The gold standard’s history reminds us that not every economic challenge demands a centralized political solution.
Editor’s Note: This essay is part of Debt, Inflation, and the Future: A Symposium.
Tonight I would like to focus on the arguments made by those who believe the amount of government debt doesn’t matter. For years, economists have been debating the best way to reduce the debt to GDP ratio. The fear is that we may soon cross over to a point of no return which inevitably leads to some form of debt crisis. However, in recent years, a growing number of economists and commentators have come to believe that the debt doesn’t matter. If we just ignore the 70s, then, thanks to permanent low interest rates and low inflationary risks, we will be able to disregard the debt and achieve low unemployment and high output.
There are problems with this position. First, the fact that interest rates have stayed low in recent years does not mean that they will never significantly rise. It might take a while, but the prospects are strong that they’ll eventually go up. Second, and maybe more importantly, even if interest rates never increase and inflation never materializes, there is a significant cost to high debt which is best avoided, especially if one values smaller government. Debt is only the symptom of overspending, i.e. an expansion of the size of government with all the distortions that comes with such a growth.
Debt, Inflation and Interest Rates
Now this is by far my least favorite part of my talk because I will be the first to acknowledge that monetary policy isn’t my area of expertise. Keeping this in mind, here are some of my thoughts on this issue.
One of the most common arguments for why debt doesn’t matter is the fact that the inflation-worriers have been with us for decades, yet inflation has only trended downward. It is true that US inflation has been stuck at low levels for 25 years now, for reasons no one seems to fully understand. More recently, despite the Fed flooding the economy with money, and the latest $8 trillion in spending paid for with borrowing, selected data suggest that the risk of high inflation is low. Some scholars, for instance, point out that inflation rates remain below 2 percent, and when measured properly, the forecast for the average inflation rate over the next five years is under 1.5 percent, well below the Fed’s target for action, thanks, they believe, to investors’ supposedly incurable appetite for US debt.
This argument may be correct for the time being, or even for the next five years. It is worth noting that some argue, including one of my co-panelists, that inflation is already here. While I don’t have the expertise to weigh on this issue, I do believe that we are in the process of what economist Arnold Kling describes as a guy of jumping out of a 10-story window, and as he passes the 2nd floor informs the bystanders that “See, so far so good!”
The Hoover Institution economist John Cochrane makes a similar argument when he writes that “Yes, I’ve warned about it before, and no, it hasn’t happened yet. Well, if you live in California you live on an earthquake fault. That the big one hasn’t happened yet doesn’t mean it never will.”
For one thing, while it is true that the Cleveland Fed shows that inflation rates are below 2 percent, others do not share that view. For instance, the New York Fed predicts that the inflation rate will be 3.1% a year out, while the Philadelphia Fed predicts a rate of 2.5%. The prediction of the Atlanta Fed is 2.4%. Which one is right? I wonder whether it is possible that we are seeing inflation but not taking these signs into account. Could the surge in the prices of real estate prices or of Bitcoin—or of equities—be the sign of a vote no confidence?
There is no doubt that US treasuries remain popular with foreign investors. But does it mean that interest rates on debt will be low forever? I am not sure about that. Over at Discourse Magazine, my colleague Jack Salmon argues that since 2013 (when foreign holdings of US debt as share of GDP peaked), debt-to-GDP has risen from 71% to 101%. Over the same 8 year period, debt held by foreign investors as a share of GDP has actually fallen from 35% to 33%. The growth in debt significantly outpaces foreign demand for US treasuries. What’s more, over this same period of time, total US debt held by foreign investors has fallen from around half to less than a third.
The point is that bond market investors willingness in the past to lend 100% of GDP to the US government at 1% interest says very little about their willingness to do the same when our debt to GDP stands at 200 percent (which we are set to reach in 2050 without accounting for the Biden administration new spending or assuming no future wars, recessions or emergencies). There is a limit out there somewhere, a tipping point that even the most prominent debt doves out there admit exists. Cochrane writes:
There is a limit, a debt/GDP beyond which markets will not lend. On this, I think, we all agree. There is a finite fiscal capacity. Even though in theory the r<g argument would allow a 1,000% debt to GDP ratio, or 10,000%, at some point the party stops. The closer we are to that limit, the closer we are to a real crisis when we need that fiscal capacity and it is no longer there.
Another important point is that we shouldn’t take much comfort from the fact that rates are low today and that they are projected to be low in the next few years because all of that could change very quickly with no advance notice. Cochrane writes:
No, interest rates do not signal such problems. (Alan Blinder, covering such matters in the Wall Street Journal, ”if the U.S. Treasury starts to supply more bonds than the world’s investors demand, the markets will warn us with higher interest rates and a sagging dollar. No such yellow lights are flashing.) They never do. Greek interest rates were low right up until they weren’t. Interest rates did not signal the inflation of the 1970s, or the disinflation of the 1980s. Lehman borrowed at low rates until it didn’t. Nobody expects a debt crisis, or it would have already happened.
In other words, these events are very hard to predict with data. This leads me to my final point. In a recent essay for Law & Liberty, Kling reminds us of the work of IMF economists Carmen Reinhart and M. Belen Sbrancia, which shows that:
Throughout history, debt/GDP ratios have been reduced by (i) economic growth; (ii) substantive fiscal adjustment/austerity plans; (iii) explicit default or restructuring of private and/or public debt; (iv) a surprise burst in inflation; and (v) a steady dosage of financial repression accompanied by an equally steady dosage of inflation.
Like Kling, I believe that growing ourselves out this mess, implementing the kind of austerity measures required to reduce our debt to GDP ratio, or the likelihood of a hard default are unlikely. That said, my co-panelists, and our moderator Alex Pollock in particular, have convinced me that financial repression is much easier to implement and more likely than I assumed. That said, the real interest aspect of the Reinhart-Sbrancia findings is “a surprise burst in inflation.” Kling notes, and I agree, that this is the least unlikely scenario. But Surprise is here the key word. No one saw it coming in the past, and no one will see it coming when our time finally comes. That is because, as Kling writes,
In my view, all attempts to predict inflation using mechanical rules fail. They fail because inflation depends on the habits, norms, and expectations of the public at large. If people are habituated to low inflation, then attempts by the Fed to nudge up the inflation rate will not work…. Conversely, if people believe that inflation will be high and variable, then they try their best to protect against this.
If that’s the case, it is essential that people believe that the Federal Reserve and Congress will be able to rein inflation back in if it got out of hands. Will they? In a recent article for National Review, Cochrane reminds us that the means available to the Fed or Congress to combat fast rising inflation are not pleasant. He also questions whether people at the time will actually believe that these institutions will have the will to do what it takes, no matter what the political price is.
Even if it is true that worries about rising interest rates or rising inflation are overblown, debt still matters because it carries very high costs.
Why Debt Matters
Here are a few reasons why high debt matters even if there is no inflation and rates remain low.
First, debt is very expensive. The more we borrow, the higher the cost of borrowing even if interest rates stay low. In other words, a very low interest rate on a gigantic debt is still a lot of interest payments. In 2020, the US government paid $378 billion in interests on the debt. In GDP terms, assuming no new wars, or major recessions, or expensive new federal initiatives, the Congressional Budget Office estimates 8.3% of GDP will go to paying interest payments in 2050. With nominal GDP projected to be $64 trillion by 2050, that in constitutes over $5 trillion in interest payments. That’s much larger than the entire 2019 Federal budget.
CBO also notes that under very modest projections of interest rate increases, interest payments will grow from 8 percent of our budget in 2020 to 27 percent in 2051, or over 40 percent of revenue. At that point, interest payments will be by far the largest government expenditure. As the CBO office notes, “even though rising interest rates have a sizable effect on the fiscal outlook, rising debt levels would substantially boost interest costs even if rates remained unchanged.” Large growth in interest payments as a share of the budget will inevitably come at the expenses of other budget items that people value.
Second, it is also likely that even without inflation, our debt expansion will lead to an increase in interest rates, which in turn creates the crisis. Here is how Cochrane explains it:
Let’s grow the debt / GDP ratio to 200%, $40 trillion relative to today’s GDP. If interest rates are 1%, then debt service is $400 billion. But if investors get worried about the US commitment to repaying its debt without inflation, they might charge 5% interest as a risk premium. That’s $2 trillion in debt service, 2/3 of all federal revenue. Borrowing even more to pay the interest on the outstanding debt may not work. So, 1% interest is sustainable, but fear of a crisis produces 5% interest that produces the crisis.
While demographics and foreign demand for U.S. debt have put downward pressure on interest rates over the years, growing debt and deficits have also put upward pressure on interest rates. Several academic studies have found that each percentage point increase in the debt-to-GDP ratio raises real interest rates by 2 to 5 basis points, while each percentage point increase in the deficit-to-GDP ratio raises real interest rates by 18 to 28 basis points.
Third, overspending that leads to very large annual budget deficits increases the likelihood that calls for new sources of revenue like a Value Added Tax will become more politically palatable. In other words, today’s spending must be financed sooner or later by taxes on someone, and those taxes will be economically damaging without successfully reducing our debt levels. The austerity literature shows that fiscal adjustment packages based mostly on tax increases are unlikely to succeed while having the deep and negative impact of economic growth.
Fourth, the money the federal government borrows comes from the savings of Americans and others who hold dollars. In other words, government spending and borrowing crowd out private spending and borrowing.
Fifth, a high debt level slows economic growth down. Assuming we never face a full on debt crisis like the one we have seen play out in Greece, then we face the unfortunate, yet increasingly likely possibility of becoming Japan. There are at least 40 academic studies published since 2010 observing the debt-growth nexus. The broad economic consensus revealed in the literature is that while threshold levels for advanced economies vary from 70 to 100% of GDP, the negative effect of large and growing public debt levels does indeed have serious negative effects on economic growth.
Most studies that estimate the economic effects find that for every 10 percentage point increase in the debt ratio, future economic growth is reduced by 0.2 percentage points. Before the Covid-19 pandemic our debt-to-GDP ratio was 78%, it is now 101%–this constitutes a loss in future economic growth of almost half a percentage point. While at 78% debt we may have grown at 2.5% on average for the years to come, we now may growth at only 2% thanks to our debt addiction. Compounded over the years, this fact means that the average American will be significantly worse over time. With our debt ratio expected to hit 200% in the long-run, the economic reality of Japanese-style stagnation is something we should be cognizant of in the debate surrounding our debt trajectory.
Milton Friedman was correct: The true measure of government’s size is found in what it spends and not in what it takes in in taxes. Because borrowing allows politicians and citizen-taxpayers to push the bill for today’s spending onto future generations, borrowing encourages too much spending today—thus irresponsibly enlarging the size of government.
For those of us who desire to keep government small, raising debt levels means a larger and larger increase in the size and scope of government. It also suggests a lack of accountability as well as a lack of transparency. For all these reasons we need to reform entitlement spending, put both large chunks of military and domestic spending on the chopping block, and start selling off federal assets. Better to do it now than during a fire sale later.