June 19, 2023 — After an interval when little attention was paid to the long-run prognosis for government debt, its sustainability is again front-and-center in the United States, as in many other countries. The reason is not the concocted debt ceiling crisis, which was resolved at the end of May, two days before a looming default. A likely reason is, rather, the big increase in interest rates over the last year.
So long as interest rates, both nominal and real, were historically low — even close to zero in 2021 — it seemed fine for the government to borrow. In particular, short-term real interest rates, that is, nominal interest rates minus expected inflation, were negative. But now that interest payments on the national debt have risen, with more to come, the situation doesn’t look so benign.
Real interest payments will continue to rise in 2023-24. A little-noticed benefit of higher inflation in 2021-22, in the US and around the world, was that, by raising nominal GDP, it actually worked to improve Debt/GDP ratios. Only the real component of higher nominal interest rates hurts the debt dynamics. Currently, inflation is apparently coming back down, which will have the little-noticed cost of raising real interest payments on the national debt in coming years.
- How bad has US fiscal policy been?
In general, the macroeconomics of sound fiscal policy calls for the pursuit of two principles. First, in the short run, it should be countercyclical: expanding spending (or cutting tax rates) to stimulate the economy in response to recession, and restricting spending (or raising taxes) in response to booms. Secondly, in the long run, borrowing should be sustainable, that is, on a trend where accumulated debt rises more slowly than the size of the economy, so that the debt/GDP ratio declines.
Chile is an example of a country that achieved both objectives, counter-cyclicality and sustainability, after it reformed its fiscal institutions in 2000. Meanwhile, Greece is an example of a country that moved in the wrong direction, after joining the euro in 2001, showing pro-cyclical fiscal policy and unsustainable debt.
American fiscal policy has generally been counter-cyclical. To be sure, it could have been better. The Bush Administration in 2008 and the Obama Administration in 2009 appropriately expanded in response to the Great Recession, but not enough to return the economy to full health rapidly. It took until May 2018 for unemployment to fall below 4 %. (Why was the stimulus cut short? The Democrats lost their congressional majority in 2010. Republicans vote for fiscal stimulus when and only when they occupy the White House.)
Again, it was appropriate for the Trump Administration in 2020 and the Biden Administration in 2021 to expand in response to the Coronavirus recession. This time they overdid it, however: unemployment came back down very rapidly, already below 4% by December 2021, but excessive expansion helped push up the inflation rate sharply in 2021 and 2022. Nevertheless, US fiscal policy has at least moved in the right direction in response to the last two recessions, and relatively promptly.
It is on the criterion of sustainability that US fiscal policy gets a low score. It is easy to lose sight of the long run picture amidst the short-run fluctuations. US debt as a share of the economy peaked at the end of World War II: debt in the hands of public reached 106% of GDP in 1946. It then came steadily down, bottoming out at 22%. But the Reagan tax cuts of 1981-83 soon led to record deficits. Debt/GDP has been on an upward trend since then, until in 2020 it almost attained the record high set in 1946. (Only during the intervals 1996-2000 and 2021-23 has the upward trend been temporarily reversed.)
- Trouble ahead
The long-term prognosis from here on out is for an ever-rising debt/GDP ratio. The aging of the population, as has long been foreseen, is driving up mandatory spending (“entitlements”). A report from the Congressional Budget Office in February projected that Social Security spending will rise from 4.8 % of GDP in 2022 to 6.0% in 2033 and that Medicare spending will rise from 2.8 % of GDP to 4.1 %. The report has the debt/GDP ratio breaking its 1946 record within 10 years:
“Federal debt held by the public is projected to rise from 98 percent of GDP in 2023 to 118 percent in 2033—an average increase of 2 percentage points per year. Over that period, the growth of interest costs and mandatory spending outpaces the growth of revenues and the economy, driving up debt. Those factors persist beyond 2033, pushing federal debt higher still, to 195 percent of GDP in 2053.”
On May 30, Larry Summers, in a speech at the Peterson Institute for International Economics, convincingly laid out a set of reasons to expect the US debt trajectory to be even worse than the CBO’s projection. (The difference mostly results from a constraint on CBO: it must assume that future spending and tax provisions will remain the same as currently legislated.)
- What do the ultra-conservatives propose?
One might naively think that the so-called ultra-conservatives, who until recently had been refusing to raise the debt ceiling, would have some ideas about how to eliminate the budget deficit and put the debt back on a sustainable path. Isn’t this what fiscal conservatism is all about? (One can’t take seriously fiscal goals that are even more ambitious, such as candidate Donald Trump’s preposterous 2016 claim that he would be able to eliminate the national debt altogether over eight years.)
The American fiscal conservative is today a mythical beast. Or, at least, one can’t find them in the Republican party. One might argue that Bill Clinton ran a conservative fiscal policy. And a few independents have single-mindedly kept the faith all along.
The ultra-conservatives, now and in the past, say that they want to balance the budget by cutting federal spending, while sparing entitlement spending — social security, Medicare, and some other health spending. In February, the ultra-ultra conservative Congresswoman Marjorie Taylor Greene, yelled “liar” in the middle of President Biden’s State of the Union speech. She was outraged at the insinuation that any Republican congressperson was proposing to cut social security or Medicare. In response, as the loud heckling spread, Biden had the presence of mind to depart from his script and welcome the apparent unanimity being expressed in the chamber that social security and Medicare were off the table.
The ultra-conservatives seem not to realize that entitlement spending adds up to roughly half of all government spending and is rising steadily. More precisely, such mandatory spending totaled 49 % in 2022, or 63 % if farm price supports and other mandatory income support programs are included. In addition, they want to increase, rather than cut, military spending. And let’s assume that the government will continue to pay the interest bill on the debt. Interest on the debt plus military spending add up to another fifth of all government spending: 20% % in 2022 and likely to rise in the future. This does not include those benefits for veterans that are not classified as either entitlements or military spending.
And, needless to say, the ultra-conservatives want to keep tax rates low. These provisos together imply that the remainder of the budget would have to bear the entire brunt of the cuts. This non-defense discretionary spending is $0.9 trillion in 2023, which is 16 % of total government spending (or 3.6% of GDP). If one adds in all mandatory income support (14 % of spending), then the sum is 30% of spending.
They can’t really mean to balance the budget by zeroing out all non-defense discretionary spending. For one thing, it would mean eliminating air traffic control, law enforcement, immigration control, the national parks, the weather service, and much more. For another thing, do the math. The federal budget deficit is $1.4 trillion in 2023 [= 5.3% of GDP]. Total government spending is $6.2 trillion [= 23.7 % of GDP], and forecast to rise rapidly. Of that spending, only $0.9 trillion is non-defense discretionary [= 3.6% of GDP]. Even in the hypothetical state where non-defense discretionary spending was eliminated entirely, it still would not be enough to bring the budget deficit down to zero: $0.9 trillion versus $1.4 trillion. That is simple arithmetic.
A sincere plan to put the debt back on a sustainable path would need (i) to slow the growth of entitlements a little, particularly Social Security; (ii) to raise some taxes (which could be done while yet improving the efficiency and equity of the tax system); and (iii) to give the Internal Revenue Service all the funding it needs to answer the phones and collect the taxes already legislated. That approach would truly be more fiscally conservative than threatening to default on the debt unless IRS funding is cut.
[A shorter version appeared at Project Syndicate. Comments can be posted there or at Econbrowser.]