Wednesday, October 1, 2008

Is the deficit "too high" to do the bailout?

Summary at bottom

One of the big arguments I see against the bailout package is that it will just kill us in the long-run: not because of the moral hazard problems, not because it doesn't actually solve the credit crunch, but because the government will have to issue $700 billion in additional debt, which is supposed to be "just too high."

Well, admittedly, there could be some problems with crowding out of investments and interplay with foreign exchange rates, but in terms of actual direct impacts on our standard of living? $700 billion isn't likely to break the bank.

The problem with debt spending is that debts have to eventually be repaid. This means, in the long run, either higher taxes or lower government spending: there is no way around it.

But what cuts will we expect?

Let's assume that we will pay for this $700 billion bailout entirely with ten year treasury bonds. Let's also assume that this massive drop of money instantly causes the market to raise interest rates dramatically, so that we have to pay double the current interest rate: that'd be 7.54%.

What would we end up paying over the next 10 years? Using handy-dandy financial calculators, and assuming semiannual compounding, this becomes a cinch: $50.46 billion per year for the next ten years, or about $168 per American.
But we probably won't pay it all in 10 years. Some of that debt will be paid for with NEW debt...meaning that we will end up paying for this over a longer period of time than just 10 years.
So, let's assume we are paying over the next 60 years. What becomes the payment then? $26.7 billion per year, or a paltry $89 per American.

Now contrast that with a recession: What are going to we lose if we wind up in a recession for even one year? Negative 1% growth is a reasonable estimate, meaning, essentially, 4% of the economy is lost (that's because the economy should be growing at 3%)
4% of $13.794 trillion is approximately $551.8 billion.
But...we're not done. If that GDP growth had occurred in the first place, then we would be growing from THAT level: IE, we would be growing 3% on that $551.8 billion, so we lose another

Over the course of, say, 60 years, how much growth will be losing?
Let's assume 3% growth. Hell, let's assume things go bad and we grow only 2%. How much growth is lost? The answer is a cool $1.77 trillion.

"But," I hear people complain, "the increase in increase rates will hurt the private sector and drive down growth!"
The argument is that by printing more debt, the government crowds out private investment. And perhaps it theory.
Looking at the past 50 years, though, we'd be hardpressed to see the story.

Here's a look at real interest rates on US 10 year bonds since 1953. I made this one myself from:
Misery Index
Federal Reserve Documents

And now let's look at the per-person deficit (not a perfect measure, I know, but better than nothing, right?):

Real Interest Rates did indeed increase with the massive increase of the the first year of Reagan. They then fell, and continued to fall. Even today, with the Bush deficits, treasury rates don't seem to be moving anywhere in a northerly direction. Rather, rates remain relatively low (3.77% for a 10 year bond)

So, government deficits...don't really drive up interest rates. Or at least, I don't see evidence that it's doing so right now, or has in the past. Theoretically, it is possible: the government may just not be putting enough T-bonds on the market yet

-Cost of bailout: $89 per person over the 60 years (that's a high estimate)
-Cost of depression: $2.2 trillion (that's a low estimate_
-Real interest rates don't seem to be driven by government deficits

-Discount rates aren't used in this. Discount rates mean that a dollar in the future isn't worth as much to you as a dollar now. That's not adjusting for inflation, it just means you'd rather have a corvette NOW than 10 years from now. People prefer consuming in the present. If discount rates are used, then bailout looks a lot less attractive, since the $700 billion has to be paid out NOW.
-I am also ignoring that we will probably recoup a large amount of the $700 billion outlay
-I am also ignoring the direct effect on public finances, and looking only at social costs. In the short-term, taking on this debt will mean a lot less flexibility, and it means public finances will be in worse position until the debt is fully paid off (or, rather, the tax revenues from increased production pay off). That means that the "break-even" point for the government is later on than it is for society as a whole

1 comment:

Anonymous said...

60 years is too long. Too much can happen in that time. Worst case scenario we could not exist by that time. I would like to see our deficit severely lowered, not just this 700 billion bailout, but the whole deficit within the next 4-8 years.