It is important to stress that at present, liquidity concerns aside; all of the Irish banks are profitable and well capitalised.
—Merrill Lynch, September 28, 20081
Alexander Hamilton may have won the policy debates of the 1790s, but Thomas Jefferson had the last word when it came to the popular understanding of the national debt. In 1816, he wrote, “I, however, place economy among the first and most important republican virtues, and public debt as the greatest of the dangers to be feared.”2 For Jefferson, national debt threatened to corrupt the basic principles of republican government.3 That moralistic attitude—not dispassionate analysis of the costs and benefits of borrowing—has shaped public rhetoric about the federal government’s finances for most of American history.4 Politicians still talk about budget deficits as if they are bad in and of themselves, some kind of moral blight afflicting the American people or a stain on the American flag—so self-evidently evil that no further discussion is required.
But the deficit and the debt are just numbers. A national debt over $10 trillion may be more than $30,000 per person in the country, but no one is coming after you for your share of that money. The real question is: why should we care about the national debt?
There is one thing that both Democrats and Republicans have been able to agree on. On July 2, 2011, during the negotiations over raising the debt ceiling, President Obama said in his weekly address, “Government has to start living within its means, just like families do.”5 He was echoing what John Boehner, then the Republican minority leader in the House, had said two years before: “American families are tightening their belts. But they don’t see government tightening its belt.”6 In 2011, Rand Paul, a newly elected senator from Kentucky, published a book titled The Tea Party Goes to Washington; its cover showed the Capitol with a belt tied tightly around its midsection.7
The comparison between the government and a family is appealingly simple. It implies that the government has to bring in enough income to cover its spending, and if it doesn’t have enough income, it has to reduce its spending; in other words, it has to balance its budget. There is something to this basic point. If the government borrows money to run a deficit today, it has to pay back that money (with interest) tomorrow. The national debt never has to be completely paid off, because the government lives indefinitely, and hence there is no final reckoning. Still, the need to pay interest means that some portion of the government’s income must be dedicated to paying for past deficits, and, under ordinary circumstances, a government cannot run primary deficits (not counting interest payments) forever.8 Similarly, the more money that a family borrows, the more of its future income will be taken up by interest payments. But this analogy has two deep flaws. First, the government isn’t like a family in some extremely important ways. Second, even if the government were like a family, that still wouldn’t mean that balancing the budget is always a good idea.
Most obviously, the federal government has the power to levy and collect taxes. This gives it considerably more control over its income than an ordinary family has. But it doesn’t have to raise taxes now: the simple fact that it can raise taxes in the future means that the government can run a deficit this year and plan to make it up later. (A family could make the same plan, but it would be betting on future income that might not materialize.) This was Great Britain’s strength in the eighteenth century, which Alexander Hamilton set out to imitate. Raising taxes in the future can have harmful effects, particularly if those taxes create major distortions in the economy, so deficit spending is not free.9 But it certainly gives the government considerably more financial flexibility than the average family.
In addition to the power to tax, the federal government also has the power to print money. In theory, a sovereign government—one that does not have to answer to a higher level of government—could finance its budget deficit and avoid borrowing by simply printing money. The problem is that printing money can lead to higher inflation—as happened in the North and especially in the South during the Civil War—and if a government gets a reputation for printing money to pay its bills, inflation can get out of control quickly. This is why, despite widespread belief to the contrary, the federal government does not print money and put it in its own wallet.10 Instead, money is “printed” by Federal Reserve banks, which use it to buy securities (usually Treasury bills) on the open market. The Federal Reserve does not take orders directly from the president or Congress, which prevents politicians from creating money whenever they want more of it. Instead, the primary purpose of the Fed’s operations is to maintain interest rates and the money supply at the levels it thinks are best for the economy.11
Even if the government were like an ordinary family, what would that mean? Families often spend more than they earn in a given year and make up the difference by borrowing: they run “deficits” to pay for houses, cars, college tuition, medical emergencies, and many other things. There is no ironclad law that says that a family can’t borrow money, or that it’s a bad idea to borrow money. Sometimes going into debt makes financial sense, as is often the case with student loans. On average, the higher earning potential you get from a college degree more than compensates for the interest you have to pay on your loans (especially since that interest is artificially low, at least for federally guaranteed loans). Sometimes you have no choice, like in the case of a medical emergency: it makes sense to go into debt, get healthy, and try to pay the debt back later—just like it makes sense for a country to go into debt to fight a war, end the war on acceptable terms, and pay down the debt later. Sometimes it’s just a bad idea all around, like borrowing money from a loan shark to gamble at a casino.
The same goes for businesses. Ross Perot won 19 percent of the popular vote in the 1992 presidential election by promising to use his business expertise to balance the budget. In 2011, presidential candidate Mitt Romney also claimed his business experience taught him how to balance budgets.12 But what many people don’t realize is that debt is a routine part of business. In this context, the government is more like a family business than like a simple family. In a family business, it makes sense to borrow money if you can invest it in a worthwhile project, such as opening a new retail location. This is even more true if some family members are unemployed, because then the new investment can also provide them with work, making both the family business and the family members better off. (It can also make sense to provide retirement benefits to grandparents who have retired from the family business, rather than kicking them out on the street.) What’s true for family businesses is equally true for big business. Put together, the companies in the S&P 500a have much more debt than equity, which means that most of their assets are funded by borrowed money. They regularly borrow huge amounts of money to invest in new projects, or even just to buy back stock from their existing investors in a piece of financial engineering. And no one expects these companies to ever pay off all of their debt; if they did, investors would criticize them for not having enough debt.13 What businesses are good at—and governments are often not good at—is figuring out when they can borrow money at low interest rates and invest it to earn higher returns.
So even though the government isn’t like a family or like a business, there is an important lesson to be learned from this analogy. Borrowing money isn’t necessarily a bad thing. What makes it good or bad is what you spend it on. For a government, it’s usually a good idea to borrow money to pay for productive investments. What’s a “productive investment” is a valid question. For example, roads and bridges are often considered good investments because they help the economy—but not the famous “Bridge to Nowhere.”14 And even if roads are good investments, people disagree about whether the government or the private sector should build them.
There’s one more problem with the government-as-family analogy. The government isn’t supposed to act like a family: that’s the point of having a government. The government exists to solve problems that families and businesses can’t handle on their own, like national defense; to do that, it pools resources from those families and businesses. In the economic sphere, this means that the government should take action to cushion the impact of economic downturns. In a recession, families have less money and consume less, causing businesses to produce less and delay investments, reducing the number of jobs and forcing families to “tighten their belts” even more. This downward spiral can continue for years, especially if the government also “tightens its belt” by trying to balance the budget despite lower tax revenues, as occurred at the beginning of the Great Depression. Government spending should go up, if only because more people qualify for welfare and other entitlement programs, and tax revenues should go down, if only because people’s incomes are lower; this will require larger deficits and more borrowing.15 One of the purposes of having a government is to take actions that are good for society as a whole but that families and businesses won’t make on their own, which in this case implies higher deficits. (The corollary is that the government should raise taxes or cut spending during a boom—something governments have never been good at doing.)
It’s fine to say that families, businesses, and governments should all borrow money when they can invest it productively. But what about when you can’t come up with the cash to make your monthly payments, you’ve hit your credit limit, and you can’t borrow any more money? After taking over the leadership of the House of Representatives in early 2011, John Boehner said, discussing the prospect that spending cuts would lead to job losses in the federal government, “If some of those jobs are lost in this, so be it. We’re broke.”16 In introducing their budget proposal that spring, the House Budget Committee, led by Representative Paul Ryan, claimed that the nation was “on the brink of bankruptcy.”17 Representative and presidential candidate Ron Paul went further, saying, “The fundamentals show this country is bankrupt.”18
This sounds serious. Being broke generally means that you don’t have enough cash on hand to make your debt payments, which means you have to default. Default can mean bad things, like losing your house or, in some cases, having your wages garnished. And there is often a hard limit on how far a family can go into debt. If you lose your job and a medical emergency wipes out your savings, at some point no one will let you borrow any more money, and you will have to declare bankruptcy.
The rules are different for sovereign governments, however. If you take out a mortgage, there are laws that govern what happens if you don’t pay, and the bank can go to court to enforce those laws; declaring bankruptcy gives you some protection from your creditors, but also gives a court the power to distribute your assets. Because there is no international government, there are no equivalent laws for sovereign government debt.19 So even if a government is unable or unwilling to raise enough taxes to make its debt payments, it has other options. For one thing, an advanced industrial nation like the United States often borrows most or all of the money it needs in its own currency: the Treasury Department sells bonds in exchange for U.S. dollars, and when the bonds mature it redeems them with U.S. dollars. One option, used many times in the past in various countries, is for the government simply to create more of its own currency and use that to pay off its debt.
In addition to raising taxes or printing money, a sovereign government has a third option for dealing with its debt: it can renege. A Treasury bond is just a promise to pay by the federal government, and governments break their promises all the time. The U.S. government’s promise not to renege on its debt is a special kind of promise—one that has rarely been broken, and that financial markets around the world assume will not be broken—but not all governments’ promises have that status.20 In the modern world, it is unusual for a government to simply default and turn its back on its creditors, because then it will have little or no access to credit. More often, they restructure their debt: they extend the maturity (giving themselves more time to pay it off), lower the interest rate, pay it off with new bonds instead of cash, or do some combination of all three. The terms might be unilaterally dictated by the government, but more often they are negotiated with its creditors. Ultimately, as in many negotiations, it’s a question of power.21 No one can legally compel a government to pay debts it doesn’t want to pay. But if the government needs more cash, or just the credit necessary to finance international trade, it can’t simply walk away from its creditors; it has to negotiate a deal that they find acceptable. So while governments do sometimes default on their debts, they have considerably more control over the outcome than a family or a business.
This doesn’t mean that default is an easy way out. A government default is equivalent to a tax on bondholders; since it makes them immediately poorer, it will hurt the domestic economy (unless all the bondholders are foreigners22). A default or even a successful restructuring will make investors less willing to buy that government’s bonds, and therefore it will have to pay higher interest rates in the future—which will often raise interest rates for private borrowers. After a default, investors are more likely to lend money in a currency that the government cannot control. So, for example, the United Kingdom might not be able to borrow money by selling bonds denominated in pounds, and might instead have to issue bonds denominated in U.S. dollars or in euros. But once again, this is a choice. Governments deciding whether or not to default or restructure have to weigh the short-term benefits of lower debt payments against the short-term costs of economic disruption and the long-term costs of higher interest rates.
In any case, a government can only get to this point if it loses the ability to borrow money on acceptable terms. Otherwise, it could always make its current debt payments by borrowing more money, just like businesses roll over their debt by issuing new debt. And for this reason, the United States is far from going broke. For all of our long-term fiscal problems, the federal government still has just about the best credit in the world, with both short- and long-term interest rates at historic lows in 2011. Even after Treasury bonds were downgraded by Standard & Poor’s in August 2011, the markets responded by driving interest rates even further down to record low levels.23
There is some evidence that, if we do nothing about our long-term deficits, interest rates will eventually go up, making it more expensive for the government to borrow money.24 But even in that case, any decisions we make about paying our debts will be based on economic factors—whether it would be better to borrow money at high interest rates, raise taxes, or restructure our debt—not on whether or not we can come up with the cash. The only thing that could plausibly cause the United States to default would be a refusal by Congress to raise the debt ceiling. Then, no matter how many investors want to buy Treasury bonds, the Treasury Department would be unable to increase its total borrowing. At that point, the government would have to start running a balanced budget immediately or default on its debt payments.25 But apart from a failure to raise the debt ceiling—the fiscal equivalent of shooting ourselves in the foot—bankruptcy is one thing the federal government does not have to worry about today.
Inaugurating his bipartisan fiscal commission in 2010, President Obama said, “We have an obligation to future generations to address our long-term, structural deficits, which threaten to hobble our economy and leave our children and grandchildren with a mountain of debt.”26 The idea that growing deficits are unfair to future generations is another one on which Democrats and Republicans can agree. In 2010, Republican presidential candidate Mitt Romney wrote, “I cannot fathom the argument that it’s fine to spend more than we earn year after year. Passing on ever-increasing debt to our children is not just bad policy, it is morally wrong.”27 Now this sounds like a compelling argument: high deficits today mean that we are spending money that our grandchildren will have to pay back.
There is something to this idea, but not as much as one might think. First of all, the simple fact that our government runs a deficit today does not by itself make us any richer or our grandchildren any poorer. The material well-being of a society depends on the total volume of goods and services that are available for consumption. When the government borrows money, it is not reaching into the distant future and eating apple pies that otherwise our grandchildren would get to eat. Instead, it is borrowing money from people who are alive today—people who prefer to invest their money in government bonds rather than eating more apple pie.
To simplify things, imagine for a moment that the United States is a closed economy—one that has no interactions with the outside world. The federal government needs cash to pay for whatever it does—building roads, managing national parks, protecting the country from asteroids, and so on. One way to do this is taxing everyone. But there’s another option: selling bonds to people who have cash left over after consuming all they want. In two generations, the government decides to pay off its debt. To do that, it raises taxes and pays the additional cash to the bondholders’ grandchildren (who have since inherited the Treasury bonds). We have deferred the taxes from now to our grandchildren, but as a whole their generation hasn’t lost anything. The transfer of cash among our grandchildren—from taxpayers to bondholders—leaves them, as a group, no better or worse off than before. (And that transfer just balances the transfer in our generation, where the bondholders’ cash pays for services that we all enjoy or for public investments that benefit future generations.)
Although this picture captures the basics, it’s too simplistic in a few ways. One is that whether future generations are better or worse off depends on what the government does with the money it borrows. If the government spends money on something, how it pays for it doesn’t matter to our grandchildren (as a whole). But what it spends the money on does matter. Our descendants’ prosperity depends on the economy that we leave to them, which depends on the investments that we make between now and then. From an economic perspective, families have two choices for what to do with their money: consumption or saving. Savings flow through the financial system to businesses, which invest it in equipment, factories, and other things that are required for higher production. So as a generation, we can either consume our income, making us happier now, or we can invest it, increasing the economic growth that will eventually benefit our grandchildren.
When the government borrows money, this can reduce the amount of money available for businesses to invest. But the government doesn’t just take that money out to a big field and burn it: it spends it on the priorities set by the political system. If it makes productive investments, the economy as a whole will benefit and all of our grandchildren will be a little better off. If instead it spends the money on “consumption”—for example, buying health care for people—this can reduce the amount of investment by our generation, making all of our grandchildren a little worse off. In this context, government spending on health care sounds bad for future generations, because borrowing is used to finance consumption today rather than investment for tomorrow. But this has to be weighed against the policy reasons for government health care programs, which can foster a healthier, more productive workforce and provide valuable insurance benefits to the population as a whole. In short, what the government spends its money on matters more than how it finances that spending.
The other issue is that the United States is not a closed economy. When the government sells bonds, the buyers aren’t just Americans, but also investors around the world—who are more than happy to buy Treasuries, since they are widely considered the safest assets available. But this means that if our grandchildren want to pay down the national debt, they will have to transfer money overseas to the grandchildren of the non-Americans who are buying Treasury bonds today. (In practice, most of the buying is done by foreign governments and institutions, but that doesn’t make a difference here.) That looks like it’s making us richer and our descendants poorer: we can borrow money from overseas and eat more apple pie today, while they will have to ration apple pie so they can pay off our debts. But things aren’t necessarily so bad. Businesses borrow money from “outsiders” all the time, meaning they have to dedicate some of their future profits to paying back their bondholders, but no one thinks that makes it a bad idea. Government borrowing from abroad to finance investment can be good for our grandchildren; borrowing from abroad to finance consumption, by contrast, shifts the burden of paying for that consumption to them.b In addition, because the government can sell bonds to foreign investors, every extra dollar of government borrowing does not automatically mean a dollar less in private sector investment. Finally, although foreign holdings of debt issued by Americans (including households, businesses, and governments) represent money that will have to be sent overseas in the future, total foreign investments in the United States are almost matched by American investments in other countries; our rising debts to foreigners simply reflect, in part, the globalization of the world economy.28
Still, we cannot be confident that the federal government is investing the money that it raises overseas in projects that will increase long-term productivity—in particular, we know that a large proportion of government spending consists of transfers to the elderly—so current deficits could force our grandchildren to pay higher taxes without giving them any commensurate economic benefits. Economists Laurence Kotlikoff, Alan Auerbach, and Jagadeesh Gokhale developed a way of calculating how the costs and benefits of fiscal policy are spread over generations.29 This technique, called “generational accounting,” predicts that if current policies continue indefinitely and the national debt must be paid down someday, future generations will have to pay much higher taxes or receive much lower transfers than people who are alive today.30 But generational accounting involves a couple of major complications. First, like any economic calculation that involves long periods of time, it requires us to place a weight (discount rate) on cash flows that will occur in the distant future, and its results depend heavily on that weight.31 Second, the tax differential between current generations and unborn generations results in part from the extreme assumption that the burden of policy change will fall entirely on the latter and not on the former.
Even if borrowing money from overseas to finance Social Security and Medicare spending does impose a burden on future generations, that doesn’t necessarily make transfers to the elderly a bad thing. Since Social Security and Medicare are self-funded systems (to different degrees), the “problem” could be framed not as excessive spending today but as insufficient payroll taxes in the past (when current beneficiaries were working). Policies that reduce transfers to the elderly also affect the young and the unborn: for example, without Medicare, working-age adults would have to spend more money taking care of their parents, leaving less to spend on their children. More generally, there is nothing intrinsically wrong with a system that transfers income from the young to the old, even if it may not be the best thing for economic growth (since investments in the young will have a greater impact on future productivity).32
This is especially true since, as a group, our grandchildren are likely to be richer than we are, just as we are richer than our grandparents were.33 A society’s standard of living is determined by the total volume of goods and services it can produce per person. The secret to a higher standard of living is productivity: if the average worker can produce more each year than the year before, then there will be more goods and services for everyone. Labor productivity has risen consistently since the nineteenth century;34 productivity has quadrupled, growing at an average rate of 2.3 percent per year, since the Bureau of Labor Statistics began collecting data in 1947.35 Over a fifty-year period—about two generations—productivity should roughly triple, which should more than compensate for the fact that a growing proportion of the population will be retired.
Rising productivity, of course, doesn’t mean that everyone will become more productive, or that wages will grow as fast as productivity. (In fact, median wages have been stagnant for the past decade or longer.) Our grandchildren may face problems of inequality, just as we do today. Higher borrowing from overseas today means that our grandchildren will have to send a larger share of their output overseas in the form of interest payments, which will partly offset the benefits of higher productivity. So the growth rate of the American standard of living could be lower in the future than it has been in the past.36
How much our grandchildren should have relative to us is ultimately a moral question, and one without a clear answer. Assuming that we want them to be better off than we are, a large national debt is one thing we should worry about, but far from the only thing. We should also worry about leaving them a productive economy and a healthy planet to live on, which means investing in the physical, environmental, and educational infrastructure that they will inherit. Simply invoking the interests of future generations does not provide easy answers to any of our fiscal policy questions.
Back in 1993, when President Clinton decided to make deficit reduction his top economic priority, he feared that high government deficits were harming economic growth. Lower deficits, he argued, would make the economy grow faster, helping to balance the budget and providing more money for the social programs he promised during his campaign. The boom of the 1990s seems to support this argument, but economic cycles have so many possible causes that it is impossible to prove that the 1993 budget act led directly to higher growth.
The impact of deficits on the economy is a controversial and complex topic, largely because different people claim that deficits have opposing effects on the economy. Some people (often but not always Democrats) argue that deficit spending in a recession will increase growth by injecting more money into the economy and thereby stimulating economic activity. Other people (often but not always Republicans) argue that when the government borrows large amounts of money, it forces up interest rates for everyone, hampering economic growth. The problem is that both schools of thought are correct; which effect will win out depends on the circumstances.
In a recession, it is generally true that increasing government spending or cutting taxes increases short-term economic growth. As the economy slows down, households reduce their consumption and businesses lay off workers, pushing the economy into a vicious cycle: in the 2007–2009 recession, consumption fell by more than 3 percent, and businesses responded by eliminating almost nine million jobs.37 In these circumstances, higher government spending or lower taxes will put more money in people’s bank accounts, encouraging them to spend more and thereby motivating businesses to invest and hire more, reversing the vicious cycle. This was the goal of the stimulus packages passed in 2008 and 2009 under the Bush and Obama administrations; without the 2009 stimulus, businesses would probably have eliminated an additional one to three million jobs.38 Higher spending and lower taxes both mean larger deficits, but if the economy returns to its full potential as soon as possible, economic growth will bring the higher tax revenues that will make it possible to balance the budget. (By the same logic, lower spending or higher taxes—which are necessary to reduce a budget deficit—can reduce economic growth.)
Considered on their own, however, all other things being equal, deficits can hurt economic growth. Deficits mean that the Treasury Department must sell its bonds in the financial markets, where they compete with all other bonds, which represent companies building factories, families buying houses, college students paying their tuition, and so on. More government borrowing means more demand for bond investors’ money, so the price of that money—the interest rate on loans—goes up, at least in theory. Therefore, as government deficits increase, bond investors will want higher interest rates from the Treasury Department and from all the other people and companies trying to borrow money. Higher interest rates make it harder for companies to build factories, families to buy houses, and students to go to college—all things that tend to be good for the economy. This phenomenon, known as “crowding out,” can result in lower growth.
To recap, then, budget deficits can hurt economic growth—but the things that create deficits (higher spending and lower taxes) can help economic growth.c This is not very helpful as a guide to policy, but it is helpful to politicians, who can pick whichever side of the issue is convenient at the time. In 1993, both President Clinton’s Democratic economists and the Republican chair of the Federal Reserve, Alan Greenspan, agreed that deficit-produced high interest rates were the major constraint on the economy, and therefore they made deficit reduction their top priority.39 In the economic slowdown of 2001, when deficits were no longer a political issue, President George W. Bush argued for cutting taxes as a way to boost economic growth.
Today, however, when deficits are high and economic growth is slow, many people debate which policy is better: increasing spending and cutting taxes to stimulate the economy at the cost of increasing the deficit, or cutting spending and increasing taxes to reduce the deficit at the cost of hurting economic growth. Although the conventional wisdom is that deficit cutting will only make a slowdown worse, it is theoretically possible that, in some circumstances, a “fiscal contraction” can help produce growth.40 Much of the policy debate for the past two years has been about precisely this issue. Democrats today usually argue that slow growth calls for more economic stimulus, especially with unemployment well above the levels that could cause inflation to accelerate;41 Republicans today usually argue that high deficits are weighing on the economy and must be slashed, preferably through spending cuts. (These positions are not set in stone, however: in 1984, Democratic presidential candidate Walter Mondale argued that large deficits were raising interest rates, reducing investment, and crippling economic growth—although he thought that higher taxes would be the solution.)42
Fortunately, there is a way to judge this debate: looking at the numbers. If high deficits are harming the economy, as was believed in the early 1990s, that should be showing up in higher interest rates demanded by the “bond market vigilantes.” Yet interest rates have remained stubbornly low, averaging barely over 3 percent in 2011—and showing no relationship to increases in the national debt (see Figure 5-1).43 These rates have also been far lower than in the periods following previous recessions.44 Low interest rates generally mean that the financial markets are more worried about low economic growth than about high deficits. In effect, the bond market has been encouraging the federal government to borrow more money by lending it so cheaply.45
That isn’t quite the end of the story, however. Even if large deficits are not showing up in high interest rates today, the theory of crowding out says that they will show up eventually. Today’s low interest rates are partly due to economic weakness itself: as long as consumers aren’t buying a lot, businesses won’t make new investments, which means less demand for money and therefore lower interest rates. As the economy recovers, interest rates should go up, and if the federal government continues to borrow large amounts of money, that could push interest rates up even faster. In 2011, Macroeconomic Advisers, a leading economic consulting firm cofounded by former Federal Reserve governor Laurence Meyer, projected that interest rates on ten-year Treasury notes would rise to 8.75 percent by 2021 because of concerns about deficits.46 But reducing the deficit still might not increase economic growth. Macroeconomic Advisers estimated that the deficit reduction plan proposed by the bipartisan National Commission on Fiscal Responsibility and Reform (established by President Obama in 2012) would reduce economic growth, increasing unemployment by almost 2 percentage points. In the short term at least, the economic benefits of reducing the deficit would be outweighed by the costs.
Figure 5-1: National Debt and Interest Rates
In the long term, we can’t be sure at what point the national debt imposes a significant drag on the economy. A recent paper by economists Carmen Reinhart and Kenneth Rogoff has been widely cited as evidence that bad things will happen if the national debt exceeds 90 percent of GDP.47 They show that growth rates tend to be somewhat lower (about 1 percentage point) for countries with debt over that threshold than for countries with debt below it.48 But while this may be a reasonable warning sign, it is hard to know what it means for the United States because even their findings for advanced economies are the averages over sixty years of twenty different countries—nineteen of which did not enjoy the particular benefits of issuing the world’s reserve currency.49 (Reinhart and Rogoff also find no evidence that higher debt levels will cause higher inflation.)50
In general, higher interest rates and resulting lower growth are a valid reason to worry about the national debt. If we do nothing about our long-term deficits, they could have real economic consequences before the end of this decade. But that does not mean that we have to slash government spending or raise taxes right now, when the economy is weak, unemployment is high, and interest rates are low. From a purely economic standpoint, the best policy is to stimulate the economy (and increase the deficit) now while simultaneously committing to deficit-reducing policies that will kick in later, when sustained growth has resumed.d 51 Politically, however, such an agreement is almost impossible to imagine because it requires Congress to do two seemingly contradictory things at the same time—and counts on Congress not to undo the painful part of the deal (deficit reduction) after the painless part (stimulus) has already happened. Given our current political system, it is likely that we will have to make tougher choices.
From the time Greece adopted the euro as its currency in 2001, its economy boomed. As a member of the eurozone, its credit was considered almost as good as Germany’s, despite a national debt hovering around 100 percent of GDP.52 The government and the private sector were both able to borrow money cheaply, allowing the country to grow much faster than Europe as a whole through 2007; that growth prevented debt levels from climbing too much relative to the economy. Then, in 2008, the global financial crisis sent the world into recession. The Greek government responded with unpopular budget cuts, fueling street riots. In 2009, a new government came to power and announced that the annual budget deficit would be 12.7 percent of GDP—over twice as high as claimed by the previous government.e (It eventually turned out to be over 15 percent.) With growing deficits and the economy still shrinking, bond investors began to worry that they might never get their money back: interest rates soared, making it harder for the government to borrow the money it needed to pay off debts that were coming due. A default would have meant steep losses for the financial institutions that held Greek debt and could have triggered another financial panic, especially since Greece was considered a leading indicator of what might happen in other struggling European countries such as Portugal, Ireland, Spain, and Italy. To prevent this potential nightmare scenario, in May 2010 the European Union and the International Monetary Fund came to the rescue with an emergency loan package that required Greece to cut spending and raise taxes even further, generating more popular unrest. But with the deficit still above 10 percent of GDP, the national debt rising, unemployment over 14 percent, and no solution in sight, the bond market again became skeptical about Greece’s prospects. Interest rates spiked above 25 percent in 2011, forcing the country to enact even more “austerity” measures and ask for another emergency bailout.53
This is a “fiscal crisis.” Instead of large government debts slowly weighing down the economy through higher interest rates, everything goes bad all of a sudden: investors stop lending money, the government can’t sell new bonds to pay off its old ones, and it either defaults or gets bailed out by an international organization, usually the International Monetary Fund. In either case, unable to borrow easily, the government must slash spending and raise taxes simply to continue functioning.
A fiscal crisis is what happens when investor psychology reaches a tipping point. The experience of the past two decades has shown us that stock markets and housing markets can swing up or down rapidly based on changes in investor sentiment; the same holds true for bond markets. For years, the market can look on serenely as Greece runs large deficits on top of an already large national debt, confident that a booming economy will solve all problems. Then one day something happens—growth projections (which are never particularly stable) get revised downward, interest rate projections get revised upward, the deficit gets revised upward, the government fails to pass a measure that investors were counting on, or something else—and suddenly no one wants to buy Greek bonds. Bond rating agencies that had blindly recommended Greek debt during the preceding boom now start downgrading it. Rising interest rates exacerbate fears of default, making rates rise even faster.
But that’s Greece. Could it happen here?
The problem with the theory of fiscal crises, like any tipping point theory, is that it is impossible to disprove. During the recent financial crisis, every time someone warned that interest rates were about to go up, they remained historically low.54 But no matter how many times you cry wolf, a wolf could still show up. Greece, after all, is suffering from an acute fiscal crisis that is dramatically lowering living standards for its citizens and putting the eurozone itself in jeopardy. As a matter of logic, the United States is not immune to fiscal crises: at some point, if the debt is big enough, the deficit is high enough, and the chances of reducing the deficit appear slim enough, we could go the way of Greece. It probably isn’t anytime soon. But no one knows when it could happen.
No one knows because there is no other country in the world quite like the United States—and there never has been one, either, for several reasons. Two centuries of fiscal responsibility count for something. So do a generally healthy economy and the ability to borrow money in our own currency (which means that, unlike Greece, we have the option of devaluing the dollar to make the debt easier to pay off55). But what really matter are our unique status as the world’s safe haven in a financial storm and the dollar’s unique status as the world’s reserve currency.
For a moment at the peak of the recent economic boom, there were rumblings that the dollar might be losing its privileged place in the international economy. In 2007, superstar rapper Jay-Z released a music video in which he flashed wads of 500-euro bills, and rumors circulated that supermodel Gisele Bündchen was insisting that she be paid in euros.56 But the ensuing financial crisis showed that the world was not yet ready to move on from the dollar. In uncertain economic times, it’s dollars that people want: not euros, with Europe facing a succession of sovereign debt crises that could split the eurozone apart; not yen, with Japan entering its third decade of slow growth and with government debt at the highest levels in the industrialized world; and not yuan, with an autocratic government in power in China. In general, wealthy governments and central banks store their rainy-day money in U.S. dollar assets. And every time the world’s financial markets wobble, investors dump their risky assets and buy U.S. Treasury bonds—never more so than in the panic of 2008–2009, when the price of everything else went down and the price of Treasuries went up so high that investors were actually paying the U.S. government to hold their money for them.57 The concentration of U.S. debt holdings among central banks does come with a risk, however. Today, Treasury interest rates are heavily influenced by a relatively small group of investors who care much more about safety than about their economic returns. So if these central banks decide that the United States is no longer particularly safe, interest rates could rise quickly—faster than if our bonds were held only by “ordinary” investors.
As long as the dollar is the dominant global safe haven, however, it’s hard to envision the United States experiencing a severe, sudden fiscal crisis at our current debt levels. There may be some debt threshold where investor sentiment is likely to turn against Treasury bonds rapidly—but it is probably higher than for other countries. Things would have to go badly before investors would pull the plug on the United States, and they would have to go worse than anywhere else. Most major shocks that would severely damage the American economy would also hurt the other contenders for reserve currency status; the financial crisis, for example, started in the United States but rapidly spread to the rest of the world, and demand for Treasuries went up as a result. To lose our privileged position quickly, we would probably have to fumble it away—for example by failing to increase the debt ceiling and then defaulting on our debts (and even that might not do it58).
Like all good things, however, our current status will not last forever. Empires rise and fall, whether military or economic. As emerging market countries mature, they may shift toward more domestic investments, reducing overall demand for dollars.59 Someday, perhaps, China will become the world’s safe haven, although that would require major changes in both its political and economic systems. Confidence in the euro is currently falling, not rising, but another possibility is that the ongoing European sovereign debt crisis will force fiscally weaker countries out of the eurozone, leaving a smaller nucleus centered on Germany; this new euro could then be a serious competitor for reserve currency status. Perhaps the most likely possibility is that we will enter a multipolar monetary world where central banks and government investment funds hold different mixes of dollars, euros, and yuan, depending on who their major trading partners are. In that case, the dollar would still be an important international currency, but demand for dollar assets would be lower than it is today.60 This is unlikely to happen in the next three years, in part because it is difficult for central banks and international markets to shift away from dollars.61 But it could happen in the next thirty, at which point our unique fiscal buffer could melt away. Over the next few decades, we may very well become more like an ordinary rich country—one that could have trouble adding continual deficits to already high debt levels. That should give us time to put our fiscal house in order before we become vulnerable to a Greek-style crisis.
Or does it?
When 2007 began, Ireland was booming. Its economy had been growing at an average of 7 percent per year for a decade, making it one of the richest countries in Europe. Newfound prosperity fueled a surge in housing construction that helped keep the economy expanding; at its peak, construction employed one in five Irish workers. Irish banks grew rapidly during the boom, gathering deposits from around the world and lending most of them to Irish developers and homebuyers. Rapid economic growth reduced the national debt from over 90 percent of GDP in the early 1990s to just 12 percent by 2007.62
But then housing prices began to fall, American investment banks started to fail, the global financial markets froze up, and suddenly Ireland’s now massive banks were unable to roll over their debt. As Ireland plunged into recession—the economy would shrink by 10 percent—the Irish government decided to guarantee the banks’ liabilities (relying in part on a Merrill Lynch memo insisting that the banks were sound),63 effectively shifting their debts onto the backs of the government and its taxpayers. Government debt soared to more than 60 percent of GDP by 2010 as the banks’ financial condition deteriorated, requiring a steady drip of government money.64 With a stagnant economy and unemployment over 13 percent, Ireland could no longer grow its way out of its economic problems. In November 2010, the Irish government had to request a bailout package from other European countries and the International Monetary Fund. But government debt continued to grow—to more than 90 percent of GDP in 2011—leading the rating agency Moody’s to downgrade Ireland’s credit rating to junk bond status amid fears that yet another bailout would be necessary.65
According to our conservative scenario (in which the income and estate tax cuts are made permanent), the U.S. national debt should grow from close to 70 percent of GDP today to around 76 percent of GDP in 2021.66 For the reasons described in the previous section, we think that these debt levels are unlikely to trigger a severe fiscal crisis during this period. But Ireland’s national debt was only 12 percent of GDP as recently as 2007. The moral of the Irish story is that bad things can happen quickly.
All projections about future deficits and debt depend heavily on assumptions—about government policy, about economic conditions, and about the state of the world. We believe the Congressional Budget Office generally does a good job of coming up with reasonable forecasts of policy decisions and economic trends (and its forecasts are consistent with and as accurate as those of private sector forecasters), but no one can see the future.67 This creates two types of risks. The first is that economic growth will be lower than expected. For example, at the peak of budgetary optimism in May 2001, when politicians were talking about surpluses for decades, the economy had already entered a moderate slowdown that was lowering tax revenues and reducing surpluses. The second type of risk is that something completely unexpected can happen. In May 2001, no one could see two specific things: the terrorist attacks of September 11, 2001, which helped tip the slowing economy into a mild recession,68 led directly to a buildup in national security spending and the Afghanistan War, and led indirectly to the Iraq War; and the financial meltdown of 2007–2009, which triggered the worst economic crisis since the Great Depression. September 11 (with the political decisions that followed it) and especially the financial crisis together added trillions of dollars to the national debt.
Every economic projection involves uncertainty, and if growth is below expectations, deficits will be larger. But forecasts may be too low as often as they are too high; forecasts in the mid-1980s tended to overestimate future growth, while those in the mid-1990s tended to underestimate it.69 But the second type of risk—large, unexpected shocks—seems to be heavily weighted toward the downside, at least as far as the federal budget is concerned. We have seen the impact of unforeseen terrorist attacks, wars that turned out to be far more expensive than promised, and a near collapse of the global financial system; by the middle of 2011, the U.S. economy was still not as big as it was at the end of 2007.70 Most of the other surprises that could significantly affect the federal budget also seem to be of the nasty variety: pandemic, natural catastrophe, or nuclear meltdown. The biggest positive “surprise” in recent memory was the rapid collapse of the Soviet bloc at the end of the 1980s, which allowed both the George H. W. Bush and Clinton administrations to reduce defense spending. This “peace dividend,” however, is unlikely to be repeated, since current projections already assume the planned drawdown of forces in Iraq and Afghanistan. In short, this second category of risk is asymmetric: if something is going to suddenly shift the national debt one way or the other, it is more likely to go up than to go down.
The fact that bad things can happen has two major implications. First, a major shock can cause a rapid jump in the national debt, bringing a country that much closer to a fiscal crisis, as happened in Ireland. Second, in order to cope with a major shock, a country may need to rapidly increase spending, cut taxes, or take on additional debts. In 2008–2009, the United States government was able to prevent the financial system from completely collapsing because it could commit trillions of dollars to back up major financial institutions and protect them from running out of money.71 The government was also able to deploy close to $1 trillion in new spending and tax cuts that helped limit the severity and duration of the recession.72 The federal government was able to take these extraordinary measures for two reasons. First, it had “fiscal space”: there was still a wide gap between the national debt and the level at which lenders might get nervous and stop buying Treasury bonds.73 Without sufficient fiscal space, the government might not have been able to bail out the financial system, and the crisis could have triggered a lasting worldwide depression. Second, the government had barely enough political legitimacy to use that fiscal space: despite the support of President Bush, both presidential candidates, and leaders of both parties, the Troubled Asset Relief Program required two votes (and a plunge in the stock market when the first vote failed) to get through Congress.
Fiscal space matters because you need it as a buffer against the sudden debt increase caused by a crisis and because having that space helps you fight that crisis. This is an idea that Alexander Hamilton would have recognized, although he was more familiar with eighteenth-century wars than with twenty-first-century financial panics. It was brought home to the United Kingdom during the 1956 Suez Canal crisis, when it was forced to withdraw its troops from Egypt—in order to gain needed United States support for an emergency loan from the International Monetary Fund. The final decline of the world’s largest empire, it turned out, was marked by a speculative run on the British pound—because pounds were no longer the world’s reserve currency.74
Unfortunately, it’s impossible to know how much fiscal space you have at a given moment. Market sentiments can change rapidly, so you may not realize you are running out of fiscal space until you have none left. A government may be able to borrow at low rates up until a nasty surprise—recession, financial crisis, or discovery that the previous government fudged the numbers—makes interest rates skyrocket.75 Greece, for example, could borrow money at an interest rate of less than 5 percent as late as November 2009; a year later, it had to pay more than 11 percent; and in 2011 interest rates went above 25 percent.76 Fiscal space also depends on political factors: whether or not the government is willing to raise taxes in the future to pay off the additional debts it needs to incur now. Since there’s no way to know how a government will behave in the future, a country’s past behavior—how willing it has been to pay down debt in the past—affects how much investors trust it today. According to an estimate by IMF economists, based on past experience, the United States probably could withstand a shock that increased the national debt by 50 percent of GDP, but probably could not withstand a shock that increased the debt by 100 percent of GDP—at least not without something changing significantly.77
Still, 50 percent of U.S. GDP is a lot of money—more than $7 trillion. Do we need to worry? We do know one thing that can add that much to the national debt in a hurry: a financial crisis. As discussed in chapter 3, the recent financial crisis caused our projected national debt level to increase by almost 50 percent of GDP in less than two years.78 This is a major reason why serious reform of our financial system should be an urgent national priority. With all the rhetoric about the national debt spinning in Washington, you would hope that politicians would at least focus on preventing a repeat of the events that triggered the current debt crisis. But instead, despite some worthwhile provisions, the Dodd-Frank Wall Street Reform and Consumer Protection Act of 2010 left largely intact the highly concentrated, highly leveraged, highly unstable financial system that failed in 2008.79 Since the 2010 elections, the new Republican majority in the House of Representatives has been working to weaken financial regulation further, cutting the budgets of key regulatory agencies in the name of saving money (even though, in at least one case, the savings go directly to financial institutions, not to reducing the deficit80) and thereby increasing the chances of a financial meltdown that could add trillions of dollars to the debt.
A financial crisis is not the only thing that could go wrong. There is the centuries-old cause of budget deficits: war.81 The Iraq and Afghanistan wars have directly added well over $1 trillion to the national debt in war-related appropriations and interest payments on the additional debt.82 And Iraq, by historical standards, was a relatively small war, mainly fought with fewer than 200,000 soldiers at any one time. By comparison, over 500,000 soldiers were deployed to Vietnam in 1968–1969, and over 300,000 to Korea in 1951–1953 (although military equipment and health care were much less expensive back then).83 The national debt will constrain our ability to use military force against overseas threats, whether real or imagined.
Lack of fiscal space and vulnerability to a major shock are serious problems. How much we should worry about them, however, is a difficult question because we don’t know how much fiscal space we have—and we don’t know how likely we are to suffer a major shock. All other things being equal, more fiscal space is always better, but other things are never equal. When it comes to budgetary policy, it’s difficult to balance unpleasant options today—higher taxes or lower spending on services or transfers that people value—against threats that are difficult to quantify and that may not materialize. That doesn’t mean that there is a magic quantity of fiscal space that we have to have, but it is another reason why, over the long term, it is important to bring down our government deficits and national debt. Right now, with Europe undergoing its own sovereign debt crises, a slow economy in the United States keeping interest rates low, and no good alternative to the U.S. dollar as a global reserve currency, we could probably cope with a major crisis. Any constraint on the ability of the government to respond to a crisis is likely to be imposed by political forces in Congress, not by the markets. But we should not assume that we will have that capacity forever.
Today, with high unemployment and stagnant wages, many families are worried about balancing their own household budgets. Compared to the day-to-day challenges of paying for housing, food, clothing, electricity, education, and health care, the federal government’s finances are a distant and unfathomable abstraction. American citizens can be forgiven for not knowing where budget deficits come from and why they matter.
In ordinary times, the national debt has only an indirect, invisible effect on most people’s lives: growing debt and continued government borrowing can produce higher interest rates, slowing down economic growth and ultimately making all of us worse off. But there are several ways that the national debt could have a direct impact on the living standards of middle-class Americans.
One possibility is that our political system will stumble along for another decade or two, with deficits growing under the weight of serial tax cuts, demographic shifts, growing health care costs, and government inaction. At the same time, Europe straightens out its debt problems; China not only continues growing but also becomes more democratic and transparent, making it an attractive place for countries to invest their excess cash; and those newly wealthy emerging market countries begin consuming more and saving less, reducing their foreign investments. The Treasury Department needs to borrow more and more money, but faces a global bond market that has less and less appetite for its bonds. As interest rates climb, investors quickly become nervous about the federal government’s ability to redeem its rapidly growing pile of outstanding debt; they demand higher interest rates, which spiral up further, and suddenly there is no one willing to lend new money. The Federal Reserve could print new money to pay off the debt, but that would fuel high inflation (and make it harder for us to borrow money in the future). Alternatively, the United States would need an emergency loan, but those loans typically come with strict conditions. One way or another, we would be forced into steep tax increases and spending cuts that would depress the economy, causing a painful contraction in living standards. The result could be widespread unemployment and poverty. This is what Greece is going through today, and it could happen here—though it would take some time for us to reach that point.
Things could also unravel faster. Imagine the financial crisis of 2018, when our largest megabanks, their balance sheets leveraged to the hilt with securities backed by real estate or commodities or whatever the latest bubble is made up of, are suddenly unable to roll over their debt and the global financial system teeters on the edge of collapse. In 2008, it was essentially the enormous credit lines of the United States and some European countries that saved the financial system and the global economy: no one doubted that the Federal Reserve and the Treasury could absorb hundreds of billions of dollars of losses if necessary to keep the system functioning. In 2018, with the national debt twice as high as in 2008 and still growing rapidly (and with Europe still recovering from a decade of sovereign debt crises), investors might have their doubts. More likely, if the current mood continues, Congress will be unwilling to sign a blank check and the government will be unable to bail out the financial system—at least not until things got much worse than they did in 2008. Deficit hysteria in 2011 was almost enough for Congress to force the government into default rather than raise the debt ceiling. By 2018, with a much larger national debt, it will probably be enough for Congress to gamble with a financial crisis rather than bail out the bankers again. Without an immediate, forceful response, the next financial crisis could produce mass chaos and another depression.
Finally, we don’t have to wait until 2018. The national debt is already having serious consequences for ordinary people—not direct economic consequences such as higher interest rates, but political consequences. Like it or not, the vast majority of Americans depend in part on the federal government for their basic livelihood, either now or in the future. Most obviously, we rely on Social Security and Medicare to maintain our income and pay for our health care in retirement. It’s not just seniors who depend on these programs. If Medicare did not exist, for example, all of us would have to save much more money to pay for health care in old age—and even then we might not be able to buy health insurance, at any price—in addition to supporting our elderly relatives. One in four people rely on Medicaid or the Children’s Health Insurance Program for health care.84 Without the trillion-dollar deficits produced by the recent financial crisis, these popular programs would not be under siege in Washington as they are today. Political posturing over deficits has also made it impossible for the government to do anything to bring down unemployment, which remains at high levels years after the worst of the financial crisis; it has made it difficult to enact even the most minimal policies to help struggling families and preserve valuable human capital, such as extending unemployment insurance benefits for the millions of people who have been out of work for more than six months; and it has even been mobilized for ideological purposes such as cutting off federal funding for Planned Parenthood and crippling enforcement of new financial regulations. In all these ways, deficits are already, through the workings of the political system, taking their toll on ordinary people.
What could a couple decades of this kind of politics look like? Every time growth goes down and deficits go up, we’ll cut spending on government services and make modest reductions to Social Security and Medicare benefits. Growth will return as the business cycle turns up, deficits will come down for a few years, and the national debt will fall off the political agenda. But then deficits will come back because of a recession or because of demographic and health care trends. Then we’ll repeat the process, cutting spending some more. Each time, services and social insurance programs that lower- and middle-income people depend on will bear the brunt of the spending cuts, eroding away our already modest social safety net. Since many government programs, broadly speaking, distribute money from the rich (who pay more in taxes) to the poor (who benefit more from social insurance), these periodic rounds of deficit cutting will have the net effect of reversing this flow, shifting resources back toward the rich and increasing inequality above its already historic levels. A few rounds of this and the United States will look like a stereotypical Latin American country, with the super-rich living on private islands in the Caribbean, a comfortable professional class that holds the desirable jobs, and a large, struggling lower class.
America does face a long-term debt problem. Today, the specter of the national debt is a blunt instrument that is used to block needed investments and chip away at the modest programs that benefit the poor and the middle class. As long as we face the prospect of significant long-term deficits, our political system will continue to be dominated by hysteria, demagoguery, and delusion. Given the current balance of political power, the most likely outcome is that government deficits will be invoked to slash spending that ordinary people depend on—while continued tax cuts ensure that the deficits never go away. In other words, if we don’t solve our debt problem the right way, it is certain to be solved the wrong way. Our challenge is to defuse our national debt crisis in a way that is credible and fair, that maintains our ability to make vital productive investments, that preserves the services that most people value and depend on, and that encourages economic growth for decades to come. It is to that challenge that we now turn.
a The S&P 500 is a stock market index that includes 500 of the largest companies in the United States.
b There is one theory, called “Ricardian equivalence” after the economist David Ricardo but most closely associated with the economist Robert Barro, that says that even in this case our grandchildren are no worse off. According to that theory, if the government borrows money for consumption today, each person will anticipate that taxes will have to go up in the future to pay back that borrowing. Therefore, people in aggregate will reduce private consumption by the same amount that the government increases public consumption; they will save the extra money, passing it down to their grandchildren to pay the eventual taxes. By the same logic, attempts to stimulate the economy will necessarily fail, since people will automatically increase saving to compensate for tax cuts or spending increases. Most economists are skeptical that people actually behave this way; in any case, the effect is likely to only partially offset current fiscal policy. Barro presented the modern theory of Ricardian equivalence in Robert J. Barro, “Are Government Bonds Net Wealth?,” Journal of Political Economy 82, no. 6 (1974): 1095–1117. For an overview and conventional assessment of Ricardian equivalence, see Douglas W. Elmendorf and N. Gregory Mankiw, “Government Debt,” chapter 25 in John B. Taylor and Michael Woodford, eds., Handbook of Macroeconomics, vol. 1 (Elsevier, 1999), pp. 1640–59. For a recent overview of empirical studies, see Oliver Röhn, “New Evidence on the Private Saving Offset and Ricardian Equivalence,” OECD Economics Department Working Paper 762, May 6, 2010, pp. 5–6.
c According to Ricardian equivalence, however, neither will have any effect. Increased spending or lower taxes don’t matter because households will increase their saving in anticipation of higher taxes in the future; higher government borrowing doesn’t matter because that increased saving means there is more money available in the bond market.
d Another argument for deficit reduction later is that then the Federal Reserve will be able to counteract the contractionary (antigrowth) effects of deficit reduction through expansionary (pro-growth) monetary policy—that is, lowering interest rates. That would be very difficult today because the interest rate that the Federal Reserve controls directly—the rate at which banks borrow money from each other for short periods of time—is close to zero, and therefore cannot be lowered any further.
e Der Spiegel reported in 2010 that the Greek government had earlier used derivative transactions with the investment bank Goldman Sachs to hide the true size of its budget deficits and comply with the requirements for membership in the eurozone. Beat Balzli, “How Goldman Sachs Helped Greece to Mask Its True Debt,” Der Spiegel, February 8, 2010. See also Tracy Alloway, “Goldman’s Trojan Currency Swap,” Alphaville (blog), Financial Times, February 9, 2010.