In a time of stark political division in the US, one issue has united the left and the right: Politicians on both sides of the aisle agree that deficits don’t matter.
Traditionally, Republicans claimed they were the party of fiscal discipline, but in reality they have tended to run bigger deficits to support tax cuts. Democrats vocally favored more spending, but it was the administration of Democratic president Bill Clinton that ran a surplus in the 1990s. The figure below is the federal surplus or deficit as a percent of GDP. Before the era of president Ronald Reagan, with the exception of bad recessions or war, the government ran fairly balanced budgets.
Debt hawks fall out of fashion
Former vice president Dick Cheney, in making the case for a second round of tax cuts under president George W. Bush, reportedly remarked ”deficits don’t matter.” After Republican president Donald Trump signed yet more tax cuts—passed by a Republican house and Senate—into law last year, the pretense of Republicans being the party of debt hawks has gone out the window. Deficits increased despite the strong economy.
The far left is also getting on board the-debts-don’t-matter train. Rep. Alexandria Ocasio-Cortez, a newly elected Democrat from New York, and Sen. Bernie Sanders, an independent from Vermont, have aligned themselves with Stephanie Kelton, an economist and former adviser to Democrats on the Senate Budget Committee, who adheres to a heterodox idea called Modern Monetary Theory, which argues running deficits is harmless, even healthy, when inflation is low.
Now debt doves have some intellectual ammunition from mainstream economists. At a speech at this year’s American Economic Association conference Jan. 6, MIT’s Olivier Blanchard, a major force in macroeconomics for decades, argued that as long as economic growth outpaces bond yields, governments can run a deficit and keep rolling over their debt (so never paying it off) to increase society’s well-being. If your income grows faster than your debt payments, you can keep running up debt forever. At first, it sounded like exactly what politicians wanted to hear.
But Blanchard and many deficit doves often assume the parameters in the economy have changed in the last twenty years. Specifically, that interest rates are permanently lower and GDP growth will hover around historical levels. At the end of Blanchard’s speech, he cautioned that interest rates could increase and even surpass economic growth. In that case, it’s possible debt will be unsustainable because governments could not refinance their debt at a low rate. Higher debt payments crowd out other spending priorities, making it even harder to issue debt, and this could send the economy off a cliff. Because this risk exists, though he thinks it is unlikely, Blanchard suggested running deficits to pay for unambiguously useful things, like stimulus to shorten a recession.
The lesson of Japan
Deficit doves aren’t worried about exploding debts because possibility of high rates seems remote after years of falling yields. Some market commentators, like economists at Goldman Sachs, argue Japan sustained high debt and low interest rates for decades. But this is not the norm. Historically, the US has experienced higher interest rates, much higher than the 3%ish rate the economy currently is growing at. Smaller population growth adds to the risk that future economic growth could be even lower because there will be fewer workers to power the economy and interest rates could outpace income.
Betting what happened the last 20 years in Japan will be repeated over the next several decades in every other rich country is a stretch. Financial economists would caution against making that bet, because they worry about risk. They argue that longer term bonds contain a risk premium, and the higher the premium the more governments must pay to borrow. The threat of inflation (which becomes more of a possibility if debt gets high and governments seek to inflate away their burdens by printing more money) or the possibility of default can increase risk premiums. This suggests running a deficit every year and increasing the stock of debt can increase the possibility rates might rise and debt could become unsustainable. Ironically, deficit spending premised on stable economic conditions might prove destabilizing.
The risk of debt
Running a deficit can be an important tool to grow an economy, especially if the economy is weak and needs a boost. A deficit can also be justified for a one-time investment, like a useful infrastructure project that pays for itself over time. But starting a new unfunded entitlement, like the proposed Medicare-for-All floated by Ocasio-Cortez, which creates a deficit every year going forward should be treated with more caution, because structural deficits come with bigger risks. Politicians and tax payers should be wary of running large deficits year after year. If interest rates do increase, there is a risk rolling over debt won’t be feasible or it will require spending cuts to pay bond holders. High rates can force governments into austerity when the economy is weak and government spending is most necessary.