A large number of economists and commentators claim that the fundamental problem facing the U.S. economy today is the government’s annual fiscal deficits—the excess of what the government spends relative to what it takes in through tax revenues—and the accumulating debt resulting from these annual deficits. These are the professional deficit hawks. They have managed to dominate the current debate in official policy circles, and as such, have turned the arguments on what to do about mass unemployment on their head. Rather than focusing on how to create jobs, the deficit hawks want us to concentrate first and foremost on reducing the deficit and debt, even if it means imposing austerity and higher unemployment rates.
Let me state things bluntly: the deficit hawks are wrong in their economic analysis, whatever may be their particular political perspectives. But rather than just asserting this, it will be important to examine their views carefully. I do this in Back to Full Employment, but, as always, there is a lot more to say than I could pack into the book.
Let’s start with the arguments of one of the leading deficit hawks, Prof. John Taylor of Stanford University. Prof. Taylor is without question one of the most eminent conservative macroeconomics in the U.S. and the world. He has held numerous high-level positions in the federal government as well having been a senior faculty member at Stanford for decades. Taylor focuses on the issue of what he terms the exploding U.S. federal government debt in his small 2012 book First Principles: Five Keys to Restoring America’s Prosperity. In fact, the Taylor book can be used as a counterpoint to my own, in that it lays out a general perspective, and does so in an accessible and relatively compact way (though his book is probably 40 percent longer than mine). Also, while the focus of First Principles is analytic economics, Taylor is very upfront in expressing his strong right-of-center political convictions.
Chapter 3 of First Principles is titled “Defusing the Debt Explosion,” and it is fair to say the tone of the chapter is alarmist—as in, the United States as a country could well be facing collapse if we don’t control the explosion of government debt now. Here is Taylor himself:
“Nothing better signifies America’s recent failure to follow the principles of economic freedom than the exploding debt of the federal government. I do not exaggerate when I use the word “exploding.” Taylor then presents the chart below, taken from the U.S. Congressional Budget Office, showing total federal government debt as a share of U.S. GDP—i.e. as a percentage of total size of the economy at any given time. His observes about this chart that “Its soaring upward climb resembles the fireworks on America’s Independence Day. But rather than remind us of America’s founding, it portends America’s ending. I carry a version of the chart in my wallet and show it to my students, and to my children and grandchildren, because it’s their future on the line,” (p. 101).
What is wrong with this picture? To begin with, please note that the part of the graph that is exploding “like fireworks,” is all happening in the future, into 2040 and beyond. None of this has actually happened—we are talking about the future here—and nobody, including Prof. Taylor, really knows whether it is likely to happen. To give some perspective on whether this debt explosion is likely to occur, we need to back up a bit and put things in context. Here is that context:
Let’s start with the basic fact that it was not the fiscal deficit, but Wall Street hyper-speculation, that brought the global economy to its knees in 2008-09. The Wall Street collapse caused the Great Recession and the rise in fiscal deficits, in the U.S. and elsewhere. To prevent a 1930s-level Depression at that time, economic policymakers throughout the world—including the U.S., the countries of the European Union, Japan, South Korea, China, India, and Brazil—all enacted extraordinary measures to counteract the crisis created by Wall Street. These included financial bailouts; monetary policies that pushed central bank controlled rates close to zero; and large-scale fiscal stimulus programs, financed by major expansions in central government fiscal deficits.
Barack Obama signed the American Recovery and Reinvestment Act (ARRA) into law in February 2009. The bill, which included $787 billion in new government spending and tax cuts for households and businesses, was the first major act of Obama’s presidency. As Obama’s first term is reaching its end, the ARRA remains his most aggressive initiative to fight mass unemployment.
Meanwhile, the U.S. fiscal deficit grew rapidly starting in 2009. The deficit reached $1.4 trillion, or 10 percent of GDP that year, and $1.3 trillion in both 2010 and 2011, equal to 8.9 and 8.5 percent of GDP in those years. Prior to that, the deficit averaged 2 percent of GDP under George W. Bush (2001–08) and 0.8 percent of GDP under Bill Clinton (1993–2000).
Fiscal deficits of the current magnitude emerged first as the normal result of the recession itself, with tax revenues falling along with incomes, business profits and asset prices, while government support payments rose for ‘automatic stabilizers’ such as unemployment insurance, Medicaid and other basic safety nets. But in addition, the ARRA deliberately added to the deficit for the purpose of bolstering government spending and aggregate demand, and thereby preventing the economy’s floor from collapsing.
As a group, deficit hawks such as John Taylor have focused on three major hazards tied to the large-scale federal deficits that have emerged since 2009, with somewhat varying formulations and emphases but following the same basic themes. They begin with the claim that high levels of government borrowing would drive up interest rates since government borrowing increases the economy’s overall demand for credit dramatically without correspondingly increasing the national savings that are the basis for the supply of credit. These high interest rates then produce two more problems: a heavy burden of government debt and strong inflationary pressures.
These issues raised by Taylor and other deficit hawks certainly need to be considered seriously. But how exactly we should act on our concerns should be guided by the facts of the situation. Two facts in particular are crucial as starting points: the interest rates of U.S. government bonds, including long-term bonds, have been at historically low levels since the Obama stimulus program was introduced; and, similarly, the inflation rate has been subdued throughout this full period.
Why have interest rates on government bonds and inflation remained low despite the large deficits? Two factors are at play. The first is that financial market investors globally have been focused on reducing their risks since the financial collapse, in a dramatic reversal of their mindset during the bubble years. Within that mindset, investors have been voting strongly in support of U.S. government bonds as the single safest store of their wealth. The European fiscal crisis that began in the spring of 2010 and continues into 2012 provides yet another reminder that, however bad conditions are in the United States, they can easily become worse someplace else.
The second factor has been the Federal Reserve’s aggressive policies to hold down interest rates. This includes the Fed’s near-zero interest rate policy for their target short-term rate, the federal funds rate. In addition, the Fed has also successfully lowered the longer-term rates on U.S. Treasury Bonds under the policy they have termed “quantitative easing.” As for lack of inflationary pressure, this is a direct result of the high rate of unemployment and low rate of capacity utilization, which imply little upward pressure on wages and prices.
The reality of low interest rates, in particular, also greatly alleviates concerns about worsening long-term debt burdens. Despite historically large fiscal deficits, the federal government is now paying interest on the total outstanding debt at a rate that is historically low, not high. As such, while it is true that the government will need to reduce its borrowing once the recession is behind us, there is no short-term crisis whatsoever in terms of the government’s ability to pay off debt obligations it faces now or over the next few years. We can see this from the figures below, which I take from a paper I published last January in the Cambridge Journal of Economics called “U.S. Government Deficits and Debt Amid the Great Recession: What the Evidence Shows.”
The first panel in the figure shows the same ratio of U.S. federal debt relative to GDP that Taylor presents. The only difference between this picture and Taylor’s is that mine starts in 1940 and ends in 2010. Unlike Taylor, I make no claims to know what the future ratio will be for the next 50 years or so. But we do still see the debt/GDP ratio rising since the recession began. No dispute about that.
But then when you look at the lower panel of t he figure, we see that as U.S. federal debt has risen as a share of GDP, both U.S. Treasury interest rates, and, most crucially, government interest payments as a share of total federal outlays are falling, not rising. Indeed, the decline in interest payments is steep. This is why I conclude that, at present—that is, today, as we debate whether the government has the financial wherewithal to do something about the jobs crisis—the federal government is facing no fiscal crisis whatsoever. That is the most important way in which Prof. Taylor and other deficit hawks are wrong. Moreover, their erroneous positions are doing significant harm toward creating a set of policies that can move the U.S. economy out the ditch in which Wall Street shoved it.
Am I also saying that the U.S. faces no problems at all with the deficit and debt in the longer term? In fact, we do face important longer-term issues with the federal deficit, even though these are second-order concerns for the present time. Still, there is nothing whatsoever that is inevitable about Taylor’s figure of exploding fireworks. The major long-term fiscal consideration we face is with controlling health care costs. A second is with controlling military spending. And finally, we need to start raising taxes on the rich. The single best way to do that is through a Financial Transaction Tax, what is now also being called a “Robin Hood Tax.” I discuss in Back to Full Employment ways to handle each of these policy areas. I also show that taking some reasonable middle course actions around health care costs, military spending and a Financial Transaction Tax, will readily enable the U.S. to avoid any and all kinds of federal debt explosions. I will take up all of these topics further in future blogs.