Overcoming the Debt Trap

By Dean Baker

The deficit hawk gang is again trying to take our children hostage with new threats of enormous debt burdens. As in the past, most of what they claim is very misleading, if not outright false.

Agreed.

First and foremost, the basis of the bulk of their horror story has nothing to do with spending being out of control, but rather a broken private health care system. If per person health care costs were comparable to the costs in any other wealthy country, we would be looking at long-term budget surpluses, not gigantic deficits. This would lead honest people to focus their energies on fixing the US health care system, but not the deficit hawk gang.

I’d guess the deficit would be much the same as it grew counter cyclically with the automatic stabilizers kicking in as the economy weakened to the point the deficit got large enough to where it provided the income and net financial assets needed to stabilize output and employment. Not that there isn’t much to be done to fix the US health care system.

But there is another part of their story that contains some truth. The government is borrowing large amounts of money right now to sustain demand in the wake of the collapse of private sector spending following the deflation of the housing bubble.

Yes, the government is spending large amounts to sustain demand, but that spending is not dependent on borrowing, though it is associated with borrowing.

If the deficit continues on the projected path, the country will substantially increase its debt burden over the course of the decade.

Yes, the deficit could go higher but ‘burden’ isn’t the right term. The national debt is the dollar savings of the ‘non government’ sectors, and as such lightens the financial burden of those sectors.

A higher debt burden will imply much larger transfers from taxpayers to bondholders in future years. This will require either higher taxes or cuts in other spending.

Not necessarily. Taxes function to regulate aggregate demand. So tax increases and/or spending cuts would be in order only should aggregate demand be deemed too high, evidenced by unemployment being too low. In that case, taxes increases and/or spending cuts would serve to cool demand, not to make payments on the debt. Also, the interest on the debt only alters demand if it gets spent, which does not necessarily happen. Japan has never spent a penny of their interest income, for example.

Alternatively, the government could run larger deficits.

The informed approach is, for a given amount of spending, to adjust taxes to the level that corresponds to desired levels of employment, whatever size deficit that might mean.

However, in a decade or so, if the economy is again near full employment, higher deficits will either lead to higher inflation if the Fed opts to accommodate the deficits, or higher interest rates if it targets a low rate of inflation. The latter could crimp investment and long-run growth.

Should the informed approach be taken, and taxes lowered and the deficit thereby increased to the level that coincides with full employment, yes, the government could then go too far and keep taxes too low and sustain excess demand that drives up prices. This would be the case whether the Fed ‘accommodated the deficits’ or not. And if the Fed did elect to implement policy to raise rates to slow inflation, the point would be to slow nominal spending without slowing real spending. And in any case there is no such thing as crowding out investment, as investment is a function of consumption, with demand driving prices to a level where investment is funded.

For these reasons, it is desirable to prevent the debt from reaching the levels now projected, even if the outcome may not be the disaster promised by the deficit hawks.

Nor is the outcome that promised by the deficit doves. US deficits incurred as a by product of fiscal balance that sustains full employment do not have negative side effects if managed by an informed government.

There is a simple way to avoid a sharp rise in the interest burden associated with a higher debt. The Federal Reserve Board can buy and hold the debt that is currently being issued by the Treasury to finance the deficit.

The Fed buying the debt is functionally the same as the Treasury not issuing it. And I have supported the Treasury not issuing anything longer than 3 month T bills for a long time, etc. More on that below.

The logic of this is straightforward. If the Fed holds the debt, then the interest on the debt is paid to the Fed. The Fed then returns the interest to the Treasury each year, meaning the net cost to the government is zero.

Not exactly. What that policy would do is add the deficit spending to bank reserve balances held at the Fed, which currently pay what for all practical purposes is the overnight rate of interest targeted by the Fed. The Fed controls the fed funds rate by offering and paying interest on the overnight balances held at the Fed. This rate is currently .25%. Interestingly, 3 month Treasury bills are purchased to yield only .14% for technical reasons. I do support the policy of the Treasury not issuing securities longer than 3 months, which will produce similar results. But in either case, should the Fed decide to hike rates the balances created by federal deficit spending will earn those rates under current institutional arrangements. One way to avoid all interest payments on deficit spending would be to increase required reserves for the banking system and not pay interest on them. That, however, becomes a ‘bank tax’ that is passed through to all borrowers, passing the interest rate burden on to them.

This is not slight of hand. The point is that the economy has a huge amount of idle resources in the form of unemployed workers and excess capacity. In this situation, the increased demand created by government spending does not have to come at the expense of existing demand. The economy can simply expand to fill the additional demand created by larger deficits.

This is 100% true and I fully support the policy of adjusting the fiscal balance to that which coincides with full employment, without consideration of the interest paid on balances created by deficit spending, as above.

While that may not be true in five or ten years, assuming the economy is again near full employment, right now deficits need not lead to either higher interest rates or higher inflation.

Again, fully agreed with the conclusion.

In fact, the financial markets and the “bond market vigilantes” should even support the decision to have the Fed purchase and hold the government debt being issued now to finance the deficit. This practice will lessen the future interest burden on the Treasury. In fact, interest should be seen as an entitlement like Social Security and Medicare since it is paid each year without new authorization by Congress. If the deficit hawks had any integrity they would be insisting that we should require the Fed to hold the government debt issued during this downturn. It is a sure fire way to substantially reduce entitlement spending.

Again, the Fed buying Tsy securities is functionally identical to and nothing more than the Treasury not issuing it in the first place. Nothing more.

Of course, no one ever accused deficit hawks of being consistent. Not only do they not advocate having the Fed buy and hold the debt, they don’t even want this policy discussed in their “everything is on the table” sessions. Keeping this simple solution off the table makes good sense if your concern is not deficit reduction, but rather cutting Social Security, Medicare and other important social programs.

Fortunately, the rest of us don’t have to be bound by the deficit hawks’ agenda. If Social Security and Medicare are on the table, then having the Fed hold the debt better be on the table; otherwise, this exercise is just a charade to cut the country’s most important social programs.

Social Security has no business being on the table even under current policy of issuing longer term Treasury securities, no matter how large the deficit might be, if there is excess capacity/unemployment. How could it possibly make sense to cut aggregate demand in the current environment? It’s not like our seniors are consuming scarce real resources and creating shortages for the rest of us.

This will be a great lie detector test. We will soon know whether the deficit hawks care about the interest burden on our children or just want to destroy the social safety net.

The doves are on the right side of this argument, but if they don’t get their act together on monetary operations and reserve accounting it looks like they will continue to go down to defeat with what are inherently winning hands, with all of us the losers.