This is the second part of a two-part post; the first can be read here.
Many contributors to the “Back to Full Employment” blog have pointed out that the current national focus on reducing the debt of the U.S. Federal Government is completely misguided. I thought it might be useful to identify the major arguments raised by the “debt hawks” and to show why, in each case, the arguments are simply wrong.
1. The U.S. national debt at the end of 2012 came to almost 16½ trillion dollars, amounting to more than $50,000 per citizen. Since we will have to pay off that debt, each of us is really $50,000 poorer than we realize.
First of all: there is no need to pay off the national debt. Hardly any country ever pays off all of its national debt, because carrying that debt can cause a problem only if the burden of servicing the debt becomes too onerous. That burden in any given year depends on the relationship between (1) the amount of debt service payments that must be paid out that year by the Federal Government and (2) the size of the national economy that year. The smaller is (1) relative to (2), the easier it is to raise the tax revenues needed to make the debt service payments.
Let’s calculate the relative size of the current U.S. debt service burden – i.e., (1) divided by (2). The debt service payments that the Federal Government must make in a given year are determined by the amount of national debt held by the non-governmental public, multiplied by the average interest rate paid to the debt-holders. Although the total U.S. national debt is indeed about $16½ trillion, roughly $5 trillion is held by branches of the Federal Government itself – such as the Social Security System. This part of the debt does not impose any repayment burden on the non-governmental public, because the government in effect repays itself to service it. The non-governmental part of the U.S. national debt – held by U.S. citizens, foreign citizens & governments, and the Federal Reserve System – amounts now to about $11½ trillion. The interest rate at which the U.S. Government services its debt to non-governmental debt-holders has been in the neighborhood of 2% over the past four years, and it was just below that in 2012. Multiplying these two figures, the amount that the Government must pay out for debt service was roughly $0.23 trillion in 2012. The size of the U.S. economy is best measured by the gross domestic income or product (GDP), which was roughly $15½ trillion in 2012. Thus the relative size of the current U.S. debt service burden is currently 0.23 divided by 15½, or about 1.5%.
What this means is that U.S. taxpayers must currently be taxed at an economy-wide average rate of 1.5% in order to service the U.S. national debt. This is a lighter debt service burden than in all but 2 of the years from 1978 through 2008.
2. The debt service burden may not be very onerous now, but interest rates are not going to remain very long at their current unusually low levels. So the debt service burden is likely to increase very soon, as interest rates return to their normal higher levels.
As long as the U.S. economy remains in recession, with employment and output well short of their potential levels, there is no reason to expect interest rates to rise much at all. Only when an economy recovers, to the point that shortages begin to develop in labor and product markets, will strong upward pressures on prices and interest rates begin to develop. As and when that does begin to happen, we will be thankful that unemployment has come down significantly and that GDP has gone up significantly. The higher level of GDP will itself help to reduce the debt service burden, because it depends on the relationship between debt service payments and GDP.
If and when higher interest rates cause the national debt to increase more rapidly than GDP, then the debt service burden would indeed begin to rise. At that point one would need to consider whether or not the rising trend was likely to persist. If so, policy-makers would have reason to be concerned about continuing to run Federal Government deficits and thereby adding further to the national debt. Dealing with the problem then, however, would be far easier than now, because the economy would be operating close to full steam. As long as that is not the case – and it is certainly not now – then it is foolhardy to focus attention on reducing deficits and debt rather than on increasing employment and GDP.
3. By running budgetary deficits and increasing the national debt, the U.S. Federal Government is passing on a huge burden of debt that will ultimately have to be paid back by our children and grandchildren – thus reducing significantly their well-being.
As noted above, there is no need to pay off the national debt; it just has to be managed so as not to impose too heavy a burden of debt service on taxpayers. And when the U.S. economy is in recession, priority must be given to reducing unemployment and raising the rate of utilization of productive capacity, which will raise GDP and thereby also help to reduce the debt burden. What is preventing this from happening now is not the growing national debt, but a lack of overall demand for the goods and services the economy is capable of producing. The Federal Government is uniquely well-placed to provide the needed aggregate demand stimulus, which it can do precisely by spending more than it receives in revenues. This means running a budget deficit in the short run; but it makes it easier to manage the national debt in the long run.
For future generations of Americans there is a much bigger threat than higher national debt. The much bigger threat is that global warming, and consequent rises in sea levels and in the frequency and intensity of storms and droughts, will significantly reduce economic growth and impair the quality of life in the U.S. and the world as a whole. Bequeathing a higher national debt is far less of a problem for our children and grandchildren than bequeathing a world whose climate has been compromised by global warming.
4. Households should not spend more than they receive, so the U.S. Federal Government shouldn’t either. (Recall that in summer 2011 President Obama asserted that “we must live within our means.” And during the presidential campaign of 2012 Mitt Romney declared that: “we have a moral responsibility not to spend more than we take in.”)
Neither in the case of individuals or households, nor in the case of private businesses, nor in the case of governments, does it make sense to rule out borrowing. Borrowing makes perfect sense if it is used for investment that increases future output and income, out of which the debt incurred by borrowing can be managed – or, if necessary, paid in full. Just as a private business will borrow heavily to finance investments that are likely to yield a real rate of return greater than the real cost of borrowing, so individuals, households and governments should borrow for purposes of investments that are likely to result in future streams of income that are greater than the streams of payments that must be made to service the corresponding debt.
Interest rates on U.S. Government bonds are currently at historically low levels (actually less than zero in real terms, taking account of price inflation), largely because of the current recessionary conditions. So now is an ideal time for the Federal Government to borrow in order to be able to spend more than it takes in, to achieve two important objectives. In the short run, such deficit spending increases the demand for U.S. goods and services and thereby raises employment, incomes and output – all of which are currently held back by insufficient aggregate demand. And in the long run, insofar as Federal Government spending takes the form of investments in education, R&D, transport, communications, and more efficient ways to produce and consume energy – all areas that have been much neglected in recent decades – deficit spending also strengthens the national economy and helps to forestall global warming, thereby raising GDP and general well-being well into the future.
5. But government spending, unlike private spending, can’t do much to make the economy stronger.
Whether or not spending strengthens the economy depends not on whether it is public or private, but on whether it adds to the productive capacity of the economy. Government expenditures on education, R&D, transport and communications, energy efficiency, etc., involve investments that enhance people’s skills, add to the nation’s stock of productive assets, improve technology, and/or prevent environmental deterioration. It is true that, at times, public investments have proven inefficient or wasteful; but the historical record shows that government investment has been crucial to the development of all modern economies. In the case of the U.S., think of the Erie Canal, the agricultural land-grant program, the post-World-War-II G.I. education program, the interstate highway system, and government-funded scientific research and development that have led to countless technological improvements – such as the world-wide web.
6. If the U.S. national debt is not reduced, the credit-rating agencies will lower the rating of U.S. Government bonds, which will cause interest rates to rise and thereby increase the debt service burden on American taxpayers.
It is true that a downgrading of U.S. Government bonds by all the major credit-rating agencies would likely raise interest rates and thus increase the cost of borrowing for the Federal Government, which would cause the burden of debt service on U.S. taxpayers to rise. (Note that this did not happen after only one agency – Standard & Poor’s – reduced the U.S. credit rating in summer 2011). Most of the economists at credit rating agencies are competent enough, however, to recognize that what really determines the ability of a country to service its debt is not the size of the debt itself but its size in relation to the size of the economy – i.e., the debt service burden. So they know that a country’s credit-worthiness depends at least as much on the prospects for economic growth as on the prospects for limiting the growth of debt. They will not be impressed when the government of a country mired in recession pursues austerity policies to reduce the national debt, because they know that such policies seriously compromise the prospects for growth.