I recently gave this presentation on the issues surrounding state insolvency:
Category Archives: Budget Deficit
A recent editorial by Paul Krugman criticized federal policymakers for having a poor understanding of the role that federal debt plays in the economy. In his words, “when people in D.C. talk about deficits and debt, by and large they have no idea what they’re talking about — and the people who talk the most understand the least.” Unfortunately, Mr. Krugman makes several mistakes of his own in explaining it to them.
Krugman has long argued that the federal government should engage in significant deficit in order to create new jobs and increase economic growth. A common argument against such a policy is that it would increase already large deficits and exacerbate an already rising debt burden. So if Krugman can show us that our fear of debt is misguided and that increased borrowing is nothing to worry about, at least not for the United States at this time, then the political path toward large spending increases should become much easier.
It is worth noting at the beginning that the federal government has not exactly shied away from deficits in the last three years. Since 2009, deficits have averaged $1.4 trillion, almost 10 percent of GDP. While lower revenues have accounted for much of the growing deficits, federal spending has increased 20 percent since 2008. Mr. Krugman wants much more than this.
Krugman does admit that debt can be a problem. But he dismisses worries about excessive borrowing by arguing that governments do not face the same constraints as households when they borrow. He offers two arguments against this analogy. Both are wrong.
The first difference he cites is that: “families have to pay back their debt. Governments don’t — all they need to do is ensure that debt grows more slowly than their tax base. The debt from World War II was never repaid; it just became increasingly irrelevant as the U.S. economy grew, and with it the income subject to taxation. ”
Many bankers are painfully discovering that families don’t always have to pay back what they owe. And, even for families debt is always easier to manage when its size falls relative to income. But that is not the direction that the United States is going in. Since 2008 gross federal debt (which includes a large share of the obligations represented by Social Security) has risen from 69 percent to 100 percent of GDP. Mr. Krugman, of course, would prefer that it rise even more.
More to the point, Krugman is wrong in asserting that the debt from World War II was never repaid. Every bond was paid off as scheduled. What he seems to mean is that instead of saving up money in order to pay off debt when it becomes due, governments can simply issue more debt, using the proceeds of the new loans to pay off the old. Once again families can also do this. Except when they cannot. Many homeowners who planned on refinancing their mortgages when the interest rate on their variable mortgage rose suddenly found that no one would lend to them. Mr. Krugman seems to think that this can never happen to governments; at least not to the United States.
But having to continually find new lenders to roll over existing debt is much different than never having to pay the debt off. It requires constant access to the credit markets. As the holder of the world’s reserve currency and its most open and competitive economy, the United States holds a unique position in the world. Investors have been willing to lend the federal government large sums at very low rates, especially in times of financial stress elsewhere. But this may not always be the case. According to the Congressional Budget Office, the average maturing of U.S. debt was roughly five years in 2010. As a result, the federal government will need to borrow trillions of dollars over the next five years even if it runs balanced budgets from now on. Doing so is likely to be much harder if we also have to borrow trillions more to finance new deficits.
Krugman’s second assertion is that: “an over-borrowed family owes money to someone else; U.S. debt is, to a large extent, money we owe to ourselves.” Technically, of course, this is true (overlooking for the time the significant share of debt held by foreign entities). But so what? The same was largely true of all the mortgage debt that existed in 2006, before the crash. Yet we found that even though loan losses by some lenders were offset by gains to borrowers, the financial impacts did not easily net out: they caused a financial crash. A government that does not pay its bills is certain to cause a financial panic. A government that wants to pay its bills cannot always assume that it will be able to raise taxes or cut spending in order to do so even though both simply transfer money from some Americans to others.
National assets do not easily net out no matter who owns them. Thus, when Krugman reassures us that: “every dollar’s worth of foreign claims on America is matched by 89 cents’ worth of U.S. claims on foreigners,” he seems to assume that it does not matter if the government owes the debt while the private sector holds the assets. Presumably the government can simply tax away the assets if it needs to.
Debt matters. It forecloses certain opportunities and imposes a burden on current budgets. When governments pursue a policy of rolling over short-term debt rather than paying it back, they suddenly have to care what financial markets think of them. If the federal government was not already committed to large and growing deficits and if we knew that the government would devote extra spending to wise investments rather than patronage, then perhaps additional spending in a time of slow growth would be safe. But neither of those conditions is likely to occur under this Administration. Without them, additional spending is dangerous.
The debate on the debt ceiling will only get louder over the coming months. Unfortunately, the debate is not likely to add much clarity to what is really not a very complicated issue. For that reason, it might be worthwhile to keep several things in mind:
- The debt ceiling is almost always a partisan vote in which the minority party gets to criticize the current president for not having a good plan to reign in government spending. The minority typically tries to use the vote as leverage to get something that is important to them. In any case, minority legislators do not see any need to incur political capital in order to help the President. They think that is his party’s job. Hence, then-Senator Obama’s refusal to vote for an increase during the tenure of President Bush. The President’s party for obvious reasons would like to see a clean, quick vote. Had Sen. John McCain (AZ) won the Presidency, most legislators would probably be on the opposite side of the issue from where they are now.
- Nobody’s preferred outcome is to default on the debt. Everyone recognizes that the United States should honor its legal commitments to bondholders. The problem is that few, if any, legislators believe that extending the debt ceiling is so important that they would vote for it under any circumstances. Many Republicans have already indicated that they will vote against any increase unless it is accompanied by significant spending cuts. They reject the idea that the choice should be between no spending cuts and default, but if faced with that choice they would presumably allow a default. Democrats also have their bottom line positions. Few of them are likely to vote to raise the debt ceiling if it is accompanied by repeal of Obamacare or the privatization of Social Security. Again, they do not think it should come down to that choice, but if it did they would also allow a default. The problem then becomes finding a package that a majority of Congressmen and the President will agree to.
- This is not a great vote for anyone. According to a recent poll by Gallop, 47 percent of Americans oppose raising the debt ceiling, while only 19 percent favor it. They may be uniformed or parochial, but they are going to elect the next Congress and President. Members are likely to vote for increasing the debt ceiling only if they think that the overall agreement makes the country better off, if they are afraid that economic disaster will accompany a default, or out of loyalty to the President. There are few Republicans in the last group.
- A clean or minor default need not jeopardize the economy, but it would cost the government a great deal. The first part of this statement disagrees with common wisdom so it deserves some explanation. Contrary to a lot of recent analysis, markets are fairly rational. But they do not deal well with uncertainty and what is rational for one individual may not be rational for a member of a group.
- There are many types of default. Although they appear to be different in type, they all have the effect of giving the bondholder less money than he was promised. For instance, the United States defaulted on its debt when it went off the gold standard. Some may protest that this is not quite the same as refusing to pay creditors everything they were promised, but creditors who got dollars that were clearly worth less than they were promised, probably felt different. The high inflation of the late 1970s and early 1980s also eroded the value of the repayments bondholders were promised. A number of economists have advocated policies that would either increase inflation or depreciate the dollar, yet they also state that any type of formal default on the debt would provoke market panic. Yet bondholders would probably prefer an explicit default of 5 percent to inflation or depreciation that would destroy 10 percent of their value. Indeed, in cases such as Greece an explicit default leading to a sustainable recovery might be preferred to continued uncertainty. The United States is a long way off from facing that problem, however.
- The United States has made a lot of promises about the future. Some of these, such as government debt, are explicit and legally binding. Some, such as Medicare and Social Security benefits, are explicit but not legally binding. And some are implicit. These include pensions guaranteed by the Pension Benefit Guarantee Corporation and retirement benefits for postal workers. Finally, others are just possibilities, such as aid to state and local government who have trouble paying their obligations.
- Nobody thinks that the government can honor all of these problems. In fact, it will have to renege on trillions of dollars worth of promises. The question is which ones and when. This is the real source of uncertainty facing the market. Right now markets seem not to care very much. But they might in the future and, since markets often act as a herd, they may switch their mind suddenly. In contrast telling bondholders they won’t get their money for two days will probably make them unhappy, but it won’t make them panic.
- A short-term decline in the market should not drive political decisions. Logic and the long-term health of the economy should. Neither Congress nor the Administration react well to market pressure. Exhibit number 1 is TARP. Both should ignore short-term drops or rises in the market and concentrate on getting the country’s fiscal position back into balance. If they do, the markets will rally.
- A temporary, minor default is unlikely to have serious consequences, especially if the end result is an agreement that puts the country on a sustainable fiscal path. Even permanent default would not be catastrophic in the medium-term as long as the United States did not have to borrow more money for a few years. Many countries have defaulted and then been allowed back into the markets once they have recovered. Investors have few alternatives to American bonds and the U.S. government is likely to remain one of the strongest borrowers in the world even if it does not maintain a perfect record.
- But in the short-term, a serious default would be highly counterproductive since the United States needs to issue a significant amount of new debt. Even if markets did not overreact, they would certainly raise interest rates. The government might not care if it did not need to borrow more money. But in order to match spending with expecting revenues, the government would have to cut outlays by roughly 25 percent. And that is not all. Since a great deal of our debt is short-term, we would still end up paying more as we rolled the existing debt over.
- For this reason, the debt ceiling will be raised and there will not be a permanent default. But there may be a temporary one because it is hard to see a deal emerging. The Administration has clearly signaled that it will not lead in putting forward a plan that can pass Congress. This means that any leadership will have to come from either the Gang of
SixFive in the Senate or House Republicans. Absent leadership, it is difficult to see how this gets solved.
- A sudden market panic may not change things much. Public opposition to increasing the debt ceiling and its distrust of the financial sector may prevent a sell-off from translating into the type of political pressure that led to TARP.
- With government having to renege on a large number of promises to voters, the politics of default may change dramatically over the next few years. There is a clear legal and economic rationale for using revenues to pay bondholders rather than preserving entitlements, but many retirees may not see the fairness in cutting their Social Security or Medicare benefits in order to pay investors in China. At some point in the future, Democrats in Congress may begin voicing these same feelings, especially if they continue to believe China is pursuing policies that hamper our recovery.
- It is not yet clear where the bargain is. There are almost certainly not enough Republicans to pass any increase in the debt ceiling unless it is accompanied by the promise of large spending cuts. The burden is higher now that many Republicans feel that they got fewer cuts than were promised in the 2011 Budget. But even if we take President Obama’s own goal of achieving $2 trillion over 12 years, it is not clear that a majority of Democrats will vote for that. The best that we might be able to achieve is a series of temporary extensions, possibly accompanied by promises to cut rather than actual cuts. It is also possible that the Administration decides to reinterpret the law in whatever ways are needed to extend the crisis beyond the 2012 election. In is not clear that such an attempt would be politically or financially sustainable, but it is not out of the realm of possibility.