Washington refuses to understand that debt can be an essential tool for economic growth. Can we overcome this irrational and destructive fear?
There’s another timing point here, made forcefully in recent commentaries by Yale economist Robert Shiller. Economists and official budget scorekeepers like the Congressional Budget Office judge the sustainability of budget plans by whether the debt-to-GDP ratio is rising or falling. Shiller points out, however, that this conflates an annual measure—GDP—with a debt measure that is decidedly non-annual. We don’t have to refinance government debt all at once in a given year. For example, it might seem intuitive that if public debt were 100 percent of GDP, we’d be insolvent, but of course that’s not the case. During World War II, that ratio exceeded 100 percent, and for good reason. A decade later, it was 52 percent.
Again, timing matters. Temporary deficits, say, to offset a downturn, make a lot more sense than permanent, or structural, deficits in a recovery (“structural” in this context means that even with a healthy economy, the deficit would persist). Seemingly large debt burdens in a given year can be dealt with over the course of many years. But while Keynesian stimulus (such as the Recovery Act) is temporary by definition, the aging of the population and the rise of health care costs are not. The problem, once again, is not borrowing—it never is. It’s what are you borrowing for, how long you will need to pay for it, and how you are going to pay it back.
Cost of borrowing: As I write this sentence, five-year Treasury bills carry an interest rate of about 1 percent, a near historic low. Why so low? Because the economy is so weak, inflationary pressures are low, stocks are volatile, Europe is a mess—all of which make hyper-safe securities like T-bills a highly desirable investment. That’s actually an important and salutary dynamic in an advanced economy with mature capital markets. It signals that government should borrow and deficit-spend on temporary measures to stimulate growth.
At such low rates and with so much economic slack, fiscal policy needs to focus on increasing the denominator of the debt-to-GDP measure, not lowering the numerator. If we borrowed 1 percent of GDP at the current interest rates to make investments in the economy, and assumed a (conservative) multiplier of 1.2 (meaning every dollar spent creates $1.20 of growth), debt-to-GDP would, under plausible assumptions, barely budge as the boost to growth would at least partially offset the increment to the annual deficit. And a lot more people could get back to work.
The point is that when borrowing costs are low because of a recession and all the slack it causes—which is precisely what we’ve seen in recent months—that’s an important signal to the government to engage in temporary fiscal expansion. To do so has the benefit of reducing unemployment and boosting growth at comparatively little cost to the federal budget. To fail to respond to this signal is to consign millions to joblessness under the false pretense of fiscal rectitude.
Little distinction in magnitudes: There’s a difference between “small” and “large” federal budget deficits. But when all debt is evil, such distinctions get lost. The concept of “primary” balance is important here. A deficit that is in primary balance is small enough that the government is raising adequate revenue to pay its operating budget—that is, everything it spends money on except the interest on the debt. Once the budget deficit is at least in primary balance, the debt-to-GDP ratio stabilizes—it stops growing. Deficits below about 3 percent of GDP right now would constitute primary balance. Indeed, the budget plan recently released by President Obama gets deficits down to below 3 percent by 2014 through the rest of the decade. Sure enough, the debt-to-GDP ratio peaks in 2013 at 76.9 percent, then falls to 73 percent by 2021.
Again, the point is that the failure to make this distinction contributes to austerity frenzy, such as the pervasive calls for a balanced budget amendment and aggressive budget cuts. When the economy is on a solid expansion trajectory, we want the deficit-to-GDP ratio shrinking each year, but it doesn’t have to go to zero or surplus right away. Primary balance is a fine intermediate goal.
“Tighten our belts”—an awful analogy: Beware simple, folksy metaphors that emanate wisdom but convey exactly the wrong message. My candidate for the most destructive of all is that old saw about deficit reduction: “Hey, families have to tighten their belts when things get tough…government should too.” President Obama himself has made this mistake.
Sounds right, but it’s totally backwards. When the economy stumbles and family income stumbles with it, then sure, families have to tighten up. But this is precisely why government has to loosen its belt. That’s the whole point of countercyclical policy: When the private sector is contracting, the public sector temporarily expands, and vice versa. The analogy is wrong on both ends: When the private sector is humming along, and working families can maybe loosen their belts a bit, that’s when the government needs to tighten its belt.
Who owns the debt?: It’s always important to remember that one person’s debt is another person’s asset. When it comes to the budget deficit, while we owe about half of it to foreign holders of Treasuries (China and Japan being the most prominent lenders), we owe the other half to ourselves. That doesn’t mean we can afford to ignore unsustainable borrowing. But from a macroeconomic perspective, it doesn’t necessarily hurt the economy to borrow from ourselves to invest in productivity-enhancing initiatives that increase the future wealth of our progeny.
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