Wednesday, May 8, 2019

How much should we worry about the national debt?

Somewhat, but not too much, argues this Foreign Affairs article co-written by Lawrence Summers:

The deficit dismissers have a point. Long-term structural declines in interest rates mean that policymakers should reconsider the traditional fiscal approach that has often wrong-headedly limited worthwhile investments in such areas as education, health care, and infrastructure. Yet many remain fixated on cutting spending, especially on entitlement programs such as Social Security and Medicaid. That is a mistake. Politicians and policymakers should focus on urgent social problems, not deficits.

But they shouldn’t ignore fiscal constraints entirely. The deficit fundamentalists are right that the debt cannot be allowed to grow forever. And the government cannot set budget policy without any limiting principles or guides as to what is and what is not possible or desirable.

There is another policy approach that neither prioritizes cutting deficits nor dismisses them. Unlike in the past, budgeters need not make reducing projected deficits a priority. But they should ensure that, except during downturns, when fiscal stimulus is required, new spending and tax cuts do not add to the debt. This middle course would tolerate large and growing deficits without making a major effort to reduce them—at least for the foreseeable future. But it would also stop the policy trend of the last two years, which will otherwise continue to pile up debt.

Policymakers must also recognize that maintaining existing public services, let alone meeting new needs, will, over time, require higher revenues. Today’s large deficits derive more from falling revenues than rising entitlement spending. More spending is not, by itself, something to be afraid of. The United States needs to invest in solutions to its fundamental challenges: finding jobs for the millions of Americans who have given up hope of finding them, providing health insurance for the millions who still lack it, and extending opportunities to the children left behind by an inadequate educational system.

Economic textbooks teach that government deficits raise interest rates, crowd out private investment, and leave everyone poorer. Cutting deficits, on the other hand, reduces interest rates, spurring productive investment. Those forces may have been important in the late 1980s and early 1990s, when long-term real interest rates (nominal interest rates minus the rate of inflation) averaged around four percent and stock market valuations were much lower than they are today. The deficit reduction efforts of Presidents George H. W. Bush and Bill Clinton contributed to the investment-led boom in the 1990s.

Today, however, the situation is very different. Although government debt as a share of GDP has risen far higher, long-term real interest rates on government debt have fallen much lower.

As shown in the table, in 2000, the Congressional Budget Office forecast that by 2010, the U.S. debt-to-GDP ratio would be six percent. The same ten-year forecast in 2018 put the figure for 2028 at 105 percent.

Real interest rates on ten-year government bonds, meanwhile, fell from 4.3 percent in 2000 to an average of 0.8 percent last year.

Those low rates haven’t been manufactured by the Federal Reserve, nor are they just the result of the financial crisis. They preceded the crisis and appear to be rooted in a set of deeper forces, including lower investment demand, higher savings rates, and widening inequality. . . .

Low interest rates mean that governments can sustain higher levels of debt, since their financing costs are lower. Although the national debt represents a far larger percentage of GDP than in recent decades, the U.S. government currently pays around the same proportion of GDP in interest on its debt, adjusted for inflation, as it has on average since World War II. The cost of deficits to the Treasury is the degree to which the rate of interest paid on the debt exceeds inflation. By this standard, the resources the United States needs to devote to interest payments are also around their historical average as a share of the economy. Although both real and nominal interest rates are set to rise in the coming decade, interest payments on the debt are projected to remain well below the share reached in the late 1980s and early 1990s, when deficit reduction topped the economic agenda.

Government deficits also seem to be hurting the economy less than they used to. Textbook economic theory holds that high levels of government debt make it more expensive for companies to borrow. But these days, interest rates are low, stock market prices are high relative to company earnings, and major companies hold large amounts of cash on their balance sheets. No one seriously argues that the cost of capital is holding back businesses from investing. . . .

The eurozone debt crisis at the start of this decade is often held up as a cautionary tale about the perils of fiscal excess. But stagnant growth (made worse by government spending cuts in the face of a recession) was as much the cause of the eurozone’s debt problems as profligate spending. . . .

It’s true that future generations will have to pay the interest on today’s debt, but at current rates, even a 50-percentage-point increase in the U.S. debt-to-GDP ratio would raise real interest payments as a share of GDP by just 0.5 percentage points. That would bring those payments closer to the top of their historical range, but not into uncharted territory.

Deficits, then, should not cause policymakers much concern, at least for now. But some economists adopt an even more radical view. Advocates of what is known as modern monetary theory (MMT), such as Stephanie Kelton, an economist and former adviser to Senator Bernie Sanders’ presidential campaign, have been widely interpreted as arguing that governments that borrow in their own currencies have no reason to concern themselves with budget constraints. . . . This goes too far. . . . In truth, no one knows the benefits and costs of different debt levels. . . .

Although the U.S. government will remain solvent for the foreseeable future, it would be imprudent to allow the debt-to-GDP ratio to rise forever in an uncertain world. Trying to make this situation sustainable without adjusting fiscal policy or raising interest rates, as recommended by some advocates of modern monetary theory, is a recipe for hyperinflation.