Since the recent global recession, concerns have increasingly risen about the amount of outstanding U.S. national debt. Congress has been consumed by conflict over this issue, leading to government shutdown and contributing to partisan divide and political gridlock. Those concerned about the level of national debt and its sustainability do have legitimate points as the debt has expanded significantly as the graph below shows. However, there are other factors in play and I would like to suggest that (1) fears are largely overblown about any imminent debt crisis and (2) that taking rash actions to diminish the debt could cause significant distress to the still recovering U.S. economy.
Houston Do We Really Have a Problem?
First, there are reasons not to fear the level of debt outstanding. The national debt has not expanded in a vacuum and has been driven by exogenous events. Recent examples show us that debt-to-GDP ratios increase substantially in financial crises and recessions. This is a natural result of economic phenomenon such as automatic stabilizers and Keynesian thinking on countercyclical fiscal polices such that “During a recession, tax revenue falls because of the contraction of GDP and governments also increase spending. The combination of these two forces increases deficits, and debt-to-GDP ratios can rise quickly as a result”. This position is further reinforced by the graph above showing that the U.S. debt-to-GDP ratio only really expanded after the downturn of the economy in 2008. However, due to the low interest rates that have been predominant since 2008 the cost of the increase in government debt has remained historically low during this period as the graph below illustrates.
Another consideration, especially among political pundits, is who owns the outstanding U.S. debt . About 67.5 % of U.S. debt is held by Americans with foreign countries holding the rest. Interestingly, China, an object of much concern, only holds 7% of the U.S. debt. Importantly, the debt held by Americans is quite substantial; “Of the $12.9 trillion chunk of debt owned by Americans, $5.3 trillion is held by government trust funds such as Social Security, $5.1 trillion is held by individuals, pension funds and state and local governments and the remaining $2.5 trillion is held by the Federal Reserve”.
Perhaps most importantly, there is empirical evidence that the long-term debt path of the U.S. is sustainable. This is based on the level of the real interest rate which largely determines the long-term degree of sustainability of the debt. Another study ,which also suggests a sustainable debt for the U.S., notes that historically: “[T]he United States had been able to grow out of their debt since the growth rate of GDP had exceeded the interest rate on government bonds for a long time period after World War II”. This trend is continuing and has been present in most of the recent periods of both economic expansion and recession as illustrated by the graph below of the average long-term TIPS yield and growth rate of real GDP .
Finally, all that being said, a theoretical point must be made in our discussion. There is no readily identifiable “right” level of debt for a country to have outstanding. OECD data revels that relative to other developed industrial nations, the U.S. does not possess an absurd debt-to-GDP ratio. Consequently, it is largely unfair to compare the U.S. to countries such as Greece because of differing country-specific factors. Ultimately, we should be cautious in giving too much weight to debt-to-GDP figures. Robert Sheller wrote an excellent piece on this noting that:
“The fundamental problem that much of the world faces today is that investors are overreacting to debt-to-GDP ratios, fearful of some magic threshold, and demanding fiscal-austerity programs too soon. They are asking governments to cut expenditure while their economies are still vulnerable”.
As for investor confidence, it would appear that U.S. credit ratings remain relatively high indicating that the debt isn’t a problem. While the U.S. was downgraded in 2011, the credit ratings by multiple agencies have remained constant since with a stable outlook.
Spend, Spend, Spend?
So, while it is not immediately clear that the level of U.S. debt is dangerous or harmful, it is important to evaluate the downsides to policies which would cut government spending. Indeed, these policies could be very detrimental to economic growth. As Neil Buchannan notes :
“[T]he best pro-growth budget policy would always see the federal government running a deficit…Balancing the budget on an annual basis would be unnecessary, and running annual surpluses…would actually be counter-productive. When there are short-run economic problems, the government should respond by temporarily increasing annual deficits, and the resulting return to economic prosperity would allow the overall increase in the national debt to be financed”.
Hence, austerity or even aggressive cutting of government programs to balance the budget, especially when the economy is recovering from a recession, is a dangerous idea as the Economist notes:
“Austerity, when everyone tries it at once, makes the debt bigger, not smaller. The E.U. is one of the two largest growth centers of the global economy. If the U.S., the other big one, decides to join in this “austerity binge” the result will be more, not less, U.S. debt and an even bigger growth crisis for the global economy”
A quick review of austerity policies enacted in foreign countries verifies that these programs can have debilitating and long lasting consequences for economic growth. Paul Krugman has done an interesting austerity and growth analysis of countries in Europe; regression results are shown in the graph below and are unfavorable to austerity. Krugman can simply conclude that “No wonder, then, that the whole austerity enterprise is spiraling into disaster”.
Olivier Blanchard of the International Monetary Fund has admitted, in what has been called a “mea culpa”, that austerity is more damaging than previously thought. An article by the Washington Post concerning a contribution by Blanchard in the IMF World Economic Outlook reads:
“[T]he fiscal multiplier appears to have been much higher over the past few years than policymakers…assumed. It’s not 0.6. It’s somewhere between 0.9 or 1.7. If true, then countries in Europe and the United States should have been pursuing stimulus measures to boost growth—and not insisting on budget cuts”.
The simple truth is that U.S. government spending is an important source of demand and investment which helps to drive the economy through fiscal multiplier effects. As the graph below shows, government expenditures since WWII have been an important component of GDP, around 20% of the total, and has remained relatively stable (though notably rising during recessions). For a closer look at the components of GDP across time see the article here.
As noted in this article, government spending has remained more stable than other factors of GDP such as investment; in many respects the private sector relies on government spending. Particularly beneficial is productive spending on infrastructure, education, and other investments that promote future economic growth. Therefore, perhaps a qualification to the benefit of government debt spending, and one that is related to long-term sustainability, is that borrowing be used to expand the capital stock to promote increases in output instead of and being used for short-term consumption purposes.
With all of this in mind, our discussion suggests that budgetary policy must evaluate an optimal level of national debt that is both sustainable, though not necessarily diminishing and perhaps even growing, and which promotes long-term economic growth. Austerity measures are dangerous to both, as are measures that allow unsustainable and unproductive spending. Hence, I would suggest that the U.S. should not take action to diminish its national debt but must proceed with caution to ensure that borrowing is optimal meaning that it fosters productive investments, and the shoring up of the economy in times of distress which will ensure long-term sustainability.