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 that 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. Thanks to permanent low interest rates and low inflationary risks, we can 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. Second, and maybe more importantly, even if interest rates never increase and inflation never materializes, there is a significant cost to high debt that is best avoided, especially if one values smaller government.
One common argument 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 U.S. 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.
Still, as Hoover Institution economist John Cochrane writes: “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.”
U.S. treasuries remain popular with foreign investors. But will interest rates on debt be low forever? Over at Discourse Magazine, my colleague Jack Salmon argues that since 2013 (when foreign holdings of U.S. debt as a share of GDP peaked), debt-to-GDP has risen from 71% to 101%. Over the same eight-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 U.S. treasuries. Over this same period, total U.S. 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 U.S. government at 1% interest says 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’s new spending or assuming no future wars, recessions, or emergencies). There is a limit out there somewhere.
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. These events are very hard to predict with data.
This leads me to my final point. I believe that growing ourselves out of 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. As economist Arnold Kling notes, and I agree, the least unlikely scenario is “a surprise burst in inflation,” as IMF economists Carmen Reinhart and M. Belen Sbrancia put it. No one will see it coming when it comes.
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.
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.
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 reducing our debt levels.
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. 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.
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, we now may grow at only 2%, thanks to our debt addiction. The average American will be significantly worse off over time.
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 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.