U.S. President Donald Trump’s newly proposed budget provides an occasion to consider some basic macroeconomics of budgeting -- namely whether “g,” the growth rate of the economy, is likely to exceed “r,” in this case, the government’s borrowing rate. Viewed through this lens, it turns out the budget released Tuesday has a potential upside, but is best thought of as a huge unsound gamble.
For background, if we expect “g” to remain over “r,” a government need not worry much about budget deficits. If the economy is growing at 2 percent and the government’s borrowing rate is 1 percent, the economy can grow out of additional debt. If the government’s borrowing rate is higher than growth, the debt will pile up and eventually either cause a fiscal crisis or require serious retrenchment.
Where does the U.S. stand today? Core underlying rates of real economic growth seem to be running in the range of 2 percent. In contrast, the one-year Treasury yield is slightly above 1 percent in nominal terms, and somewhat negative in real terms, depending on what you think is the proper measure of inflation. Ten-year yields are slightly above 2 percent nominal and, after adjusting for inflation, a bit above zero in real terms. In other words, right now the growth rate of the economy exceeds borrowing rates, or “g” is greater than “r.”
If those conditions were to stay put (a big if, to which I shall return), a Trump budget could increase the deficit with impunity. And that is true even if the budget contains unrealistic “supply side” projections or receives scary reports from the Congressional Budget Office. The late Nobel laureate Paul Samuelson even suggested that in such situations budget deficits could usefully pull extra resources from the future into the present, for a net economic gain.
The Trump budget, while it is difficult to parse and involves contradictoryelements, includes big tax cuts and reductions in discretionary and transfer program spending, such as Medicaid. I disagree with many of the embedded priorities, but it is interesting to set aside the politics and consider this purely from a macro point of view.
Critics are complaining that the budget assumes 3 percent economic growth to make the numbers work, but that suffices if “g” remains higher than “r.” In other words, under default assumptions about the American economy, the Trump budget is affordable, even if it balloons the measured deficit for some period of time. The tax cuts are simply grabbing a kind of free lunch (borrow at 1 percent and invest at 2 percent or more), as Samuelson had suggested, but this is a point many Democrats are now putting on the back burner.
What’s also striking is that, if the Trump budget can work at all, the spending cuts are probably not needed. It would suffice to cut taxes only, and allow the economy to grow out of an even-greater budget deficit. In this regard, the Trump budget reflects a deep incoherence, and it inconsistently mixes various optimistic and pessimistic scenarios. If the spending cuts are required for fiscal stability, then we probably shouldn’t be doing the tax cuts.
This framework allows us to pinpoint the huge and, I would say, excessively dangerous gamble in Trump’s budget. There is no guarantee that the growth rate of the economy remains higher than the government’s borrowing rate. It is common in American history that government borrowing rates run 5 percent or higher, and the aging of the American population, or perhaps an unexpected catastrophe, such as a war, could lower the growth rate. And once a government becomes addicted to borrowing, it is hard to shake the habit, as subsequent tax increases damage economies.
Maybe growth rates will remain above interest rates, as futures markets seem to be indicating, but I would not stake the future of the republic on this. It also seemed in 2004 that home prices were doing fine.
In essence, the Trump budget is proposing the biggest leveraged “real estate development” -- for all of America -- in the history of this country. On one side, the critics are underestimating the possibility that this can be pulled off. But those who drew up the budget, and those who are defending it, don’t understand their own incoherence. By this point, virtually all involved seem to be wondering whether we have exactly the right CEO for a further bout of American risk-taking.