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Which U.S. Administration is Fiscally Responsible?

Merih Uctum
July 31, 2017

Several times since 2010 the U.S. government has faced the possibility of hitting a debt ceiling, a situation where, if not raised, the U.S. Treasury is not able to borrow to pay its bills on expenditures that were voted and already incurred.  Since the U.S. Congress ratifies the spending package, raising the debt ceiling to finance the spending has typically been automatic.  But that was not the case in 2013 where the debt ceiling conflict culminated in a government shutdown.

We are fast approaching the next deadline when the government will hit yet another debt ceiling, now expected to be in October of this year.  Overall, the U.S. government has a tradition of following responsible policies: as debt rises, the government reacts to it by reducing the primary deficit or generating a primary surplus, defined as tax revenues minus spending excluding debt service, a pattern that was repeated most drastically by the previous administration despite economic weakness.

In this post, we examine the reaction to rising public debt during each administration since the 1970s.  We use both descriptive figures and evidence from an econometric study to show that the Republican charge against Democrats is unfounded. Since the early 1970s, Republican administrations have started their mandates with lower levels of debt and have bequeathed higher levels to the Democrats.

Debt and deficit since the 1970s

Although most talk in the media is about debt in nominal U.S. dollars, policy analysts look at the figure as it relates to the productive capacity of the economy and analyze it as a proportion of nominal gross domestic product (GDP). The idea is that as the economy expands, it can support a larger nominal amount of debt or deficit.

Figure 1 shows the time plots of the debt-to-GDP and the deficit-to-GDP ratios since the late 1960s.  The light blue and pink areas represent Democratic and Republican administrations, respectively, and the dotted vertical lines denote the business cycles peaks and troughs as defined by the National Bureau of Economic Research. Looking at these trends leads to two observations: (i)  By the beginning of 2013, the debt-to-GDP ratio (blue line) reached a level unprecedented since 1973, equaling levels attained only during the Great Depression of 1933. However, public debt by itself is simply the result of the cumulated deficit, which is a reflection of public policy and business cycles (red line). (ii) An inspection of the behavior of the deficit line shows that the recent debt explosion was caused by the spectacular increase in the deficit during the Great Recession that started under the Bush administration. By contrast, during the subsequent administration, the government reversed this negative trend by reducing the deficit before the impact of recession ended and continued doing so before the recovery was established.   

Looking back, it is interesting to note that over this period Republican administrations started their mandate with low deficits and end with higher deficits. By contrast, Democratic administrations start with higher deficits and end with lower deficits.

Figure 1: US Public Debt and Deficit Ratios

We can dig deeper into these figures by examining the two components of the deficit (Figure 2), outlays (red line) and revenues (green line), along with the primary deficit (blue line). The primary deficit follows closely the total deficit in Figure 1. It has been mostly negative since the late 1960s but turned significantly positive during the Clinton Administration with a combination of decreased spending and increased revenues. During the Bush Administration, the two lines diverged, first because of tax cuts and increases in spending due to the expansion of Medicare, second because of the financing of two wars through borrowing, and finally because of the Great Recession. Under the Obama Administration, both lines begin to converge again.

Figure 2: US Primary Balance, Outlays, and Revenues (ratios to GDP) 

Is the U.S. government fiscally responsible?

One way of verifying the solvency of government policies is to look at whether the government systematically reacts to debt accumulation by generating a primary surplus or reducing the primary deficit. We saw in Figure 2 that the primary deficit is often reduced. But is this a systematic policy or is it simply due to improving economic activity that raises tax revenues and cuts fiscal stabilizers? Using an econometric technique, we estimate a model of a government reaction to the buildup of debt and compare the government behavior between the two administrations.  This technique yields an estimate of the impact of government policy on the deficits and debt apart from any effects of an improving economy. 

Figure 3 illustrates what happens to primary balances over a ten-year period following a 1% increase in the Federal debt.  We find that overall, the US government starts raising the surplus within a year (starred line), so the US debt is sustainable (left panel).  However, the pattern of changes in the surplus differ dramatically between administrations with a Democratic President and Republican President.  While the Democratic President Administration immediately starts generating a surplus and paying the debt back (middle panel), under the Republican President Administration the surplus rapidly vanishes and the government starts adding to federal debt (right panel).  Changes in debt can be best seen in Figure 3 where the primary balances are cumulated (straight line).  At the end of the eigth year, the Democratic President Administration reduces the debt/GDP ratio by more than the initial 1% increase, while the Republican President Administration reduces it only by 0.1%.

Figure 3 Response of the Primary Surplus to a 1% Increase in Debt (ratios to GDP)

 

Debt-ceiling crises and a dim picture in the future

The costs associated with a failure to raise the debt ceiling are multilayered and go well beyond the mere government shutdown. In addition to the economic cost, successive debt-ceiling crises create a much more harmful uncertainty about the ability of the U.S. government to honor its commitments. This can affect its credit standing, as happened in 2012 when the U.S. AAA rating was downgraded and can hurt the dollar’s international reserve currency status. The dollar has enjoyed an unchallenged supremacy, which lowers U.S. borrowing costs by 0.8 to 1 percent. The Government Accountability Office estimated that the probability of default increased the government’s borrowing cost by 0.5 percent in the last crisis in 2011. In the long term, if the reputation of the U.S. economy is damaged, this could result in a permanently higher cost of borrowing and bigger deficit and debt.

However, both an aging population and rising interest rates put greater pressure on the deficit in the next 30 years.  The Congressional Budget Office predicts that by 2047 the deficit will grow back to 9.8 percent of GDP. Discretionary spending (education, welfare, infrastructure, etc.), will amount to only 7.6 percent of GDP or a quarter of total federal government spending.  Cutting discretionary spending as proposed by the Republican administrations not only slows down the economy and fails to put a dent into the deficit but as the European experience has shown, it can exacerbate budget problems during a slowdown by reducing revenues. This forecast into the future clearly calls for a national discussion about our social welfare priorities if we are to build a fiscally sustainable future.

Which U.S. Administration is Fiscally Responsible?2018-07-04T19:37:50+00:00

Tech. Note: Which U.S. Administration is Fiscally Responsible?

Merih Uctum
July 31, 2017

Model

We conduct a time series analysis of the government reaction function using impulse response of the primary surplus/GDP ratio to an increase in debt/GDP ratio.  This is one of the metrics used in the fiscal policy literature to measure the sustainability of the public finances.  First developed by Bohn (1995), it consists in testing whether the government generates a primary surplus when debt/GDP increases over time in order to reduce it

[1] using a simple reaction function:

(1) st = α + Βbt-1 + γgt + et, where et~i.i.d.

Where s, b and g are the share of primary surplus to GDP, the share of government debt to GDP, output gap, respectively.  Primary surplus is defined as government tax revenues net of government spending, and it is equal to government deficit excluding the debt service component.  Output gap is deviation of real GDP from its potential.  Sustainability requires Β>0: as debt accumulates, the government has to generate a primary surplus.  It can do this either by reducing the spending or increasing taxes or both.  This is a partial equilibrium model that ignores the secondary effects of a change in debt and deficit on interest rates and the feedback to the government budget.  The impact of business cycles is proxied by the variable gap.  When GDP rises above its potential, primary surplus is expected to rise, γ>0.

In order to introduce the political economy dimension in our analysis we include two multiplicative dummy variables on the coefficients of debt/GDP and output gap.  DUMD represents the years with a Democratic President Administration (DP Administration) and  DUMR = 1 – DUMD the years with a Republican President Administration (RP Administration).  The model then becomes:

(2) st = α0 + Β1DUMDbt-1 + Β2(1-DUMD)bt-1 + γ1DUMDgt + γ2(1-DUMD)gt + εt

Data and Methodology

All data come from Bureau of Economic Analysis except potential GDP that is from CBO and are from 1976 to 2017 and is annual.  We divide the sample into two, democrats and republicans.  Each subsample consists of the years during which the president from one of the parties is in power.   covers the years 1966-68, 1977-1980, 1993-2000, 2009-2016 and  the years 1969-76, 1981-92, 2001-08, 2017.  We first test the stationarity of each variable.  Tests reject non stationarity of all the first differenced series at the 5% confidence level (10% level for debt/GDP) suggesting that they are integrated of order one.  To control for the impact of recessions on the estimation, we generate a dummy variable, recess, where we indicate with 1 each NBER recession period from peak to through and include it as an exogenous variable into the estimation equation. 

The VAR lag order selection criteria (Table 1, top panel), such as Likelihood Ratio, FPE, and Akaike information criteria indicate that 4 lags are optimal.  Since for small samples AIC is more appropriate, we select 4 lags.  Both the Trace test and the maximum Eigenvalue test in the Johansen Full Information Maximum Likelihood (FIML)test suggests one cointegrating equation for three model assumptions concerning deterministic trends (Table 1, lower panel).  We select the more flexible model that allows for linear deterministic trend in the data and no intercept in the VAR, which is also supported by Schwarz criteria. 

Next, we proceed to build a Vector Error Correction Model (VECM) with 3 lags determined optimally as described above:

(3) Δyt = -Πyt-1 + ∑i=1 ΦjΔyt-i + ui,

where yt = [st, bt-1, gt]’, Π = (I-∑i=1Ai) and Φi = -∑i=1Aj = -A(L).

We present below the impulse responses (IRs) for 10 periods.

Results

Table 2 presents the long-run cointegration relations under the two administrations.  An increase in the debt/GDP ratio generates a primary surplus in the economy, irrespective of the political party in the administration, indicating that the US government is overall fiscally responsible and does not let debt accumulate without reacting to it.  This suggests that the US debt is sustainable.  As expected, an increase in output gap, i.e. a rise of GDP above its potential is associated with an increase in the primary surplus, under both administrations, spurred by higher tax revenues.  However, quantitatively both estimates are starkly different under both administrations.  When the debt/GDP ratio goes up, over the long run, DP Administrations generate a primary surplus that is twice larger than that of a RP Administration to pay the debt back, suggesting that unsustainability of debt is likely to become a bigger issue under the latter.  Similarly, a positive output gap creates a larger surplus under a DP Administration than RP one.

Do these results also hold in the short run?  To answer this question, we now turn to impulse response functions.  Table 3 (Figure 3 in the text) illustrates the response of the primary surplus to one percent change in the innovation of the lagged debt/GDP ratio.  Here also the short-run results are consistent with the long-run results.  When debt rises by 1% a democratic administration starts generating a surplus immediately following the year when debt rises and starts reducing it.  It continues doing so every period and at the end of the 8th year, it accumulates 1.59% surplus, more than   A Republican President Administration, however, allows the primary deficit to continue throughout the fourth year, turns the budget into a surplus only after a large lag and at the end of the eighth year accumulates a surplus of only 0.36%. 

In practice, once recovery takes place, with a virtuous cycle the primary surplus continues to rise independent of government’s reaction and reins in debt accumulation, as can be seen from the full-sample reaction function (Figure 3, left panel).  Although the impact of the business cycle is controlled for, as mentioned above, this is a partial equilibrium model and ignores other channels through which debt and deficit interact with each other, such as change in the cost of borrowing, external and internal factors.  Yet, it also isolates the reaction of the government under various administrations, which the raw data hint at in Figures 1 and 2.

Table 1: Lag and Rank Order Selection

Lag order

LAG log(L) LR FPE AIC SC HQ
1 -855.5271 392.2858 3.65e+10 38.50118 39.69377* 38.94793
2 -810.0298 69.23498 1.56e+10 37.60999 39.79641 38.42904*
3 -793.6648 21.34567 2.51e+10 37.98543 41.16567 39.17676
4 -744.2902 53.66800* 1.08e+10* 36.92566* 41.09973 38.48929

Rank Order

Data Trend None None Linear Linear Quadratic
Test Type No Intercept, No Trend Intercept,
No Trend		 Intercept,
No Trend		 Intercept, Trend Intercept, Trend
Trace-Max 3 3 1 1 1
Eigenvalue 2 2 1 1 1

*Critical Values based on MacKinnon-Haug-Michelis (1999).

Table 2 : Cointegrating Equations

st 1.000000
DUMD*bt-1 -0.15706
  [-4.67674]
(1-DUMD)*bt-1 -0.06647
  [-1.99883]
DUMD*gt -0.03307
  [-12.3364]
(1-DUMD)*gt -0.01415
  [-4.25750]
Trend 0.085705
  [2.08808]
C -2.39962

5% t-statistics are in parentheses.

Table 3 Impulse Response of primary surplus to a 1% change in debt/GDP

Response Period DP Administration   RP Administration  
  Level Cumulative Level Cumulative
1 0.00  0.00 0.00 0.00
2 0.21  0.21  0.00  0.00
3 0.29  0.50  -0.17  -0.17
4 0.24  0.74  -0.07  -0.23
5 0.26  1.00  0.03  -0.20
6 0.26  1.26  0.09  -0.11
7 0.18  1.44  0.10  -0.01
8 0.16  1.59  0.10  0.09
9 0.14  1.74  0.12  0.21
10 0.13  1.87  0.15  0.36

[1] See Bohn 1995, and Uctum at al. 2006, Polito and Wickens 2012 for literature review and application.

References

Bohn, H. 1995. The sustainability of public deficits in a stochastic economy.  Journal of Money, Credit and Banking 27, 257-271.

Polito, V. and Wickens, M. 2012. A model based indicator of the fiscal stance. European Economic Review 56, 526-551.

Uctum, M. Thurston, T. and Uctum, R. 2006. Public debt, the unit root hypothesis and structural breaks: a multi-country analysis.

Tech. Note: Which U.S. Administration is Fiscally Responsible?2018-07-04T19:37:50+00:00

July 28: U.S. GDP Rose 2.6 Percent in Q2, According to the BEA Advance Estimate

U.S. GDP, after its slump in the first half of last year, is back resting comfortably in its trend 2% real rate of growth path. Inventory, government spending, and other random quarterly events have created the illusion of more volatility than there really is. Real final sales of domestic product was up 2.6% Q/Q SAAR in Q2 compared to 2.7% in Q1. On a Y/Y basis, 2.2% in Q2 and Q1. On the buying side, real final sales to private domestic purchasers was up 2.7% Q/Q SAAR in Q2, a slight slowdown from the 3.1% pace in Q1. On a Y/Y basis – 2.8% in Q1 versus 2.9% in Q1. Read more

July 28: U.S. GDP Rose 2.6 Percent in Q2, According to the BEA Advance Estimate2018-07-04T19:37:50+00:00

July 26: New York State GDP Expanded by 0.3 Percent in Q1

New York State GDP expanded by 0.3 percent at a seasonally adjusted annual rate in the first quarter of 2017. This growth rate roughly matches the 0.4 percent rate recorded in the fourth quarter of 2016, but is below the 1.4 percent GDP growth rate recorded nationwide in the first quarter of 2017. Read more

July 26: New York State GDP Expanded by 0.3 Percent in Q12017-08-18T18:03:40+00:00

July 20: Total Employment in New York State in June Was up 1.7 Percent from a Year Ago

Total employment in New York State in June was up 1.7 percent from a year ago, supported by the 2.3 percent year-over-year job growth rate in New York City.  The state and city job growth rates were both above the 1.5 year-over-year percent growth in jobs nationwide The state’s 4.5 percent unemployment rate in June roughly matched the 4.4 percent nationwide unemployment rate. Read more

July 20: Total Employment in New York State in June Was up 1.7 Percent from a Year Ago2017-08-18T18:04:55+00:00

A Finger Exercise on Hyperglobalization

Paul Krugman
July 11, 2017

The days when surging world trade was the big story seem like a long time ago. For one thing, trade has stopped surging, and seems to have plateaued. For another, we have faced more pressing issues, like financial crisis.

But I recently gave a presentation on trade issues, have been playing around with them again, and anyway want to take occasional breaks from the headlines. So I find myself trying to find simple ways to talk about “hyperglobalization,” the surge in trade from around 1990 to the eve of the Great Recession. None of the underlying ideas is new, but maybe some people will find the exposition helpful.

The idea here is to think about the effects of transport costs and other barriers to trade pretty much the same way trade economists have long thought about “effective protection.” 

This concept was introduced mainly as a way to understand what was really happening in countries attempting import-substituting industrialization. The idea was something like this: consider what happens if a country places a tariff on car imports, but not on imports of auto parts. What it’s really protecting, then, is the activity of auto assembly, making it profitable even if costs are higher than they are abroad. And the extent to which those costs can be higher can easily be much bigger than the tariff rate.

Suppose, for example, that you put a 20% tariff on cars, but can import parts that account for half the value of an imported car. Then assembling cars becomes worth doing even if it costs 40% more in your country than in the potential exporter: a nominal 20% tariff becomes a 40% effective rate of protection.

Now let’s switch the story around, and talk about a good an emerging market might be able to export to an advanced economy. Let’s say that in the advanced country it costs 100 to produce this good, of which 50 is intermediate inputs and 50 assembly. The emerging market, we’ll assume, can’t produce the inputs, but could do the assembly using imported inputs. There are, however, transport costs – say 10% of the value of any goods shipped.

If we were talking only about trade in final goods, this would mean that the emerging market could export if its costs were 10% less – 91, in this case. But we’ve assumed that it can’t do the whole process. It can do the assembly, and will if its final costs including inputs are less than 91. But the inputs will cost 55 because of transport. And this means that to make exporting work it must have cost less than 91-55=36, compared with 50 in the advanced country.

That is, to overcome 10% transport costs this assembly operation must be 28% cheaper than in the advanced country.

But this in turn means that even a seemingly small decline in transport costs could have a large effect on the location of production, because it drastically reduces the production cost advantage emerging markets need to have. And it leads to an even more disproportionate effect on the volume of trade, because it leads to a sharp increase in shipments of intermediate goods as well as final goods. That is, we get a lot of “value chain” trade.

This, I think, is what happened after 1990, partly because of containerization, partly because of trade liberalization in developing countries. But it’s also looking more and more like a one-time thing.

A Finger Exercise on Hyperglobalization2018-07-04T19:37:51+00:00

July 7: Total Employment Increased, but the Unemployment Rate Ticked up to 4.4 Percent

Total nonfarm payroll employment increased by 222,000 in June, and the unemployment
rate was little changed at 4.4 percent, the U.S. Bureau of Labor Statistics reported
today. The unemployment rate ticked up as more Americans rejoined the workforce. Employment increased in health care, social assistance, financial activities,
and mining. Continue Reading

 

 

July 7: Total Employment Increased, but the Unemployment Rate Ticked up to 4.4 Percent2017-07-07T15:21:32+00:00

The United States, Mexico, and NAFTA

The Economic Studies Group
Jun 28, 2017

The terms of current and proposed U.S. trade agreements are getting renewed attention as to their impacts on the U.S. economy and workforce.  Recently, U.S. trade with Mexico has become a particular focus for reconsideration as trade between the two countries has grown remarkably since the 1994 passage of the North American Free Trade Agreement (NAFTA), and reaching agreement on the benefits and costs of NAFTA has been hard.

Most of the recent discussion centered around the impact of trade on the loss of U.S. jobs in manufacturing.  While the factors causing this outcome are diverse and not limited to NAFTA, ranging from globalization and automation to monetary and fiscal policies, the argument leaves out the benefits that are derived from trade with Mexico   Several features of U.S.-Mexico trade flows were noted in a recent analysis of the U.S-Mexico trade relationship by the Trade and NAFTA Office of the Ministry of the Economy of Mexico, and could warrant consideration in any review of NAFTA.  In this post, we highlight four of the features of that analysis: the intra-industry nature of goods trade, the U.S. surplus in services trade, the specialization in agricultural trade and the geographic concentration of the importance of Mexico to state exports.   Each of these presents an aspect of U.S.-Mexico trade that is related to the potential benefits and costs of a renegotiated agreement.

U.S. trade with Mexico has grown dramatically since the passage of NAFTA.  The figure below shows roughly balanced trade in 1994 totaling $100 billion expanding to $525 billion by 2016 and with a bilateral deficit of about $63 billion.  With $1.5 billion dollars in products traded bilaterally each day, Mexico has become the third largest partner and the second largest export market for the U.S., and the second largest supplier of imports. 

A closer look at the trade flows indicates that trade has strengthened supply chains in key industries, particularly autos and electronics.

 

 

These intermediate goods also comprise a large share of Mexico’s exports to the U.S., though there is a larger component of finished goods.  These bilateral trade flows further indicate that U.S.-Mexico trade reflects the expanding supply chain between manufacturers in the two countries.

 

More generally, U.S, exports to Mexico consist largely of intermediate goods or products that are used as inputs into the manufacturers in the two countries.  In fact, it has been estimated that there is 40 percent value added by U.S. producers in Mexico’s exports, a figure much larger than that for other suppliers.

 

U.S. – Mexico trade in services has also expanded greatly since the 1990s.  Much of that trade is in the area of travel and transportation, rough 65 to 70 percent, but there is also trade in telecommunications and financial services.  And similar to overall U.S. trade flows, the U.S. maintains a surplus in services trade with Mexico.

 

Trade in agricultural products between the two countries is also large, with the U.S. exporting about $18 billion worth of products to Mexico and importing almost $25 billion worth of products from Mexico annually.  The composition of this trade reflects the resources of the two countries.  A look at the 2016 trade figures below shows, U.S. exports consist of meats, dairy products, grains, and oilseeds while U.S. imports comprise a large amount of fruits, vegetables, and beverages.

 

The concentration of U.S. goods exports to Mexico in autos, electronics, and other intermediate inputs together with these agricultural exports of U.S. staples suggests an uneven geographic pattern of the source of these exports.  The figure below looks at states and shows that Mexico is an important export market for the four border states, and South Dakota, Nebraska, Iowa, Missouri, and Kansas in the Midwest, and Michigan, and Mexico ranks among the second and third largest export markets for 21 additional states.

 

The data on trade flows between the U.S. and Mexico suggest that the economic relationship between the two countries has several specific features that should be considered in the discussion of a renegotiation of NAFTA.  The evolution of goods trade into a large component that reflects supply chains within manufacturing firms and industries could be costly to break.  The composition of trade in agricultural products and services actually suggests a more typical pattern of trade observed with other countries.   So, it is really with regard to goods trade that negotiators need to bear in mind that the composition of trade flows reflects the evolution of intra-firm and inter-industry relationships that have developed over time.     

The United States, Mexico, and NAFTA2018-07-04T19:37:51+00:00

June 14: Federal Reserve to Raise Fed Funds Target Range to 1 to 1.25 Percent

In view of realized and expected labor market conditions and inflation, the Committee decided to raise the target range for the federal funds rate to 1 to 1-1/4 percent. The stance of monetary policy remains accommodative, thereby supporting some further strengthening in labor market conditions and a sustained return to 2 percent inflation. Read more

June 14: Federal Reserve to Raise Fed Funds Target Range to 1 to 1.25 Percent2017-06-14T20:54:04+00:00
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