This Selected Issues paper focuses on U.S. potential growth in the aftermath of the crisis. It discusses recent productivity developments in the nonfarm business sector. The paper uses back-of-the envelope calculations to gauge the effect of diminished financial sector activity on GDP growth in coming years. A simple production function framework is used to give a long view of key factors explaining potential GDP growth in the United States in the last 30 years and explore possible developments in the next few years.

Abstract

This Selected Issues paper focuses on U.S. potential growth in the aftermath of the crisis. It discusses recent productivity developments in the nonfarm business sector. The paper uses back-of-the envelope calculations to gauge the effect of diminished financial sector activity on GDP growth in coming years. A simple production function framework is used to give a long view of key factors explaining potential GDP growth in the United States in the last 30 years and explore possible developments in the next few years.

IV. The U.S. Federal Debt Outlook: A Stochastic Simulation Approach

Oya Celasun and Geoffrey Keim

A. Introduction

1. The future path of U.S. federal government debt is subject to an unusual level of uncertainty. Current federal debt projections (Figure 1) rely on highly uncertain projections for the economic outlook, future course of fiscal policies, and gross borrowing needs for measures to stabilize the financial sector.1 Carefully assessing the risk profile of debt projections is important for policymakers since the public debt outlook has potential implications for borrowing costs in the United State and abroad, and puts limitations on the set of feasible future fiscal policies.

Figure 1.
Figure 1.

Federal Debt Held by the Public

Citation: IMF Staff Country Reports 2009, 229; 10.5089/9781451839746.002.A004

Sources: Office of Management and Budget; Haver Analytics; and Fund staff estimates.

2. Drawing on stochastic simulations, this chapter quantifies the uncertainty surrounding medium-term debt projections.2 It derives frequency distributions for debt over the horizon 2011–19 based on plausible constellations of shocks to real output, interest rates, and primary balances. The chapter also evaluates debt profiles under two alternative assumptions for the evolution of the primary balance: the primary balance path implied by the President’s FY 2010 Budget Proposal versus a primary balance path implied by estimated past policy adjustments to changing debt levels and the output gap.

B. Results

3. Federal primary budget balances in the United States. have historically increased rapidly in response to higher debt and the deviation of real GDP from potential output. A simple estimated fiscal reaction function for the period 1949–2008 suggests that the primary balance has risen on average by 0.039 percent of GDP for a one percentage point of GDP increase in debt held by the public (Table 1). This result can be interpreted as indicating policymakers have bolstered public finances in response to increases in debt, and suggests that fiscal policy has on average been responsible. Likewise, the primary balance has on average increased by 0.310 percentage points of GDP given a percentage point increase in the output gap, illustrating the sensitivity of the federal government balance to economic conditions. Notably, however, actual surpluses exceeded the predicted levels quite significantly in most of the 1990s, but fell short of the model predictions over most of the 2000s (Figure 2).

Table 1.

Determinants of the Primary Balance

article image
Note: Standard errors are shown in brackets. *** and ** denote significance at the 1 and 5% levels, respectively. Ordinary least squares estimation, dependent variable: the Unified Federal Government Primary Balance as a percent of GDP. Sample: 1948-2008.
Figure 2.
Figure 2.

Actual vs. Predicted Primary Balances

Citation: IMF Staff Country Reports 2009, 229; 10.5089/9781451839746.002.A004

Sources: Office of Management and Budget; Haver Analytics; and Fund staff estimates.

4. The policy proposals under the FY 2010 budget would lead to a significantly higher level of debt than the path of primary surpluses implied by historical policy behavior. Under the Staff’s baseline macroeconomic projections, if primary balances from 2011 onwards were to follow the equation estimated above using historical data, debt would decline to around 67 percent of GDP by 2019 (Table 2). By contrast, the FY 2010 budget projections—adjusted for differences between the Staff’s and the Office of Management and Budget’s (OMB) macroeconomic assumptions—would bring debt to almost 100 percent of GDP by 2019.3

Table 2.

Primary Balances and Debt Under Staff’s Baseline Projections vs. Historical Primary Surplus Behavior

(Fiscal years, in percent of GDP)

article image
Sources: Office of Management and Budget and Fund staff estimates.

5. Stochastic forecasts of growth and real interest rates derived from a vector autoregression model, combined with the primary surplus path under staff’s baseline, imply a significant degree of uncertainty around debt projections. The probability that FY 2019 debt would fall into the range of 69–107 percent of GDP would be 80 percent, with a relatively greater chance of debt falling into the upper half of that range (Figure 3).4 The probability of debt being higher than the Administration’s projection of 67 percent of GDP in 2019 would top 90 percent. The staff’s baseline debt projection is higher than the mean path of the simulated debt distribution since the average economic forecast based on the estimated VAR is more favorable than the economic assumptions under the staff’s baseline. Nonetheless, debt would exceed Staff’s baseline debt projection with a probability of more than 20 percent in 2019.

Figure 3.
Figure 3.

Debt Profile Under Projected Primary Surplus Behavior

Citation: IMF Staff Country Reports 2009, 229; 10.5089/9781451839746.002.A004

Sources: Office of Management and Budget; Haver Anaytics; and Fund staff estimates.Note: The dark cone in the center is the 20 percent standard error interval around the median projection, and the overall cone marks the 80 percent confidence interval.

6. Combining the estimated historical primary surplus reaction function with stochastic forecasts of real GDP growth and real interest rates—and allowing for empirically realistic shocks to the primary surplus—imply a much more favorable median projection but slightly larger risks around the baseline. If the federal government on average adjusts the primary surplus as it has done in the past—implying a stronger improvement in the primary balance than under the baseline projections—the probability that debt would exceed 67 percent of GDP by year 2019 would be around 40 percent (Figure 4). Notably, with 80 percent probability, debt would be lower than the level it would reach under Staff’s baseline by 2019.

Figure 4.
Figure 4.

Debt Profile Under Historical Primary Surplus Behavior

Citation: IMF Staff Country Reports 2009, 229; 10.5089/9781451839746.002.A004

Sources: Office of Management and Budget; Haver Anaytics; and Fund staff estimates.Note: The dark cone in the center is the 20 percent standard error interval around the median projection, and the overall cone marks the 80 percent confidence interval.

C. Conclusions and Policy Implications

7. Fiscal policies that yield a strong primary balance response to debt in line with the historic experience in the United States would imply a much higher chance of bringing debt to levels projected by the Administration in the medium term, as compared with the FY 2010 budget projections adjusted for the staff’s baseline economic forecasts. Taking account of the joint stochastic behavior of real growth and real interest rates suggest significant uncertainty around the debt projections, with risks tilted toward a higher level of debt at the end of the forecast horizon, especially if primary surpluses do not rise to the same degree in response to rising debt as they have since 1949.

1

The Staff’s fiscal projections are based on the Administration’s FY 2010 budget proposal adjusted for differences in the staff’s macroeconomic projections and assumptions on the costs of financial system stabilization policies.

2

A vector autoregression (VAR) model is estimated for real GDP growth and real interest rates on three-month and 10-year Treasury debt. A large number of stochastic forecasts are then derived from the estimated equation system, with shocks to the variables sampled from the estimated joint error probability distribution. For a description of the methodology see Celasun, O., X. Debrun, and J. Ostry, 2006, “Primary Surplus Behavior and Risks to Fiscal Sustainability in Emerging Market Countries: A Fan Chart Approach”, IMF Staff Papers, Vol. 53 (3), pp. 401–25.

3

The Administration’s FY 2010 budget projects debt to reach levels similar to those that would be obtained under the assumption of historical fiscal behavior, but with much less primary fiscal effort.

4

The asymmetry (upward skewness) of the debt distribution around its mean reflects the relatively greater likelihood of adverse economic outcomes and debt dynamics—real growth falling short of real interest rates through the forecast horizon—given the unfavorable initial economic conditions.

United States: Selected Issues
Author: International Monetary Fund