Cleveland) : The Debt Burden : What You Don't See, May 1, 1985

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The Shortfall in Domestic Savings
Even if debt is not explosive, a persistent
structural deficit in the neighborhood
of 5 percent of GNP-as
projected by
the CBO - poses a serious threat to
long-term economic growth. The danger
stems from the current imbalance
between domestic savings and credit
demands - an imbalance that is likely
to continue.
Historically, the private domestic
savings rate has been stable, and
impervious to the level of interest rates
and credit demands of the federal
government. In this situation, any
large increase in federal credit demands
must be met either by an increase in
foreign savings (a net capital inflow)
or by a decline in private credit demands.
The present concern is that federal
demands will crowd out private credit
demands and thereby stifle private
investment. So far this has not happened
because the shortfall in domestic savings
has been met by a sharp increase in
the net inflow of foreign savings. In
the past year alone, this net inflow
approached $100 billion, amounting
to almost one-third of the net private
domestic savings and to more than
one-half the budget deficit.

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Financing a large structural deficit
with foreign savings is not without cost,
either in the short run or in the long
run. The immediate costs are clear.
The net inflow of savings has encouraged
a very strong dollar. The strong dollar,
in tum, has made goods produced in
the United States more expensive
relative to goods produced abroad and
thereby has contributed importantly
to the record trade deficits. Thus, while
the large budget deficit has not yet
had a discernible adverse effect on
domestic investment, it has crowded out
exporters, farmers, and businesses
that compete with imports.
This has put the current economic
expansion in a precarious position. If
the dollar were to strengthen significantly
this year, the growing imbalances in
the export sector could spill over into
the general economy, leading to a
slowdown in overall growth. What's
more, the adverse impact on certain
sectors of the economy would lead to
additional political pressures for trade
restrictions and economic relief which,
in the long-run, would only make the
situation worse. Ironically, a slowdown
in the economy would also worsen
chances for substantially reducing the
Federal deficit.
Many analysts believe that a rapid
decline in the dollar is a greater risk.
This would be accompanied by a weakening in foreign savings that would
put upward pressure on interest rates.

•

At the same time, the falling dollar
would also put upward pressure on
the inflation rate.
The long-run costs of the deficit
depend on how long the net inflow of
foreign capital can be sustained. If it is
to continue, holdings of U.S. assets by
foreigners must grow at unprecedented
rates. Most economists believe that
foreign portfolios will eventually become
saturated with dollar-denominated assets.
The inflow of foreign savings would
then cease, unless interest rates were
to rise. In either case, federal credit
demands would then begin to crowd
out private investment. A slowdown in
private investment reduces the rate
at which new production techniques
are adopted, thereby slowing productivity
growth. This has the obvious effect of
reducing potential growth and hence
the standard of living relative to what
it might be. A cessation of foreign
savings would also lead to a fall in the
dollar and to an increase in interest
rates and inflation.
So far, the behavior of foreign savings
has confounded forecasters throughout
the recovery. Predicting when the inflow
of foreign savings will cease, like predicting when an under-inflated tire will
become damaged, is virtually impossible.
This is what makes the deficit so
insidious and so dangerous.

BULK RATE
Paid
Cleveland, OH
Permit No. 385

u.s. Postage

Federal

Reserve Bank of Cleveland

May 1,1985
ISSN 0428·1276

ECONOMIC
COMMENTARY
A day doesn't pass without some public
discussion of the federal deficit. Advocates of immediate deficit cutting use
terms like 'explosive' and 'unstable' to
describe the debt burden, suggesting
imminent catastrophe. Others describe
this as hysteria, pointing to the current
performance of the economy as evidence
that nothing serious is wrong. Neither
view is quite right.
The deficit problem could more
properly be characterized as an insidious
danger, much like a slow leak in a car
tire. A tire with inadequate air pressure wears much faster, but worse, it
eventually becomes permanently
damaged and potentially dangerous.
Unfortunately, one cannot always tell
whether or not a tire is damaged by
looking at it from the outside. This
makes it difficult to assess how soon a
low tire will become dangerous; hence
it's always prudent to treat the problem
as urgent. One doesn't wait until an
accident occurs to acquire insurance.
Similarly, the case for urgent action
on the deficit is to insure against the
risk that government debt requirements
will stifle private investment that is
necessary for a healthy, growing
economy. The current state of the
economy, like the outside of the tire,
doesn't reveal the problem. The
unfortunate consequences of deficits
will manifest themselves in the future.
The insidious danger of large persistent deficits is that they are likely
to reduce growth of output and to reduce
our standard of living.

John B. Carlson is an economist at the Federal
Reserve Bank of Cleveland. The author would like
to thank Jim Siekmeier for especially capable research assistance and Ed Stevens, Gary Wyckoff.
and Owen Humpage for offering valuable com·
ments throughout the preparation of this article.

This Economic Commentary examines
some potential problems that could be
caused by large persistent deficits. It
begins by identifying conditions that
could lead to runaway debt. The real
cost of deficits - a primary element of
these conditions - is described in some
detail.
Recent projections by the administration and by Congress suggest that
while large deficits will persist, there
is no evidence they are explosive. Nevertheless, the projected deficits will lead
to a continued imbalance between
domestic credit demands and private
savings. The implications of this
imbalance are discussed in the final
section of this article.

The Potential of Runaway Debt
In some respects, the federal debt
situation is like debt in personal finance.
Early in adult life people typically build
up debt for a sustained period as they
purchase their first homes, furniture,
appliances, and cars. During this stage,
the change in a family's outstanding
debt has two components: one is
generated by interest payments on the
past accumulation of debt - debt
service - and the other is created by
current overspending - the primary

deficit.

l. Although debt service is sometimes defined to
include repayment of principal, it is assumed here
that principal due is refinanced.

The Debt Burden:
What You Don't See
by John B. Carlson

Debt service has a momentum of its
own, a momentum determined by
interest rates, and by the rate of increase
in the individual's income. To illustrate,
suppose an individual needs only to
borrow an amount equal to the interest
on his existing debt so that his primary
deficit would be zero. If the market
rate of interest were 10 percent, then
his debt would grow 10 percent that
year, even though his non-interest
expenditures would not exceed his
income. In this way, an initial level of
debt would increase at a rate equal to
the interest rate. The higher the interest
rate, the faster the debt would accumulate and the greater would be the
concern about default.
An increase in an individual's income,
on the other hand, would reduce concern
about his debt because it increases
his ability to service the debt without
further borrowing. Even if borrowing
and debt service were to grow over a
period, the momentum of debt service
would not be problematic unless debt
service were to increase persistently
at a rate faster than income. An
important distinction therefore is between
the interest rate paid on the debt and the
rate of growth in an individual's income.
This distinction is also relevant for
government debt. 2 Much attention has
been given to the issue of whether or
not deficits are explosive, that is,
whether or not the growth of debt service
alone could overwhelm growth in the

2. However, unlike the individual whose earning
potential will ultimately end, government income
(its revenues) can grow indefinitely at rates as fast
as the economy will allow. Most estimates of potential
growth of the economy exceed 2.5 percent annual
rates. Population growth alone generally assures
growth in advanced economies over long periods.

.,p..

economy. The term explosive is misleading because it refers to long-term
growth without limit that, like the tire
with a slow leak, does not necessarily
cause an immediate blowout.
The essence of the issue is simply
that debt cannot grow relative to GNP
without limit - and become runawaybecause borrowing to finance debt
service would ultimately absorb all
current income in the economy. In the
process, private incentives to invest
would be overwhelmed by the everincreasing credit needs of government.
Conditions sufficient for runaway debt
are that the level of the deficit exceed
the level of interest payments and that
the interest rate on government debt
be greater than the growth rate of
the economy. 3

The Net Real Cost of Debt
Most of us who have borrowed know
that the nominal interest rate is not an
accurate measure of the actual cost of
our debts. The real cost is affected
by our own marginal tax rates and by
inflation. These same factors are also
important in assessing the real burden
of government debt. 4 The appropriate
measure of the cost of private or public
debt is the interest rate adjusted for
inflation and taxes.
A home mortgage provides a clear
illustration of how the tax rate affects
the effective interest rate an individual
pays. Because an individual can write
off mortgage interest as a deduction
against taxable income, he offsets
part of his interest payments through
reduced taxes. For example, an individual in a 25 percent tax bracket will
recoup 25 percent of his interest payments. The net interest rate he pays
will be 25 percent less than the nominal
interest rate on the mortgage.
Federal income taxes also reduce
the effective rate that the government
pays on its debt, but by a reverse
process. Whereas the individual benefits
by reducing his tax liability, the federal
government benefits by increasing its
revenues because the public pays taxes

Increasing productivity will account for additional
gains. This seemingly endless potential for growth
has made deficit spending politically attractive.

on some of the interest payments. The
government recoups part of its interest
payments through extra taxes that are
paid on taxable interest income. A
common estimate is that the marginal
tax rate on government debt is about
25 percent. Thus, the after-tax nominal
interest rate paid by government would
be about 25 percent less than its average
nominal yield.
Inflation also has an important effect
on the burden of debt. To illustrate,
consider someone seeking a loan in a
market where the interest rate is
10 percent, while the expected rate of
inflation is 5 percent. Ignoring tax
advantages, the individual expects to
pay a real interest rate of only 5 percent.
That is, measured in terms of work
effort or commodities sacrificed, 5 percent
of the value of the debt will be paid in
interest. If inflation actually turns out
to be 7.5 percent, then the individual
pays only 2.5 percent in real terms. An
unanticipated increase in inflation
favors the debtor over the creditor, but
an unanticipated decrease in inflation
favors the creditor.
The same reasoning holds true for
government debt. The nominal interest
rate overstates the real cost of debt in
an economy with inflation. This suggests
an obvious way that a government
might reduce the real cost of its debt,
that is by deliberately pursuing
inflationary policies. This would only
work, however, if the public could be
fooled by continuous unanticipated
inflation into accepting a low interest
rate for government securities.
Although unanticipated increases in
inflation sharply reduced the real value
of federal debt in the 1970s, the government cannot count on surprises in
inflation. Most economists today believe
that policymakers have no advantage
over the public in anticipating inflation
and hence cannot adopt an inflationary
strategy to reduce the real cost of debt.
Unlike individuals, the Federal
government has another important
factor that reduces the real cost of its

3. These conditions are not necessary, however.
Deficits could be explosive even if there is a primary
surplus, that is, if the total deficit is less than interest
payments. If the primary surplus were not great
enough to cover growth in interest payments above
trend growth in the economy, the deficit would still
grow without limit relative to GNP.

..,

debt. This factor is seigniorage - the
revenue earned by the government
when it provides money for the economy.
In early exchange economies, seigniorage
was the profit taken from minting coins,
usually the difference between the
value of the bullion and the face value
of the coin."
In the modem U.S. economy, the
revenue from money creation is earned
by the Federal Reserve, which acquires
government debt when it supplies bank
reserves and Federal Reserve notes
(currency) - base money. The revenue
(minus relatively small and fixed
expenses) is turned back to the U.S.
Treasury. In effect, an increase in base
money directly reduces the net cost of
the Federal government's outstanding
debt. To obtain the net cost of government debt, one must exclude the effects
of seigniorage by reducing the nominal
interest rate by the proportion of
government debt held by the Federal
Reserve.
Taking account of all factors, the net
real interest rate on government debt
(rnel) is approximated by the following:
rnel=(1-m) (l-t)R-P,
where
m proportion of the debt monitized,
t average marginal tax rate,
R nominal interest rate, and
P inflation rate.

=
=
=
=

,..

other and to the real growth rate of
the economy.
Although econometric forecasting
models may provide reasonably reliable
estimates of these variables in the
short-run, the models are not considered
a reliable basis for long-term forecasting.
Nevertheless, medium-term projections
based on macroeconomic models, and
on rules of thumb, may offer some
indication about whether or not' the
deficit is on an explosive track.
Chart 1 Total Deficit, Interest Payments
on Debt, and Primary Deficit as
Percent of GNP
Percent
CBOPROJECTIONS

4
3
2

1985

1986

1987

1988

1989

1990

Is the Deficit Explosive?

4. The relevance of these and other factors for
federal debt dynamics was presented in Tobin's
discussion in Savings and Government Policy.
Conference Series No. 25, sponsored by the Federal
Reserve Bank of Boston, October, 1982, pp. 126-37.

CBO
rnd

1986
1987
1988
1989
1990
SOURCE:Congressional Budget Office;and Officeof
Management and Budget.

Recently the Office of Management
and Budget (OMB) and the Congressional
Budget Office (CBO) each released a
report that presented its projections of
federal revenues and spending through
1990. While the CBO projections
assumed that current laws and policies
would remain unchanged, the OMB
based its projections on the assumption
that Congress would pass the Reagan

5. Total revenue of government could be increased
so long as the government could induce the public
to hold additional coins without affecting the general
price level. Stable prices, then as now, implied some
constraint on seigniorage.

that a surplus would arise in the primary
deficit for 1989 and beyond. Besides
assuming passage of a deficit reduction
policy, the OMB projections are based
on an optimistic 4.0 percent growth
trend for real GNP. This assumes a
substantially faster growth in productivity
than prevailed in the 1970s.
Although neither of the projections
provides evidence of explosive deficits,
both seem precariously dependent on
optimistic recession-free outlooks.
Such outlooks imply that future deficits
would be almost exclusively structuralthat is, unrelated to the business cycle.
The OMB defends its trend growth
assumption on historical grounds. It
notes that from 1961 to 1969, the
economy grew 4.6 percent. But this
performance - the longest expansion
on record - was also accompanied by
accelerating inflation. Many analysts
are skeptical that non-inflationary
economic growth can endure for so
long. If a cyclical slowdown occurs in
the next three years, it would be quite
probable that the primary deficit would
jump sharply, reflecting the additional
spending on automatic stabilization
programs and reduced revenues. The

Table 1 Net Real Interest Rate on Government Debt
and Real Economic Growth Projections, Percent

The relevant value of each factor is the
equilibrium value, measured by its
expected long-term average. 6

Whether or not the deficit is explosive
depends on the net real interest rate
on government debt, rnel, and on the
trend growth rate of the economy (g).
If rnel is greater than g, and if the deficit
exceeds interest payments, then, sooner
or later, deficit financing required by
debt service will exceed total income
and output of the economy. The critical
problem then is to estimate long-run
average values of g and rnel> where
determinants are all related to each

administration's current budget proposals. Neither projection indicates
that the debt will become runaway.
However, taken together, they indicate
that a deficit reduction policy would
reduce the probability of such an event.
As chart 1 illustrates, the CBO
projections seem to suggest that the
deficit borders on being explosive, at
least over the five-year horizon, even
though output is projected to increase
without interruption. Interest payments
on debt rise relative to real output.
However, the estimates of rnel tell a
different story (see table 1). Because
rnel is less than g, interest payments
will ultimately slow relative to GNP.
Interest payments increase through
1990 only because the primary deficit
adds to the stock of outstanding debt
faster than the government can retire
debt with its increasing revenues.
Eventually, however, increases in
output will be more than enough to cover
interest payments on the accumulated
debt. At this time, the total deficit
would either stabilize or fall, relative
to GNP, depending on whether or not
the primary deficit were to stabilize
or to fall.

1.5

OMB
Growth in
real GNP

1985
1986
1987
1988
1989
1990

0.7
1.1
1.2
1.1
1.2

3.5
3.2
3.3
3.4
3.4
3.4

Average

1.2

3.4

rHei

1.2
0.9
1.0
1.2
na
na
1.1

Growth in
real GNP
3.9
4.0
4.0
4.0
na
na
4.0

NOTE: The net real interest roel was estimated by the ratio of net interest payments (adjusted for Federal Reserve
payments to the Treasury) to averageoutstanding debt for the same year. Anaverage marginal tax rateof 25 percent
was assumed. The real growth rate of GNP is on a calendar year basis; all other figures are on fiscal year basis.
SOURCES:Congressional Budget Office;and Officeof Management and Budget.

The OMB deficit projections are more
optimistic in that the total deficit falls
relative to GNP. While the OMB
published its interest payments projection only through 1988, it is apparent

addition of such cyclical deficits would
put increased pressure on credit markets,
potentially leading to conditions consistent with runaway deficits.

6. Indexation of tax rates makes a difference here.
The government recoups in tax revenues on the
amount of taxes paid on the interest payments it
makes on its own debt. The holders of debt report
the nominal value of interest payments as income.
Thus, the tax rates apply to the nominal yields. The
real net return is approximated by factoring out
the tax payments from the nominal return before

subtracting inflation. Until this year, tax rates were
not indexed. This meant that inflation, whether
anticipated or not, pushed taxpayers into higher
tax brackets. Thus, the average marginal tax rate
grew relative to income. While indexation of tax
rates will tend to stabilize marginal tax rates around
current levels, rising real income level will still
tend to raise the average marginal tax rate.