Should deficits matter any more?

Although the former and current president agree on little, both support large scale COVID relief packages irrespective of their implications for federal debt and deficits. Their agreement on the desirability of deficit spending is indicative of a political environment in which balancing the budget no longer seems to matter. We have entered an era of “deficit denial” in which austerity has become a dirty word. But the laws of accounting have not been repealed: There are limits to debt sustainability — and risks to probing them.

Republican budget hawks, marginalized and often silent during the Trump era, have ceded the high ground of fiscal responsibility. It may be up to Democrats to rein in their own spending ambitions out of a concern for the nation’s long-term future.

Unfortunately, Democrats have migrated far from the fiscal conservatism of the late Paul Tsongas and Bill Clinton. They have embraced a variety of justifications for large deficits, some of which have a factual foundation. Fiscal conservatives need to come to grips with these arguments and find areas of common ground. While we cannot expect to see a balanced budget during the Biden era — or likely in the years beyond — the problems with debt are real, and hopefully we can agree on some intermediate fiscal objective that could stave off a financial meltdown in the decades ahead.

The United States has already returned to the record debt-to-GDP ratio last seen in the aftermath of World War II. IMF projections show the United States’ government debt burden converging with that of Italy by 2025. But, as Larry Summers points out, today’s debt poses less of a risk due to ultra-low interest rates. Low interest rates mean the cost of servicing debt can remain under control even with large amounts of debt.

While true, this argument has its limits.

In 1946, interest rates were also quite low: 10-year Treasury bonds earned 2.19 percent, not dramatically above recent levels of around 1.2 percent. But today’s rate environment offers the federal government an opportunity to minimize debt service costs by borrowing at very short maturities. For example, three-month Treasury bills recently yielded 0.09 percent.

If the government could convert its entire debt to three-month Treasuries, debt service costs would indeed be a tiny share of the federal budget. But rolling over debt so frequently comes with great risk: If interest rates return to the levels we saw during the 1980s, debt service costs would suddenly consume half the federal budget or more. In fact, some fiscal experts recommend locking in today’s relatively low interest rates by lengthening the average maturity of Treasury debt. This would increase interest expenditures short term but would reduce their volatility in the future.

Another way to minimize interest costs is for the Federal Reserve to buy up more Treasury debt — something it did during the Great Recession and again in 2020. The Fed reimburses the Treasury for most of the interest it collects, and its presence on the demand side of the bond market drives down interest rates for competing bond buyers.

But the Federal Reserve must buy Treasury securities with newly created money. All else being equal, more money should cause consumer price inflation as it did during the 1960s and 1970s. High inflation destroys lifetime savings and depresses economic performance. But during the current cycle of debt accumulation and monetization that started under George W. Bush, consumer prices have only risen slowly.

The lack of price inflation — thus far — has emboldened supporters of Modern Monetary Theory (MMT) who are increasingly common in the Democratic Party. MMT proponents argue that the government can safely fund itself by printing money so long as the economy remains below full employment, as it is now.

But Federal Reserve money creation can cause distortions aside from consumer price inflation. Since the early 1980s, newly printed money has been pumping up the prices of investments rather than consumer goods. While nominal GDP has grown six-fold since 1983, the S&P 500 index has increased over 25 times. Stock prices are now well above pre-pandemic levels despite the devastating impact COVID-19 has had on the economy’s performance and long-term potential.

Higher stock prices may seem like an unalloyed good, but there are some downsides. When asset prices become inflated, they are more vulnerable to sudden drops as we saw last March. Also, because stocks are disproportionately held by the affluent, inflated stock prices increase wealth inequality. Lofty stock valuations have produced the centibillionaires of today such as Elon Musk and Jeff Bezos.

Monetary inflation is impacting other assets as well. Gold is now seven times more expensive than it was when George W. Bush took office. And, today, “hard money” investors are now more likely to turn to bitcoin, which rose by a factor of 40 during the Trump years.  It remains to be seen how much of the run up in bitcoin reflects a speculative frenzy, but it is likely that a large portion of the price rise shows increasing skepticism about the future value of the U.S. Dollar. Foreign currency traders also appear to be worried about the dollar, since it has fallen significantly against the Euro over the 10 months of the pandemic.

So, the two major Democratic defenses of big deficits today have elements of truth, but also limitations. Interest rates are historically low, but there is no guarantee that they will stay there. Fed monetary creation has only produced minimal price inflation thus far, but it appears to be affecting asset prices and the value of the dollar. If and when money printing feeds through to consumer prices, it will likely trigger a spike in interest rates as investors try to protect the real value of their principal. With such high levels of debt, the result could cause a dangerous feedback loop: higher interest rates increasing federal interest costs, raising the deficit, necessitating more money creation which could trigger more inflation and even higher interest rates.

President Biden suggested a third argument for high deficits shortly before taking office. During his introduction of the $1.9 trillion American Rescue Plan, he said:

“It’s not just that smart fiscal investments, including deficit spending, are more urgent than ever. It’s that the return on these investments — in jobs, in racial equity — will prevent long-term economic damage and the benefits will far surpass the costs. A growing number of top economists has shown even our debt situation will be more stable — not less stable — if we seize this moment with vision and purpose.” (italics added)

These comments imply that running large deficits now will improve the nation’s long-term debt trajectory. This could only occur if the plan causes GDP and government revenues to grow faster than the debt (to which it will add). While theoretically possible, this is extremely unlikely. Many aspects of the spending plan do not have high fiscal multipliers, meaning that they will contribute relatively little to GDP growth. Further, the economy is likely to be already accelerating this Spring as the pandemic and lockdowns ease, meaning that the spending package will probably only have marginal benefits.

While Congress is likely to pass additional COVID relief, a concern for long term fiscal sustainability should militate for a much lower price tag than the $1.9 trillion President Biden has proposed.

Moving forward, Congress and the president should find new benchmarks to protect fiscal wellbeing. Although a balanced budget seems politically impossible, restricting the annual growth of the debt-to-GDP ratio may be a reasonable goal that could attract bipartisan support. As Baby Boomers continue retiring, pressure from Social Security and Medicare spending will continue to grow. Keeping an upper limit on the national debt until this large cohort passes from the scene will protect succeeding generations from a fiscal calamity that could endanger their own retirement security.

Marc Joffe is a policy analyst at Reason Foundation, former senior director at Moody’s Analytics, and author of the study “Unfinished Business: Despite Dodd-Frank, Credit Rating Agencies Remain the Financial System’s Weakest Link.”