Debt and Deficits, Again
With the possibility that the Democrats will retake Congress and press demands for increased spending in areas like health care, education, and child care, the deficit hawks (DH) are getting prepared to awaken from their dormant state. We can expect major news outlets to be filled with stories on how the United States is on its way to becoming the next Greece or Zimbabwe. For this reason, it is worth taking a few moments to reorient ourselves on the topic.
First, we need some basic context. The DH will inevitably point to the fact that deficits are at historically high levels for an economy that is near full employment. They will also point to a rapidly rising debt-to-GDP ratio. Both complaints are correct, the question is whether there is a reason for anyone to care.
Just to remind everyone, the classic story of deficits being bad is that they crowd out investment and net exports, which makes us poorer in the future than we would otherwise be. The reason is that less investment means less productivity growth, which means that people will have lower income five or ten years in the future than if we had smaller budget deficits. Lower net exports mean that foreigners are accumulating US assets, which will give them a claim on our future income.
Debt is bad because it means a larger portion of future income will go to people who own the debt. This means that the government has to use up a larger share of the money it raises in taxes to pay interest on the debt rather than for services like health care and education. Or, to put it in a more Keynesian context, there will be more demand coming from people who own the debt, which means the government would need higher taxesnto support the same level of spending than would otherwise be the case.
There is an important intermediate step in the deficit-crowding out story that is worth stating explicitly. The Federal Reserve Board could opt to keep interest rates low by buying up debt directly. The assumption in the crowding out story is that the Fed allows interest rates to rise or even deliberately raises them, presumably because it is concerned about inflation.
If there is no basis for inflationary concerns, there is no reason that the Fed could not simply keep interest rates low in spite of a large deficit, and therefore prevent any crowding out. The question then is whether a budget deficit is pushing the economy up against its limits, leading to inflationary pressures. When we look at the various sources of demand in the economy, there are two reasons for thinking that a larger budget deficit would be needed today to sustain something close to full employment than would have been true four decades ago.
First, we have the enormous upward redistribution of income that has taken place over this period. Roughly ten percentage points of disposable income have been transferred from people at the middle and bottom of the income distribution to those at the top. To take very rough numbers, if we think the rich will on average spend half of this increase in income, whereas the losers would have spent 90 percent, it implies a loss of consumption demand equal to 40 percent of this ten percentage points. With disposable income equal to roughly 75 percent of GDP, this implies a loss of consumption demand equal to 3 percentage points of GDP (0.4*10 pp*0.75 = 3.0 pp).
This implies that we would need a budget deficit that is 3 pp of GDP greater in 2018 than in 1978 to keep demand in the same place, other things equal. The upward redistribution of income creates a large gap in demand that we need to fill through some other channel.
The other big change is the trade deficit. If we go back to the 1960s and 1970s, trade was nearly balanced. We started to move towards deficits with the OPEC price hikes that led us to pay far more money for the oil we imported. But even with these price hikes, the trade deficits were still generally less than 1.0 percent of GDP. The trade deficit is currently running close to 3.0 percent of GDP. (It had been almost 6.0 percent of GDP in 2005 and 2006.) This creates another demand gap that could be filled by a budget deficit.
If we combine the gaps in demand due to less consumption, as a result of the upward redistribution of income, with the gap due to a higher trade deficit, it can be as much as 6.0 percent of GDP. This implies that, other things equal, we need to run deficits in the neighborhood of 5.0 to 6.0 percent of GDP to fill the demand gap created by the upward redistribution of income and the trade deficit. In that context, budget deficits of the size we are now seeing may be necessary to sustain something close to full employment.
It is worth qualifying this story somewhat. First, the impact of upward redistribution on consumption has likely been offset in part by the wealth effect associated with unusually high asset prices. The value of stock relative to GDP has been unusually high in recent years, although not as high as at the peaks of the stock bubble in the 1990s. House prices are also above their long-term trend. As a result, the savings rate out of disposable income (the share of disposable income not consumed) is not unusually high. This means that the loss of consumption due to the upward redistribution may not be very much.
However, the conventional story of a demand gap being filled as a result of low interest rates spurring investment seems not to be holding up. In spite of the extraordinarily low interest rates for the last decade, investment is roughly equal to its long-term share of GDP. Investment is presumably somewhat stronger than it would be with higher interest rates, but this component of spending has not risen to fill the demand gap.
Anyhow, with net exports and possibly consumption considerably weaker than in prior decades, we need a larger budget deficit than in the past to get to full employment. Given where the economy is today in terms of employment/unemployment, could we up spending by another $100 billion to $200 billion a year (0.5 to 1.0 percent of GDP), without offsetting tax increases? I would be worried that this could be pressing things too far, but I would have said the same thing a year ago when the unemployment rate was a half percentage point higher.
I would like us to press demand until we see clear evidence of constraints, which would show up in rapidly rising wages and accelerating inflation. At that point, we could put on the brakes, both with tax increases and higher interest rates, but it is important to know how far we can push the economy.
In this respect, we essentially performed a similar experiment in 1990s when Greenspan allowed the unemployment rate to fall far below the level that almost all economists considered consistent with full employment. The unemployment rate averaged 4.0 percent for the full year in 2000 and the low point was 3.8 percent. Back in the mid-1990s, the conventional wisdom was that the unemployment rate could not get much below 6.0 percent without triggering spiraling inflation. By allowing the unemployment rate to fall so low, Greenspan proved the conventional wisdom wrong and showed we could have many more people employed than previously had been believed.
We can tell a similar story today. Let’s push the limits and see how low the unemployment rate can go. There are risks — inflation could suddenly start to take off in a serious way — but this seems unlikely. There may be a gradual rise in the inflation rate, but if we see an inflation rate that stabilizes 0.5 or even 1.0 percentage point higher, it is hardly the end of the world.
And, we have to remember there are very large costs to having a higher than necessary unemployment rate. It means that millions of people are needlessly kept from having jobs. Or, if we want to put it in terms of future generations, unnecessarily high unemployment means that millions of kids are being brought up in homes with one or more unemployed parent. That’s a pretty bad story.
For some reason, the deficit hawks are never held to account for policies that prevented larger stimulus and therefore more rapid growth in employment following the Great Recession. This is not only a passing problem, the losses endure as many workers lose skills and we forego hundreds of billions of dollars in investment that would have led to more rapid productivity growth. The cost of unnecessary austerity since the Great Recession literally runs into the trillions of dollars, yet we never hear anyone in major news outlets talk about the enormous harm caused by the DH. But somehow if progressives propose a policy with some potential downside risk they want us to reject it out of hand.
Getting back to debt, there are two stories that get told. One is the worthless debt problem. This is one where we wake up one day and no one wants to hold US government debt. There literally is no precedent for this with a country with a healthy economy. We can point to countries that have been devastated by war or catastrophic weather events, but countries with otherwise healthy economies don’t suddenly find that no one wants to buy their debt.
Even in this absurd situation, we could still have the Fed buy the debt. Remember, we are talking about an economy that is growing at a decent pace with no major bottlenecks impairing future growth. In this context, if foreign and domestic investors decide they don’t want government bonds, the Fed could just buy them up.
Will this cause inflation? What would be the mechanism? If we somehow were overstimulating the economy it certainly could, but this is not something that would just happen overnight. It would require some period of excessive stimulus, with no response in either fiscal or monetary policy. If we had policymakers that were this irresponsible, then the problem would be incredibly irresponsible people in policy positions, not the debt.
The other story we get with the debt is that it is a drain on the government’s resources. Money that could go to meet important social needs is instead being paid out in interest to bondholders.
This is a real issue, but it needs to be put in context. In the early and mid-1990s, we were paying out more than 3.0 percent of GDP in interest payments. In 2018, the Congressional Budget Office projects that we will spend 1.3 percent of GDP, net of money rebated by the Federal Reserve Board, in interest payments. This is projected to rise rapidly to almost 3.0 percent of GDP in a decade, but even at that level we’re just getting back to where we were in the early 1990s. That amount of interest did not prevent the second half of the 1990s from being a very prosperous decade.
The other part of this story that for some reason the deficit hawks never mention, is that the government is constantly making debt like commitments in the form of patent and copyright monopolies. These government-granted monopolies allow drug companies, medical equipment suppliers, and software companies to charge prices that are many thousand percent above the free market price.
And, there is a huge amount of money at stake. In the prescription drug industry alone patent monopolies like cost the public close to $380 billion a year (1.9 percent of GDP) in higher drug prices. How can deficit hawks concerned about our children not be concerned that the government is allowing drug companies to effectively impose a huge tax on prescription drugs?
In short, there seems little basis for the DH’s concerns about debt and deficits. If the Democrats retake Congress, and try to push for increased spending on health care, education, and other areas of social spending, the DHs will likely be appearing frequently in major news outlets. Remember not to take them seriously.