The Congressional Budget Office (CBO) published its long-term deficit and national debt projections last week. These are the projections most widely cited in policy discussions about long-term “sustainability” of the national debt and entitlement programs. In this post I focus on a small but very important part of the report—the CBO’s discussion of the “Consequences of a Large and Growing Debt,” which can be found on pages 13-15. This section can be found in past reports going back several years, and hasn’t change much if it has changed at all during this time. It is also consistent with the thinking of most economists on these issues. As readers of this blog will recognize, the CBO’s analysis is “out of paradigm” in that it is inapplicable to a sovereign, currency-currency issuing government operating under flexible exchange rates such as the US, Japan, Canada, UK, Australia, etc.
CBO presents four consequences of a large and growing national debt. I discuss each in turn.
- Less National Saving and Future Income–Large federal budget deficits over the long term would reduce investment, resulting in lower national income and higher interest rates than would otherwise occur. Increased government borrowing would cause a larger share of the savings potentially available for investment to be used for purchasing government securities, such as Treasury bonds. Those purchases would crowd out investment in capital goods—factories and computers, for example—which makes workers more productive.
This would be laughable if it weren’t for the fact that most economists believe it and the dangers of following policy based on such a belief. The analysis is based on the loanable funds market—which DOES NOT EXIST in the real world. In reality, the funds that banks lend are created out of thin air, not constrained by saving, the flow of deposits, or fractional reserve requirements. Even a 100% requirement changes nothing as long as the central bank is targeting the interbank rate that sets the banks’ cost of funds. More reserves are always forthcoming via open market operations if the interbank rate starts to move above the central bank’s target, so there is no rise in interest rates of the sort that the loanable funds model supposes.
So there is no threat to funding available for private investment in capital goods, and no threat to the growth rate of future national income. CBO’s analysis is simply inconsistent with how the modern financial system actually works. (My post here from 2012 described the process of bank lending. For more detailed analysis of the interaction of banks and central banks, see here, here, here, and here.)
As an aside, consistent with neoclassical theory in which factors of production receive their marginal product, CBO writes that “because wages are determined mainly by workers’ productivity, the reduction in investment would reduce wages as well [since the investment is driving productivity of workers in CBO’s analysis], lessening people’s incentive to work.” Wow. Apparently CBO hasn’t noticed that (a) wages and productivity have diverged for the past 40 years, with productivity far outstripping wage growth, and (b) low wages haven’t lessened the incentive to work at all (if they did, US workers should be working far less than there French and German counterparts while the opposite is true). Three words—Cambridge Capital Controversies, which neoclassicals still haven’t actually bothered to understand. Instead they hide behind a theory that suggests CEOs making exponentially more than the average worker somehow “deserve” this excessive pay even as anyone that bothers to look can see that these same CEOs have led the private sector to far slower growth rates of productivity than we saw in the 1950s and 1960s when the ratio of CEO pay to worker pay was far smaller. But I digress. (And apologies for the rather simplistic analysis here—I realize there’s much more going on with wages—but again, this isn’t the main point of the post.)
- Pressure for Larger Tax Increases or Spending Cuts in the Future– When the federal debt is large, the government ordinarily must make substantial interest payments to its lenders, and growth in the debt causes those interest payments to increase. (Net interest payments are currently fairly small relative to the size of the economy because interest rates are exceptionally low, but CBO anticipates that those payments will increase considerably as interest rates return to more typical levels.)
In other words, when interest rates rise, they will take up a larger percentage of the government’s outlays, increasing the likelihood of future large deficits unless spending is cut or taxes are raised. Similarly, a desire to raise spending or cut taxes in the future will be thwarted by projections of even larger deficits and require still greater cuts or taxes elsewhere. CBO wants us to believe that it is just trying to protect us from the difficult political decisions this would bring.
In some ways this is a legitimate point, but I would say it differently. Any increase in the government’s deficit can result in greater aggregate spending on existing productive capacity, so if the government is sending more interest to bond holders, ceteris paribus, this is creating the potential for inflation. However, the issue here isn’t the larger deficits as much as it is the larger deficits relative to the inflation threat. But CBO presents us with no analysis of the future inflation threat of rising debt service—in fact, its long-term analysis assumes both an economy at full employment beginning a few years from now and very modest inflation throughout even with the larger deficit and debt service projections. In other words, the real danger of rising debt service or rising government deficits in general (aside from the obvious potential misallocation of the government’s spending) is assumed away by CBO from the start.
Furthermore, rising debt service for a currency-issuer under flexible exchange rates like the US is a monetary policy variable, as I explained here and here. If rising debt service is pushing the government’s deficit too high, CBO should explain to us why an inflation-targeting central bank is raising the risk of inflation by raising the government’s debt service.
In any case, an economy reaching the point at which a central bank running a Taylor Rule type of interest rate targeting strategy will raise rates should also be precisely when the government is experiencing fairly rapidly declining primary deficits (the deficit aside from debt service)–which is the case in the US’s history—and probably shouldn’t be entertaining thoughts of increasing deficits at that point if low and stable inflation is a serious policy goal. In most other cases, the central bank shouldn’t be raising rates and the government should be increasing its deficit. CBO’s assumption of continuous full employment and low inflation mistakenly abstracts from the fact that the real world economy is always in the midst of some stage of a business cycle.
- Reduced Ability to Respond to Domestic and International Problems–When the amount of outstanding debt is relatively small, a government can borrow money to address significant unexpected events—recessions, financial crises, or wars, for example. In contrast, when outstanding debt is large, a government has less flexibility to address financial and economic crises—a very costly circumstance for many countries. A large amount of debt also can compromise a country’s national security by constraining military spending in times of international crisis or by limiting the country’s ability to prepare for such a crisis.
This one’s pretty amazing—seriously, how can someone actually believe this stuff? First off, as we know, government’s that issue their own currencies don’t need to borrow back their own money. Second, even if you do think so, as above, the interest rate on this increase in the national debt is a monetary policy variable, not one that is set by markets. There is no danger of a currency issuing government not being able to finance its deficits in a time of crisis. And we know that times of war and financial crisis are in particular the times at which safe, default-risk free government debt is at its lowest rate of interest relative to the debt of non-currency issuers. Third, such crises are also the points at which the central bank typically has its policy rate—and by extension interest rates on the national debt—set at its lowest. In fact, it is the private sector that experiences such problems in these times, not the currency-issuing governments—just look back to how private credit markets responded to the global financial crisis of 2008-2009 for the most recent example.
The second part of CBO’s rationale here is even more ridiculous—did they not notice that times of war and financial crisis have been the times of most of the largest increases in the US national debt? Indeed, the real danger is that in a time of such crisis policy makers will actually believe analysis like CBO’s here. Thankfully, during WWII they didn’t. They didn’t listen after September 11, 2001. And they didn’t listen in 2008 (TARP) or 2009 (Obama stimulus—though the CBO-types did in fact keep the Obama stimulus insufficiently small, not that I was necessarily in favor of many of the spending priorities in the bill). And in every case of policy makers not listening, interest rates remained low while the government ran the deficits it wanted to run.
- Greater Chance of a Fiscal Crisis—A large and continuously growing federal debt would have another significant negative consequence: It would increase the likelihood of a fiscal crisis in the United States. Specifically, there would be a greater risk that investors would become unwilling to finance the government’s borrowing needs unless they were compensated with very high interest rates and, as a result, interest rates on federal debt would rise suddenly and sharply relative to rates of return on other assets. That increase in interest rates would reduce the market value of outstanding government bonds, causing losses for investors and perhaps precipitating a broader financial crisis by creating losses for mutual funds, pension funds, insurance companies, banks, and other holders of government debt—losses that might be large enough to cause some financial institutions to fail. Unfortunately, there is no way to predict with any confidence whether or when such a fiscal crisis might occur in the United States. In particular, there is no identifiable tipping point in the debt-to-GDP ratio to indicate that a crisis is likely or imminent. All else being equal, however, the larger a government’s debt, the greater the risk of a fiscal crisis.
Here we see the “US could become Greece” argument, with “we can’t say when it could become Greece, but we don’t want to find out!” added on. In fact, the CBO in the footnotes links to its 2010 report, “Federal Debt and the Risk of a Fiscal Crisis” (in which it makes the same four points as here, by the way, regarding the consequences of large and rising debt), which analyzes recent fiscal crises in Argentina, Ireland, and Greece and then considers how their difficulties dealing with rising interest rates on the national debt, diminished access to financial markets, etc., could harm the US economy.
Again, though, a currency-issuing government under flexible exchange rates can’t have such crises because it doesn’t need to borrow its money; interest rates on its debt are a monetary policy variable. The doomsayers have been at this for decades now, but have not explained why the US, UK, and Japan ran continually large deficits starting in 2008 at low interest rates while Greece, Spain, Italy, etc., could not. Their only response is, “Just wait! This time is NOT different!” At least CBO doesn’t fall into the typical trap of citing the Reinhart/Rogoff paper on “tipping points,” which has been discredited (see here and here as well). CBO simply notes here that as of yet “there is no identifiable tipping point”—this is true of course, since there isn’t a tipping point at all if it’s your own currency and you have the ability to set the interest rate on it. At some point one would think the “US could become Greece” argument would be widely recognized as fraudulent, but if you’re in the wrong paradigm it’s difficult to accept even a simple explanation of why the paradigm is wrong.
In the end, what we see from these four points made by CBO is that the real danger to policymakers isn’t large deficits and debt. The real danger is that they will pay attention to analysis done of large deficits and debt by CBO and others like it—such as most economists—and unfortunately they are all paying attention and echoing this same sort of analysis. And here we all sit in a six year trough relative to potential GDP, continued high unemployment (particularly if you include underemployment, etc.) and low participation rates, and with even fairly decent job creation that however is focused on the low-wage end compared to previous recoveries (see here). And this isn’t even to mention the Eurozone nations that are still in depression states.