There’s been substantial discussion of how the debt-to-GDP ratio evolves under the Obama plan. In part, the House attempts to pare back certain provisions of the Obama budget are a reaction to the projected rise in the debt-to-GDP ratio [0].

Inspection of Figure 1 does provide some support for the view that we need to pare back spending, or raise taxes (seldom mentioned).

Figure 1: Ratio of Federal debt held by public to GDP (blue), CBO baseline (green), Obama budget as scored by CBO (black), and CBO baseline minus stimulus package (red), by fiscal years. Sources: CBO, CBO historical statistics, and CBO letter to Grassley (March 2, 2009), and author’s calculations.

I’ll make three observations at this point.

• A big chunk of the increase in the debt-to-GDP ratio occurs because of the recession-driven collapse in revenues and the policy actions undertaken by the previous administration and Congress. Graphically, this is shown by the sharp jump in the series in FY 2009 (which started in October 2008.
• The debt-to-GDP projections do not take into account the stimulative effects of the stimulus plan, and in the budget. This is appropriate (as I have argued in the past, in my discussion of dynamic scoring [1]) because the magnitude of the stimulative effect is a subject of debate. Still, for those who are neither RBCers, nor Classical economists, we would expect the actual path of the debt-to-GDP ratio to be lower than projected (ceteris paribus) as GDP is higher than baseline [2] [3].
• The baseline debt-to-GDP ratio is in some sense unrealistic because it assumes discretionary spending grows with the CPI. Assuming that discretionary spending grows with nominal GDP — a more realistic assumption [4] — would make the gap between the baseline and the Obama budget as scored by CBO smaller.

Still, even taking into account these factors, one should worry about crowding out, and the possibility that dollar denominated assets will become less desirable as the supply of Federal debt increases.

At this juncture, it might be useful to take a longer, historical, perspective on this issue. Below I plot data going back to FY 1938

Figure 2: Ratio of Federal debt held by public to GDP (blue), Ratio of end-FY Federal debt held by public to Calender Year GDP (real), CBO baseline (green), Obama budget as scored by CBO (black), and CBO baseline minus stimulus package (red), by fiscal years. Sources: CBO, CBO historical statistics, and CBO letter to Grassley (March 2, 2009), FRED II, and author’s calculations.

So, in the past, the Federal debt-to-GDP ratio has been higher than it is projected to be. Admittedly, the times are different. Financial autarky (approximately) prevailed in the 1940’s and early 1950’s, so the degree of substitubility between dollar and pound (and franc) denominated assets was low. That is not so now. However, it’s also important to realize that debt-to-GDP ratios are rising in many other economies that are associated with currencies that might be thought to be close substitutes (think UK). And in the euro area, doubts about the government debt of certain economies is likely to make euro denominated assets also poor substitutes. (Remember that many of the debt-to-GDP ratios in Europe are higher than that in the US — see slightly different [gross] ratios here). In any case, the analysis of the dilemma we are currently facing I laid out in this post from last July.

A last observation. Just think if the 2001 and 2003 tax cuts had never occurred. What would the debt-to-GDP ratio look like? I suspect we’d have a lot more latitude for stimulus. Not a new observation — see here (and the accompanying commentary, which in retrospect is quite amusing) — but one useful to recall.

Last 5 posts by Menzie Chinn

• Blogonomics: Some Random Thoughts - November 26th, 2009
• Debt and Interest Rates: Some Empirical Evidence and Implications - November 23rd, 2009
• Baselines, Counterfactuals and the Stimulus - November 21st, 2009
• China, the Renminbi, and Global Imbalances: A Quantitative View - November 20th, 2009
• GDP: Revisions and Forecasts - November 19th, 2009