Jared Bernstein had a post last month, Is It Really Important to Stabilize the Public Debt? And, If So, When and At What Level?, which summarizes what I’ve come to believe is the right way to view national debt. You can’t decouple national debt from fiscal policy. You may view one as more important than the other but, whether you intend it or not, your views on one has implications on the other.
In his post Jared coins the term “Cyclical Dove and a Structural Hawk (CDSH)”. As he puts it:
If you’re a CDSH, your fiscal question in recessions and sloggy periods like the US (and much of Europe) are experiencing today is this: “is our budget deficit large enough to offset the demand contraction from the private sector?”
Cyclical doves believe that economic downturns, such as the current one, can be driven by declining demand. (The current downturn is, by any rational measure, driven by demand contraction.) Cyclical doves don’t try to account for the facts on the ground presuming that only the supply side matters. (Remember Reagan’s Supply-Side economics?) While CDSHs are okay with running deficits during downturns, they’re not okay with deficits in general. Jared explains:
When strong private sector growth is back, the CDSH asks “now that we’re back to robust growth, are our revenues and spending lined up such that the debt we built up during the down economy will soon start to recede?” That is, deficits and debt that grow in full employment economies are called “structural” budget deficits as distinct from cyclical ones. They’re to be avoided.
There’s a very, very important point there: One’s view of whether running a deficit is okay or whether it’s a bad thing depends upon context. Under current conditions, where economy is demand-starved and the government can borrow money at negative real interest rates, i.e., people are content to lend us money so long as we give them most of it back, deficits are okay – provided, of course, that we do something constructive with the borrowed cash. [UPDATE 8/22/2015: Real interest rates are no longer negative (they’re now slightly positive) but they were negative when I originally posted in March 2013.] In contrast, deficits run during ‘normal’ times require that we pay significant interest on our debt and limit our ability to do constructive things with revenue. Structural deficits are not okay.
This all begs the question, “What is an acceptable level of national debt?” Jared addresses this:
… “stabilizing the debt” means to stop the debt ratio—debt/[Gross Domestic Product]—from rising (where “debt” means debt held by the public—that’s what matters for all that follows). For our debt to grow more slowly than our GDP, our deficits don’t have to be zero, but they do have to be below 3% of GDP. Why is that a good thing?
Jared calls out 3% of GDP because that’s the historic GDP growth rate. So long as the debt increases at less than the GDP growth rate we’re okay – not necessarily great but at least okay. There’s another important point: From the standpoint of maintaining a healthy economy, it is not necessary to pay off the national debt. Ever. So why do deficits do matter? Back to Jared:
Well, in fact, [that deficits only need to be less than 3% of GDP is] not always a good thing. In times of crisis—recessions, depressions, war—the [debt] ratio goes up for good reasons. Our borrowing temporarily outpaces our growth in order to offset some disaster.
But there are also good reasons to lower the debt ratio when the economy’s solidly back on track. First of all, in weak economies, interest rates tend to fall and servicing our growing public debt tends to be the least of our worries.
That’s exactly the situation we’re in now. As I noted above, real interest rates on Treasury securities are very low. Why? Because buyers, anticipating that our economy will be in the tank for some time to come, don’t fear inflation. When the economy gets stronger it is reasonable to believe that people will demand higher interest rates. Why? Because they’ll be more inclined to invest in stocks and will require a higher rate of return from treasuries in order to be convinced to lend their money.
But as the economy improves and interest rates go up, it’s more expensive to service a larger stock of debt, so in the “interest” of not having to devote resources to debt service that we might rather use for education, infrastructure, and so on, it’s good to get the debt on a declining trajectory.
So, given that interest rates on short term debt are more inflation sensitive than long term rates, it would make sense for the government to borrow money by issuing long bonds. (This is one of the reasons Quantitative Easing makes me uncomfortable. We’re buying securities – mainly mortgage-backed securities – and paying for them by issuing short term debt. I’m not seeing the wisdom of it. But I digress.) Back to the merits of keeping the debt ratio low:
Also, a lower debt ratio leaves you better positioned the next time your public debt needs to go up. It’s easier to make that case when you start at 40%—where we were in 2009—than north of 80%.
A debt ratio that keeps growing in good times and bad signals a persistent imbalance in the willingness to raise the needed revenues to pay for government without borrowing. This sounds like the very definition of unsustainable and eventually government borrowing will crowd out everything else while spooked investors insist on large interest rate premiums, further pressuring the debt spiral. At that point, “we’re Greece” has more bite.
For differing views on the appropriate level at which to stabilize the debt ratio see here and here. (Links also in Jared’s post.)
I think that covers the major points: 1) Don’t afraid to borrow and make investments when demand is down and the economy needs a boost and 2) Have a plan to scale back borrowing and keep the debt ratio in a reasonable range when the economy is healthy again.
At the risk of stating the obvious, I am a Cyclical Dove and a Structural Hawk.
Bonus: Brad DeLong and Larry Summers on how investing borrowed money now will more than pay for itself later, Fiscal Policy in a Depressed Economy.