For this post, I want to focus on the question of whether our deficits are sustainable or unsustainable, and what makes them the one or the other. All of what follows comes from an article by James Galbraith, John Kenneth Galbraith's son, and like his father, a noted economist and writer. Galbraith presents a formula developed by Willem Buiter, former adisor to the Bank of England and now an economist at Citibank, for describing the elements that contribute to the debt/GDP ratio. Here is the formula and some explanation:

∆d = –s + d* [(r–g)/(1+g)]

"Here, d is the starting ratio of debt to GDP, s is the “primary surplus” or government budget surplus after deducting net interest payments (as shares of GDP), r is the real interest rate, and g is the real rate of GDP growth. This formula permits us to put the discussion of debt sustainability on a much clearer foundation. We can say that a path that leads to uncontrolled and explosive increases in the ratio of debt to GDP is “unsustainable”—in the precise sense that the path will have to be changed to prevent the explosion from occurring."

Now here is Galbraith's own chart derived from the CBO Baseline Scenario:

Obviously, this is the pits: a debt to GDP ratio going up over 500%. CBO had us at about 300% by midcentury. What are the assumptions here: Nominal interest rate is plugged by CBO and Galbraith at 5%, inflation is set at 2%, meaning real interest rates are 3%; GDP growth rate is 3%; the starting debt/GDP ratio is .74; and the budget defiit stays at 5% of GDP.

But Galbraith asks if these interest rate assumptions are reasonable. The Government does not need to issue long term debt, with its higher rates; it can stay with the much lower short term rates (right now, just above zero). So he runs the model again with one change: nominal interest rates are set to 1%, not 5%. Here's the result:

Obviously a much prettier picture. And if we still think the almost 130% debt/GDP ratio is too high, then Galbraith runs numbers with a 5% budget deficit for 15 years, dropping back to 3%. Here's what he gets:

It turns out that if the real interest rate is positive, any amount of deficit is unsustainable. But with interest rates below the rate of inflation, quite significant levels of budget deficits can be "manageable."

My question: what will Republicans do when we Americans stop being afraid? There are clearly other questions related to deficits and the economy; but certainly one of them has been this fear that our "unfunded entitlements" were going to overwhelm the economy, in the form of rising debt/GDP ratios, and our kids' lives would be ruined. This is simply poppycock. Much more about this soon.

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