That old view was born of the theory of “crowd out.” According to this theory, because the government competes with the private sector for “loanable funds,” budget deficits push up interest rates and slow economic growth. But while interest rates and deficits tended to be negatively correlated in the 1970s and early 1980s, that hasn’t been the case for years. What changed?
For one thing, it was always a mistake to think of “loanable funds” as a fixed lump of capital that borrowers from the public and private sector must fight over. Our economy is large and open, with deep, liquid, global credit markets, and our debt is considered among the world’s safest places to invest excess savings. And our central bank — the Federal Reserve — has its fingerprints all over the low rates-high deficits combo. The Fed held its benchmark interest rate below 1 percent for most of the past decade and convinced investors that it would keep inflation low and stable.
Alongside the lump-of-loanable-funds fallacy is the fact that our current, unusual fiscal stance is not leading to faster inflation and higher interest rates. The usual pattern, called “countercyclical” fiscal policy, holds that improving economies lead to lower deficits and weak economies require larger deficits. But today, we’re into “upside-down Keynesianism,” with growing deficits amid a long economic expansion — and no overheating in sight.
So, if we’re not paying the price of historically high debt, why not party on? Here are four reasons deficits still matter.
First, interest rates could eventually rise. If they do, we’ll be servicing a much larger stock of debt, thus devoting a larger share of national income to debt payments. I’m not predicting a return of crowd-out; I’m saying prudent risk management does not assign a zero probability to higher future rates.
Second, financing more of our public debt with foreign capital has led to an increasing share of our gross domestic product “leaking out” through debt payments abroad. Back in 1970, public debt held by foreigners amounted to less than 2 percent of GDP; most recently, the share was 30 percent. Thanks to that increase, a larger share of the income generated in the U.S. flows to residents of other countries, rather than to U.S. residents.
Third — and this is the concern I find most worrisome — is the lack of perceived, vs. actual, fiscal space. When the next recession hits, the main policy responses will be monetary and fiscal. The former involves actions by the Federal Reserve to reduce the cost of credit. Because interest rates have been low, the Fed is likely to have reduced monetary space — less room to lower their benchmark interest rate — in the next downturn.
Fiscal policy, which takes the form of deficit-financed policies like expanded unemployment insurance, nutritional support, fiscal relief to states and so on, does not face an analogous limit. However, if we mistakenly perceive a lack of fiscal space, it will hamper our recovery efforts. Research finds countries that go into recessions with debt-to-GDP ratios similar to ours tend to do less fiscal stimulus than needed. Were Congress to point to the deficit as a reason to hold back, and not take sufficient action to offset a downturn, it would be a fateful mistake, one that would disproportionately harm those who are already economically vulnerable, and who are least insulated from recessions.
Finally, our fiscal imbalances will make it harder to garner political support to fund current obligations (especially if interest rates rise). Public spending is expected to rise as a share of our economy — not because we’ve enacted a bunch of new programs, but due to pressures from our aging population and health care costs. Rising debt service has already sparked political competition between debt reduction and other budget functions, like safety-net and entitlement programs.
To be clear, a lot of Republican politicians complaining about the debt are in stark violation of the Bernstein Rule: If you voted for the tax cut, you can’t complain about the deficit. As I point out in my testimony, revenue loss drives our current deficits more than spending increases do.
So, if deficits do not pose the economic threat that many once assumed but there are still good reasons to stay wary of them, where’s the balance?
Like the fiscal serenity prayer says: We must divine the difference between good debt and bad debt. Good debt is investing in productive public goods, including education, jobs for those who need them, anti-poverty programs, green infrastructure and retirement and health security. Bad debt is tax cuts for the wealthy that only exacerbate our inequality problem, with no payback in terms of growth or investment.
If that sounds simple, that’s because it is.