These worlds seem to be talking past each other, and for one reason in particular. There is, in the Washington conversation, a generalized aversion to deficits. It's an aversion with an almost moral dimension. In fact, sometimes the moral dimension is explicit: Mitt Romney often called deficits a "moral crisis."
But to economists, deficits are simply the difference between revenues and outlays. A large deficit could be a good thing if it's going toward a productive investment. A small deficit can be a bad thing if the economy needs more support. So if you're worried about deficits, you need to say why.
So here’s a guide to why the economics crowd isn’t as nervous about deficits and debt as the Washington punditocracy--and some of the reasons they could turn out to be wrong. For the benefit of Washington players who find arguments that deficits aren’t an imminent concern to be jaw-droppingly insane, we’ll look at some of the more plausible reasons for why deficit reduction is urgent. (Hint: Simply pointing out that the deficit has exceeded $1 trillion a year lately, and that that is a really big number, isn’t much of an economic argument).
First off, looking at debt levels in raw numbers doesn’t tell you a whole lot. I could tell you a giant number I owe on my mortgage, but you can’t really make sense of whether that is too much debt for me or not unless I also tell you my income (and, even better, whether my prospects are for that income to rise or fall in the coming years). So it is with the U.S. government. Last year’s deficit of $1.1 trillion may be a lot of money, but remember that the U.S. economy grew in 2012, so it represented a decline as a percent of GDP, to 7.3 percent from 8.7 percent in 2011. Total U.S. government debt held by the public is at 73 percent of GDP, which is indeed higher than it has been since the aftermath of World War II.
But annual deficits are on track to decline in the coming years, reflecting both an improving economy (which means more tax revenue and less need for social welfare spending), spending cuts agreed to as part of 2011 debt ceiling negotiations and the fiscal cliff deal that raised taxes on upper-income people. We’ll get the CBO’s latest formal estimates on Monday, but it appears that if the economy grows steadily and there is no new budget-tightening, the debt to GDP ratio would rise a few more percentage points over the next decade—not nearly as fast as the jump it has taken since the start of the recession in 2007 from 36 percent of GDP to around double that.
But wait a minute, a deficit hawk might say. To have debt of three-quarters of the nation’s economic capacity is way too high! (Even if that is the nation's economic output for just a single year). It's dangerous! Foolhardy! Well, there’s a case to be made that that’s true (more on that later), but it’s not really a case that can be arrived at by first principles of economic theory. There is no automatic number that triggers a danger zone of when debt ratios are too high. Japan has a debt to GDP ratio of around 200 percent. Italy is around 120 percent. Yet Japan can borrow easily and Italy can't.
And there is a quite real risk that efforts to cut the deficit could be counterproductive in bringing down the debt burden. Britain has been implementing deficit-reduction measures for the past three years, and while it has succeeded in cutting deficits, its economy has been stagnant as austerity sucks the wind out of growth. As a result, its debt to GDP ratio has been rising! (By the IMF’s numbers, Britain’s deficit has fallen from almost 9 percent of GDP in 2008 to 5.6 percent in 2012—yet in that span its debt level has risen from 61 percent to 84 percent).
So if you see large deficits and debt as a major and imminent threat to the United States—as plenty of smart people do—the burden is on you to argue the economic case for it. Here are the strongest options.
Risk management. We don’t really know what the future holds and if our debt levels remain in the trillions, we may have less capacity to deal with unexpected contingencies. Suppose there is a new recession in the next few years in an already feeble recovery, which could knock the nation’s deficit reduction progress off the rails. What if there is another war? What if climate change happens so quickly and severely that the nation must start investing hundreds of billions of dollars to protect Florida from the sea?
The future is unknowable, and when there are high debt levels, even if the interest burden is seemingly manageable, it could cramp a future government’s ability to respond decisively to the challenges of the future. This, ironically, is one of the best arguments against the tax cuts, unfunded wars and Medicare expansion in George W. Bush’s first term. It made the deficits in the aftermath of two wars and a financial crisis much higher than they would have been if pre-2001 tax and Medicare spending had remained in place.
National security. This is a variation on the risk management case. Sure, America’s debt and deficit is manageable now. But it leaves us vulnerable. Foreigners own nearly half of the U.S. government debt outstanding, most significantly China and Japan. What if China were to dump its bonds, perhaps as a hostile political gesture? This sort of thing seems to be what former Joint Chiefs chairman Mike Mullen is talking about when he says that “The most significant threat to our national security is our debt.” Could we ever fight a war that China doesn’t want us to fight at a time when they are one of the leading buyers of Treasury bonds?
An important thing to keep in mind, though, is that in a time of geopolitical instability, the more likely outcome is that Treasury bonds would soar in value and interest rates plummet. Even with a large national debt, when the world seems scary and dangerous, investors habitually run to the safety of Treasuries. It’s hard to see why that would change in some future era of geopolitical threats. This is a good thing: When the U.S. government most needs money to fight a war, investors seem most inclined to lend it the money on favorable terms. And, for the record, if we're fighting a war with China, we have bigger problems than whether or not we decide to pay them back.
The baby boom is retiring. It is certainly the case that as the post-World War II generation retires, it will put a strain on the federal government’s finances. The costs of entitlements—mainly Social Security and Medicare—for this generational bulge would be more easily managed if deficits were lower.
But there are two weaknesses in this argument. First, the fact is that the costs are manageable today, and arguments that we should pre-emptively adjust the programs’ finances to match projections of their future challenges have an odd circularity to them: “We have to cut entitlements, because otherwise in the future we might have to cut entitlements.”
Second, the biggest source of the problem is health care costs that have persistently risen much faster than the economy. The longer-term fiscal problem the nation faces is, overwhelmingly, a health care problem. If we can succeed in making health care for seniors more affordable, the finances of Medicare will be fine. If not, they will be utterly impossible, and the program will have to be slashed dramatically. But that has more to do with fixing the details of how the U.S. health care system works than it does the levels of U.S. deficits or debts.
Greek-style fiscal crisis/ bond bubble popping/burst of inflation. A persistent fear is that investors will at some point decide that the U.S. government’s finances are a mess and/or inflation is at risk of getting out of control, and shun U.S. treasury bonds. This could cause a spike in interest rates and, for the Treasury, trouble rolling over the debt. The thing is, there is not even a shadow of a hint of this risk priced into financial markets. Treasury borrowing costs are extraordinarily low, as are market expectations of inflation. In traditional economic models, inflation can only really take hold if and when the economy is getting back close to its full economic capacity—and if that happens, it would also mean a rapidly falling budget deficit.
After the last few years we should certainly be aware that markets can misjudge risk, sometimes dramatically so (it was markets that placed a high value on subprime mortgage backed securities in 2007, after all). But if deficit hawks think the markets are wrong, they need to identify what exactly is wrong, and why they're so certain they're right.