WSJ Aug 24, 2019
It’s Time to Start Worrying About the National Debt
Expecting economic growth to rescue the U.S. from unprecedented federal deficits is a dangerous gamble, as history shows.
By Valerie Ramey | 940 words
For much of the 20th century, the U.S. government operated under the principle that it should finance its spending mostly by collecting taxes rather than by borrowing. While conventional wisdom favored running temporary deficits during emergencies, such as wars or recessions, no one argued that a fiscally responsible government should commit itself to running budget deficits so large and sustained that government debt would grow faster than the size of the economy.
Yet today the federal government is on such a path. The usual voices urging fiscal restraint have been drowned out by some policy makers and academic economists who, as aptly noted by the investor Ben Hunt, are urging us in the fashion of Dr. Strangelove to “learn to stop worrying and love the national debt.”
But history has repeatedly taught us that a country with an outsize national debt often finds itself facing terrible economic trade-offs that cause misery for its citizens. The budget deficit this year is expected to reach $1 trillion. The government is financing this gap between its outlays and tax revenue by borrowing from American and international investors, selling them Treasury bills and bonds. Every year that the federal government runs a deficit, it adds to the national debt, which is the accumulated amount of past and present deficits.
The stock of national debt in the hands of the public now stands at almost $17 trillion, which amounts to almost 80% of U.S. gross domestic product, the value of what the economy produces in a year. This level of the debt-to-GDP ratio is not unprecedented. The highest debt-to-GDP ratio in American history occurred at the end of World War II, when debt reached 106% of GDP. As soon as the war ended, the government ran budget surpluses for a few years, reducing the national debt by about 12%. However, the main driver of the subsequent steep decline in the debt-to-GDP ratio was the rapid growth of GDP, owing to growth in the real economy as well as to inflation, which raises the dollar value of current GDP but has no effect on the amount of outstanding debt.
Today, the argument for deficit spending relies on repeating that kind of growth. In principle, proponents of deficits argue, if the interest rates that the government must pay on its debt are less than the growth rate of GDP, then an economy can run deficits and still grow its way out of the national debt. Is such a free lunch possible? Perhaps, but only in small bites.
An important part of the deficit is the government’s interest payments on the national debt. In fact, interest payments are expected to account for half of the entire deficit by next year and to grow in importance after that. The noninterest portion of the budget deficit needs to remain very small relative to GDP for government to be able to grow its way out of debt.
Under current law, however, the noninterest share of the federal budget deficit is so large that this free-lunch limit won’t be met under current projections. In fact, the debt-to-GDP ratio is projected to continue to climb steeply, reaching an unprecedented 144% by 2049. Future deficits are projected to be large because current law governing taxes, entitlements (such as Social Security, Medicare and Medicaid) and other elements of the budget leave a large budgetary gap. The combination of the aging of the baby-boom generation and rapidly rising health costs are causing government outlays to grow faster than GDP.
To make matters worse, tax cuts have reduced tax revenues as a percent of GDP. These unsettling projections are based in part on economic growth forecasts and the path of interest rates. The interest rates the federal government pays on its debt are currently very low, but there is no guarantee that they will stay low. History is replete with episodes in which governments responded to low interest rates by spending freely and accumulating massive debt, only to find that their behavior led to a crisis of investor confidence and skyrocketing interest rates.
The Greek government was paying interest rates of between 3% and 5% on its debt during the 2000s, until investors lost confidence and forced interest rates up to 25% by 2012. The subsequent budget austerity measures helped to push the Greek economy into a depression from which it still hasn’t recovered. Today, a practitioner of what is called Modern Monetary Theory might argue that a country that issues its own currency, as the U.S. does, can avoid budget austerity because it can always print more money to pay for its deficits.
Venezuela chose the money-printing strategy to deal with growing government budget deficits when its oil revenues declined a few years ago. The result has been hyperinflation reaching 10 million percent this year—the worst case in modern history. The U.S. has more latitude than Venezuela because the dollar currently plays a preeminent role in the world economy, both for financial investments and for trade. If fiscal profligacy causes investors to lose confidence in the U.S., however, the dollar may lose that preeminence.
These examples highlight the risk in taking what economists such as Greg Mankiw have called a “deficit gamble”: The bet is most likely to fail exactly when the economy is weak. Adopting fiscal austerity, such as higher taxes and lower spending, when the economy is already weak is particularly painful. That is why the conventional wisdom of the past century makes sense. Prudent governments keep their fiscal house in order during good times so that they have more fiscal room to deal with bad times.
Ms. Ramey is a professor of economics at the University of California, San Diego.