January 13, 2021
With a Democrat in the White House, the season of the deficit hawk has returned. So, it’s worth going through the old arguments just to remind everyone that the best response to these people is ridicule.
It looks like President Biden will propose a robust stimulus package of well over $1 trillion. According to press accounts, the package is likely to include another check for $2,000. (I believe it is supposed to $1,400 above the $600 in the last package.) It is likely to include a refundable child tax credit that will do much to reduce child poverty.
It will also include money to state and local governments to make up massive pandemic induced shortfalls. There will also be money for mass transit and a down payment on green new deal programs. Biden also plans to increase the subsidies provided in the Affordable Care Act, to make its insurance more affordable. And, he is likely to ask for a reduction in the age of Medicare eligibility.
In other words, this will be a really big deal. And, it will cost money. Biden will propose tax increases on the rich and corporations, but there is little doubt there will be a large increase in the deficit and the debt. So should we be worried?
The immediate issue is the deficit. The deficit hawks will be screaming that the Biden package will over-stimulate the economy, leading to rising interest rates and inflation. There is some truth to these claims, but we have to think clearly about what is at issue.
Interest rates have been extraordinarily low following the pandemic shutdown as the Federal Reserve Board sought to use the power it had to boost the economy. It set short-term interest rates to zero and brought the long-term interest rate on Treasury bonds down to 0.5 percent. Long-term rates have crept up over 1.0 percent, both due to economic recovery and the expectation that Biden will have a robust rescue package.
When Biden puts his proposal on the table, it is likely to push interest rates higher and they will rise further when we actually see the spending taking place. This should not bother us. We more typically have seen long-term interest rates in the 4-6 percent range and considerably higher in the decades of the 1970s and 1980s.
We saw interest rates first plummet in the Great Recession before recovering modestly in the recovery. They then plummeted again with the shutdown. Suppose interest rates return to the 4-6 percent range we saw before the Great Recession. What’s the problem?
Interest rates in this range would have been considered normal, or even low, prior to the Great Recession. Higher interest rates will have some negative effects. We will see less construction, mortgage refinancing will slow sharply, and there will be a modest falloff in public and private investment. The dollar will also likely rise. This will make U.S. goods and services less competitive internationally, leading to a somewhat higher trade deficit.
These downsides are real, but if we are engaged in useful spending, like reducing child poverty, rescuing state and local governments so that they can maintain vital public services, slowing global warming, extending health care coverage, then these costs seem minor by comparison. In any case, it is hard to understand how having the same interest rates we saw in the 1990s and pre-Great Recession 2000s is supposed to be a major catastrophe.
There is also the issue that we might see higher inflation. This also needs a big “so what?” The Fed sets a target of 2.0 percent inflation. This is supposed to be an average, not a ceiling. We have not hit this target since before the Great Recession. (The measure targeted by the Fed is the core Personal Consumption Expenditure Deflator (PCE), which is consistently 0.2-0.4 percentage points lower than the Consumer Price Index we more often see mentioned in the media.)
Suppose the inflation rate increases by 1.0 percentage point. The core PCE increased by 1.4 percentage points over the last year. A 1.0 percentage point increase puts us at 2.4 percent. This is totally consistent with the Fed’s target of a 2.0 percent average inflation rate. (We can debate whether the 2.0 percent target is even appropriate, but let’s ignore that for now.)
If we continue to push the economy too hard, we can see inflation rise further, hitting rates that should trouble us. But there are no models that show inflation just jumping from a modest level to more worrisome levels, barring some sort of catastrophe like a climate disaster or war. The Fed is totally prepared to take steps to slow the economy if inflation threatens to be a problem.
In short, there seems little basis for concern that too much spending will create a dangerous inflationary spiral. In addition to the valuable goals that will be furthered by this spending, we also can see the economy move back to full employment, with workers enjoying increased bargaining power.
As I and others (including Fed Chair Jerome Powell) have frequently argued, low unemployment disproportionately benefits the most disadvantaged in the labor market. The sharpest gains in employment and wages will be seen by Blacks, Hispanics, the less educated, people with disabilities, and people with criminal records. This is a really huge deal for those concerned about inequality and racial justice.
The Hit to the Stock Market
There is one issue with higher interest rates that should be noted. If long-term interest rates rise even back to pre-pandemic levels, it could lead to a substantial decline in the stock market. One of the reasons the stock market was so strong in 2020 was that there were few alternative options for investors. With long-term interest rates under 1.0 percent, the return from holding government bonds was extremely low. Also, investors took a risk of large capital losses on their bonds if interest rates rise. If the interest were 2.5 percent or 3.0 percent, holding bonds looks much better. Also, there is much less risk of a capital loss due to further rises in interest rates.
With bonds becoming a more attractive alternative, many investors will switch from stocks to bonds, putting downward pressure on stock prices. It wouldn’t be unreasonable to see a 20 or 30 percent drop in stock prices. While the Donald Trump whiners will be screaming bloody murder, more serious people need not be concerned. The vast majority of stock is held by the richest of the population, with close to half held by the top one percent. A drop in stock prices would mostly be hitting the wealth of the relatively affluent and the very rich.
We should think of stock prices as being like wheat prices. A drop in wheat prices is bad news for wheat farmers, but for the rest of us, it might mean lower bread prices. We should think of the stock market the same way. Lower stock prices are not necessarily bad for the economy (they can be if the drop is due to a plunge in the economy), but they are bad news for the wealth holdings of the very rich.
Of course, not everyone who owns stock is rich. Plenty of middle-class people own stock. Also, pension funds are heavily invested in the stock market. While we may not be happy to see these folks take a hit, there are two points to keep in mind.
There was an extraordinary run-up in stock prices in the years following the Great Recession. If the market were to fall 20, or even 30, percent, investors would still be looking at a pretty good return in the last decade. They have little grounds for complaint.
The other point is that if we look at the annual returns to stockholders from dividends and share buybacks, there is little reason to think they would be hurt. If we look at a company like Apple or Walmart, their profits are likely to be just as good, or possibly even better, with a robust Biden rescue package. This means that on annual basis, these shareholders will be getting just as much money with lower stock prices as do with the current high stock prices. They have a loss of wealth, but their income from their stocks should be little affected.
Long and short, we should not be worried if we see a stock market correction in the next year or two. We need to worry about employment, wages, and other factors affecting the living standards of the bulk of the population. A drop in the stock market need not be a cause for concern.
The Debt and our Children
Perhaps the most pathetic argument against an ambitious rescue package is that the debt will be an enormous burden on our children. This argument usually begins and ends by pointing out that the debt is a really large number. (It is.) But throwing out a really big number doesn’t tell us anything about the burden of the debt.
This is measured by the interest we pay. Last year, we paid $338 billion in interest, this year we are projected to pay $290 billion. Measured as a share of GDP, last year our interest payments came to around 1.6 percent, this year’s payments are projected at 1.4 percent. By comparison, in the early and mid-1990s (a very prosperous decade) our interest burden was over 3.0 percent of GDP.
But even the 1.6 percent figure overstates the actual burden. The Federal Reserve Board currently holds trillions of dollars of government debt. The interest paid on the debt held by the Fed is refunded right back to the Treasury. Last year the Fed paid $88.5 billion to the Treasury, reducing the true interest burden by 0.4 percentage points, which leaves the interest burden at only slightly above 1.0 percentage point of GDP.
The deficit hawks rightly point out that if interest rates rise then the burden will be greater, but this ignores two points. First, interest rates are only likely to rise very much if inflation increases, in which case inflation will be eroding the real value of the debt and the burden on our children.
The other point is that higher interest rates will only gradually raise the interest burden. Much of the debt outstanding is long-term, which means that we will only see higher payments when a ten-year or thirty-year bond expires. So the idea we will suddenly be facing a crushing interest burden doesn’t make any sense.
Debt Burden and the Burden of Government-Granted Patent and Copyright Monopolies
The deficit hawks not only exaggerate the burden of deficits and debt, they are not honest about them. Direct spending is only one way in which the government pays for things. It also pays for services by offering patent and copyright monopolies. By my calculations, these government-granted monopolies cost the economy over $1 trillion a year in higher prices for drugs, medical equipment, software, and other items.
This is a real burden that swamps the interest payments that the deficit hawks tell us will impoverish our children and grandchildren. I have never seen any economist other than myself make this point, so I will try to explain the issue in a way that even an economist can understand.
Suppose the government were to spend another $90 billion a year on developing prescription drugs, replacing what the industry currently spends. (This is in addition to the $45 billion we spend annually through the National Institutes of Health and other governmental agencies.) This $90 billion would be added to other spending and would add to the debt, with an implied future interest burden.
Suppose that to cover this spending, the government raised taxes on prescription drugs to cover the future interest cost. While the taxes will mean future deficits would be lower, they don’t change the fact that the additional spending has added to our debt.
Instead of paying for the development of new drugs with direct spending, we pay for the development of new drugs by granting patent monopolies. These monopolies effectively allow drug companies to impose a tax on prescription drugs. It makes no sense to say that the interest we pay on the debt from direct government spending is a burden, but the patent rents that drug companies are allowed to collect are not a burden. In the case of prescription drugs alone, I calculated the burden in the form of higher drug prices to be close to $400 billion a year.
I’m not raising this point to say that our debt burdens are even higher than the deficit hawks claim, I’m raising the issue to make the point that our debt burden really doesn’t tell us anything about the hardships we are imposing on future generations.
We will hand down a whole economy and society to future generations. If we had zero national debt, but massive amounts of patent and copyright rents, it would be hard to claim that we had served them well.
But the issue goes much further. If we fail to educate our children, with more than one-sixth growing up in poverty, we have not done well by future generations. If we leave them a decrepit infrastructure, we will not have served future generations well. And, if we destroy the natural environment by not arresting global warming and destroying the country’s natural beauty, we will not have been fair to our children.
In short, the debt doesn’t really measure anything. Highlighting the debt is a way for people with a political agenda to oppose spending that they don’t like. It is not an honest complaint and doesn’t deserve to be treated as such.
We should have a serious debate of whether the specific items being put forward by President-Elect Biden are a good use of resources. They will surely be grounds for real criticisms. But the complaint that they will add to the debt should simply be laughed out of the public debate.