Another bad economic idea has come back into fashion

Dennis Robertson, a Cambridge University economics professor in the 1960s, was fond of saying that fashion in economic ideas was like going to the greyhound races. If one stood still long enough, the dogs would come around yet another time.

If ever a bad economic idea has come back into fashion it is that budget deficits in the United States do not matter. And if ever U.S. budget deficits have ballooned it has to be today in the wake of the coronavirus pandemic. 

According to the Congressional Budget Office, as a result of the government’s recent massive fiscal stimulus programs, the budget deficit is set to reach a staggering 17.9 percent of GDP in 2020 before receding to a still very high 9.8 percent of GDP in 2021. That in turn will take the U.S. public debt-to-GDP ratio to a higher level than it reached in the immediate aftermath of World War II. 

Those like Stephanie Kelton, who peddle the snake oil of Modern Monetary Theory, tell us to learn to love big government budget deficits and not to worry about large public debt levels. They do so on the argument that unlike other countries, the U.S. government borrows in its own currency and the Federal Reserve can print as much money as is needed to cover those deficits.

Leading economic lights in U.S. academia like Olivier Blanchard and Larry Summers too tell us not to be overly concerned about large public debt levels. They argue that in a world of very low interest rates, the U.S. government can borrow in after-inflation adjusted terms at a very much lower rate than the rate at which the U.S. economy can grow. As such, they take the view that the U.S. can always grow its way out from under a large public debt mountain.  

A key point that proponents of the Modern Monetary Theory overlook is that large government budget deficits entail a reduction in the country’s saving level as the government spends more than it receives in tax revenues. That in turn has the effect of increasing the country’s external deficit as the country as a whole consumes more than it produces.

Now, while it is true that we can print an unlimited amount of money to finance our budget deficit, we are dependent on the kindness of strangers to finance our external deficit. Foreigners cannot be expected to keep adding to their already very large dollar holdings if we insist on trying to live ever more beyond our means. Should foreigners tire of financing our external deficit, we could be headed for a major dollar crisis down the road that in turn could usher in a painful period of stagflation.

The key point overlooked by those who argue that in a world of low interest rates we need not worry about increased public spending is that a country’s future public debt burden is not simply determined by the country’s economic growth rate and by its government’s borrowing cost. Rather, it is also determined in an important way by the government’s primary budget balance (that is, its budget balance after interest payments have been excluded).  

Even if a country’s government can borrow at a low after inflation-adjusted interest rate relative to the country’s economic growth rate, it can still have its public debt-to-GDP ratio on an ever-increasing path if it has a high primary budget deficit. 

An arithmetical example not much different than the current U.S. situation might illustrate the point. If a country’s public debt-to-GDP ratio were 100 percent and if its real economic growth rate exceeded its real borrowing rate by 1 percent, the country would need to have a primary budget deficit of no more than 1 percent of GDP if the country’s debt-to-GDP ratio were to stabilize at 100 percent.

But if it had a primary budget deficit of, say, 5 percent of GDP, its public debt-to-GDP ratio would rise to 104 percent after one year, 108 percent after two years and keep on rising thereafter.

As Herbert Stein might have put it, when something is unsustainable, it will at some point come to an end. In the case of the U.S., an unsustainable public debt situation might come to an end in the form of a dollar crisis. It would do so as foreigners came to fear that the U.S. would in the end try to inflate itself out from under its public debt mountain by printing money. That in turn would make foreigners wary of lending to the U.S. government. 

All of this is not to say that we should not have responded to the coronavirus induced economic depression with massively increased public spending. It is to say that an unintended longer-run consequence of that spending is that we might soon lose the exorbitant privilege that the dollar has afforded us over the last 70 years to live beyond our means.

Desmond Lachman is a resident fellow at the American Enterprise Institute. He was formerly a deputy director in the International Monetary Fund’s Policy Development and Review Department and the chief emerging market economic strategist at Salomon Smith Barney.