what we know about government budget problems

[Dave Backus @ NYU]

An excerpt from a piece Tom Cooley and I wrote connecting the work of
Sargent and Sims to government budget problems in the US and Europe:

These classic academic papers [by Sargent and Sims] address, in
different ways, the underlying logic of the [government budget]
problems we face right now [in the US and Europe]. Governments
finance their deficits by collecting taxes and borrowing. Their
borrowing works because there’s an implicit promise to pay back
principal and interest. If the magnitude of the debt calls this
promise into question, something must give. Basic accounting tells us
we will see some combination of lower spending, higher revenue, or –
somehow – lower debt. In some cases, thankfully rare, governments
reduce their debt through default, as Argentina did in 2002 and as
Greece is contemplating today. In other cases, inflation reduces the
real value of the debt. In still others, the government runs primary
surpluses and the economy grows, making the debt more manageable. The
budget constraint doesn’t tell us which of these things will happen,
only that one of them must. Pension and healthcare obligations may
not be honoured, taxes may be raised or inflation may increase, taxing
consumers and debt holders indirectly. None of them are politically
popular, but if governments don’t take action, history tells us that
action will be imposed on them. Sargent’s study of hyperinflation in
interwar Europe offers compelling reading on the consequences of
government indecision.

Link: http://www.voxeu.org/index.php?q=node/7244