As a result of the 2009 financial crisis and now of the global pandemic, government budget deficits have exploded and levels of debt have soared. Yet the US, the UK, major European economies and Japan have all been able to borrow at ever lower interest rates—even negative rates in countries such as Germany.
Decades ago, economists worried about government deficits and debt. In the 1980s, mainstream thinking focused on ‘crowding out’, where government deficits would drive up real interest rates and sideline much-needed private sector investment. The Maastricht criteria, which guided the formation of the European Monetary Union, imposed strict fiscal rectitude on candidate members, motivated by fears that member countries might run up unsustainable deficits and debt inside of a common currency area.
In a recent paper, President Obama’s Chairman of the Council of Economic Advisors, Jason Furman, and former US Treasury Secretary, Larry Summers, made the case that conventional measures such as ‘Debt/GDP’ might signal potential risks where there may be none, or at least none for a significant period of time. Furman and Summers also contend that the near four-decade downward trend in real (i.e., inflation-adjusted) interest rates imply a debt load for the US that is not as high as perceived by the Debt/GDP ratio. They proceed to argue that ample room exists for fiscal expansion, and not just during times of stress, such as the ongoing recession.
Furman and Summers also argue that achieving a balanced budget is not necessary during the expansionary phase of a business cycle, particularly if fiscal rectitude results in slower growth. Instead, they suggest that in order to boost the economy’s long-term growth potential, government spending (investment) ought to be targeted to areas that have higher rates of return than their cost of financing.
All of this begs the fundamental question – do deficits and debt still matter?
They do, and here’s why.
First, deficit spending in times of stress and expansions is nothing new. With the exception of 1998-2001, the US federal budget has been in a deficit every single year since the late 1960’s. That has led to an inexorable rise in national indebtedness, however measured. At some point, the stock of national debt must stop growing as a share of income. That imperative becomes more pressing once the cost of servicing that debt rises.
Second, while a strong case can be made that targeted outlays on productivity-enhancing investments is worthwhile, can governments do so indefinitely and recoup significant multipliers? Even if investment is restricted to ‘public goods’—such as education, training or transportation, that free markets tend to shun—can economists be certain that governments will make the most optimal choices? Investing in highways or railroads, for instance, may be unwise and inefficient if new technologies usher in ‘smart modes’ of moving people and things about.
Third, while Furman and Summers correctly note that given excess global capacity and a very low cost of capital, ‘crowding out’ is less relevant today, theirs becomes an argument for short-term counter-cyclical fiscal policy, rather than long-term sustained deficit spending. After all, at full employment, increased borrowing by the government must raise the real rate of interest, implying that some private sector investment will be forgone.
Indeed, when full employment is restored, the relevant questions should change. For instance, can an economy sustain a dependency on deficit spending without the need for structural realignment of the private-public relationship? If not, what kind of realignment is necessary and appropriate? How will the financial markets respond to such a realignment?
Fourth is the issue of current low productivity. Is it coincidence, or causal, that slowing productivity growth – especially since the global financial crises – has been accompanied by exploding government spending?
Finally, it has not escaped notice that a key driver of low borrowing costs owes to highly expansionary monetary policies, underpinned by record-low policy rates and unprecedented asset purchases. Quite apart from their potential distortions to asset prices and the broader economy, how might fiscal policy have to adjust should inflation begin to accelerate, necessitating a tightening of monetary policy? At that point, fiscal dynamics might appear more precarious.
Is it time to jettison conventional economics when it comes to government deficits and debts? We agree that fiscal policy—appropriately designed—can be deployed to boost economy-wide productivity growth. Equally, fiscal expansion is warranted in recessions, particularly when monetary policy may have lost effectiveness. But reducing the share of output derived from fiscal deficits should still remain a target of policymaking, especially when momentum in the private sector favors greater investment.
Deficits and debt do matter. Although tax and spending policies can be put to good use to promote growth in both the short and the long run, the age-old wisdom of all things in moderation still holds. Even for fiscal policy.