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In the Nation's Interest

Is the U.S. Public Debt Really Nothing to Worry About?

Last week I co-authored a column with the Brookings Institution’s Bill Gale (originally published on Real Clear Markets) commenting on a recent paper written by IMF economists which suggests that the U.S. should not worry about and certainly not devote resources toward reducing deficits right now.  Instead the U.S. should be using funds to invest in more public infrastructure.  Bill and I point out that the IMF researchers’ “don’t worry, be happy” message on the debt, on close examination, is no surprise.  They assume their conclusion.

Their answer comes directly from their starting assumption—built into their theoretical model—that the U.S. currently faces essentially no economic costs to not paying down, or even adding to, the debt.  As the IMF authors themselves explain, they consider the U.S. to be a country in the “green zone”—meaning one with “ample fiscal space” and with no current or impending “sovereign risk.”  So if one assumes that debt and deficit financing is essentially a free source of funds, it is not terribly surprising that one will choose to use such debt-financed funds to buy anything of any positive marginal benefit.

In fact, one does not even need to identify a specific type of spending or tax cut, nor quantify the exact expected benefits from that purpose, to conclude that the government should not raise net funds to reduce the deficit (let alone turn deficits into surpluses and “pay down” the stock of public debt).  The IMF authors’ promotion of infrastructure spending as a better use of the net funds is really just a marketing point and frankly a distraction, intended or otherwise.  It suggests that the U.S. faces an either-or choice:  either we should reduce the deficit, or we should invest in more public infrastructure.  But as Christine Lagarde (the head of the IMF herself) is careful to say, we can, and should, do both.  So ironically, Lagarde’s point on the need for “medium-term fiscal policy that is aiming at reducing the long-term debt” is challenged by her own staff’s research paper that assumes there is no economic benefit in doing so. 

How can a theoretical model of the economy assume there are essentially no economic costs associated with carrying debt and hence no benefits to slowing its growth?  Fundamentally, by saying that government debt does not subtract from the productive capacity of the national economy.  In the IMF economists’ model, increases in public dissaving (government deficits) are assumed to be made up for by increases in private saving, so that national saving (the sum of public plus private saving) is unaffected—which essentially means that, in turn, there are no adverse effects on economic growth.  And without the “crowding out” of private capital that government borrowing might otherwise cause, there’s also none of the strong upward pressure on interest rates that you would expect.  So the cost of borrowing remains very low and close to zero, which is a low bar for the potential benefits from the uses of these deficit-financed funds (whether greater spending or more tax cuts) to clear. 

How does this theoretical assumption about the U.S. being in the “green zone”—with no economic costs of debt to worry about—line up with reality?  Not very well, according to the nonpartisan Congressional Budget Office (CBO) in their latest long-term budget outlook report issued last week.  (The chart of debt/GDP above comes from the report.)  In the summary of their findings, CBO explains that:

If current law remained generally unchanged in the future…The deficit would grow from less than 3 percent of GDP this year to more than 6 percent in 2040. At that point, 25 years from now, federal debt held by the public would exceed 100 percent of GDP. Moreover, debt would still be on an upward path relative to the size of the economy. Consequently, the policy changes needed to reduce debt to any given amount would become larger and larger over time. The rising debt could not be sustained indefinitely; the government’s creditors would eventually begin to doubt its ability to cut spending or raise revenues by enough to pay its debt obligations, forcing the government to pay much higher interest rates to borrow money.

And in chapter 1 of the report, CBO discusses the “consequences of a large and growing federal debt”—effects on the economy that sound far from benign (emphasis added):

The high and rising amounts of federal debt held by the public that CBO projects for the coming decades under the extended baseline would have significant negative consequences for the economy in the long term and would impose significant constraints on future budget policy. In particular, the projected amounts of debt would reduce the total amounts of national saving and income in the long term; increase the government’s interest payments, thereby putting more pressure on the rest of the budget; limit lawmakers’ flexibility to respond to unforeseen events; and increase the likelihood of a fiscal crisis.

In fact, CBO emphasizes the “crowding out” effect that the IMF model assumes away:

Increased government borrowing would cause a larger share of the savings potentially available for investment to be used for purchasing government securities, such as Treasury bonds. Those purchases would crowd out investment in capital goods—factories and computers, for example—which would make workers less productive.

In other words, despite the fact that deficits are currently at a short-term low point (the lowest share of GDP since 2007), they still are high in a longer-term perspective.  And under current policies, deficits and debt as a share of GDP get right back on a rising path within a few years, and that rising debt burden implies rising economic costs (not mere budgetary accounting costs).  In their take on the “likelihood of a fiscal crisis,” CBO suggests that there are risks of crisis even now, because of the impending squeezing of “fiscal space”  that is associated with continued deficits and rising debt/GDP. In other words, CBO’s report is telling us that even if it’s appropriate at this instant to characterize the U.S. as being in the “green zone”, we’re not going to stay in the green zone for long—and therefore that even now there are positive, not-at-all-trivial marginal costs of our adding to deficits and debt.

To be sure, despite the significant economic costs to continued deficits and rising debt the nation still should identify more productive uses of public funds—from whatever source.  There is always an opportunity cost associated with whatever we are currently choosing to do more of—whether that “more” is financed via higher deficits, new tax increases, or more spending cuts.  We can always do better for our economy by reprioritizing how the public sector taxes, spends, and borrows—maximizing the benefits of the uses of those funds, and at the same time minimizing the costs of obtaining those funds.  But whatever else it includes, the menu of the best uses of public funds today absolutely must include reducing budget deficits as well.