Every morning, around 8:30 a.m., a staff member is texting Sen. Joe Manchin (DW.Va.) with the current amount of the national debt. On Wednesday, the total topped $30 trillion for the first time – a number more than double what it was when Republican Paul Ryan predicted the ‘debt crisis’ would be the biggest issue in the US election. 2012, and about six times what it was. It was when President Bill Clinton declared that the era of big government was over.
Yet here we are. We suffered the deepest recession since the Great Depression and the worst pandemic since 1918, massively increased debt to support our economy, and there was no crisis. So is Manchin worrying for nothing? Or is it really time to worry about debt again?
The answer, as is so often the case with big economic questions, is not entirely clear.
Sovereign debt is very different from household debt or state and local debt because the federal government borrows in a currency it controls. This means that there is effectively no short-term limit on how much the government can borrow, because if it needs money, it can always print it. But the United States is far from the point where it “needs” money in this direction. US Treasury bond markets are the deepest in the world and, for this reason, form the basis on which a host of other financial assets are valued.
The United States therefore has no reason to worry about the type of debt crises that countries like Argentina or Russia – which have borrowed huge amounts of foreign currency – have faced in the past. But that doesn’t mean we don’t face any limits. However, discerning where precisely those boundaries lie is as much a crystal ball as it is a science.
At an extreme limit is hyperinflation. When a country monetizes its debt – that is, when it sells new debt to its central bank rather than in the market – it directly coordinates monetary and fiscal expansion and avoids the discipline of public auctions. The risk, in doing so, is that these markets see in this avoidance the true objective of coordination, that monetary policy is henceforth put at the service of fiscal indiscipline. This would mean that monetary policy could no longer be used to control inflation without triggering a sudden fiscal crisis – and the expectation that inflation would go unchecked is precisely what would trigger an inflationary spiral. The end of this road is the destruction of much private savings and ultimately economic collapse.
Alarmingly, we know very little about how to spot hyperinflation in its early stages. But with Federal Reserve officials talking with increasing vigor about raising rates and shrinking the central bank’s balance sheet, that risk seems extremely remote. Even in its most expansionary phase, monetary policy was never tasked with facilitating fiscal expansion; on the contrary, fiscal and monetary policies worked together to support a plummeting economy. Today, any fiscal expansion would trigger a more severe monetary contraction, which is precisely why new spending is no longer a free lunch. For the same reason, however, a hyperinflationary spiral should not be on the menu either.
There are, however, other limits – or rather other potential adverse effects of too much debt. If domestic savings are insufficient to finance growing debt, then an increasing percentage of public debt will be held abroad. This would mean that an increasing percentage of the national income would be sent abroad in the form of interest; it would also mean a growing trade deficit (because a budget surplus must be offset by a trade deficit) and make the US fiscal position more vulnerable to decisions by foreign central banks.
But the US personal savings rate has actually exploded during the pandemic, from a base that was already significantly higher than the abysmal levels of the 2000s. The percentage of government debt held by foreigners has also decreases. Of greater concern might be the distributional effects of high deficits, since domestic savings tilt very heavily towards the wealthy, as well as pensioners. However, as long as interest rates remain relatively low, the political and economic effects of these transfers should remain moderate.
This “if”, however, indicates the most obvious risk we face due to our large debt: even if huge debt can be easily refinanced, interest must be paid. Currently, this interest cost as a percentage of GDP is relatively low – about half of what it was at its peak in the early 1990s and only slightly higher than it was in the early 1950s. interest rates were to rise significantly, this cost could inflate. If that happened, either taxes would have to go up or other federal spending would have to be cut, otherwise we would end up borrowing more simply to pay the interest on our previous borrowings, digging a deeper and deeper hole.
If you want to paint a plausibly ominous scenario, then it would look like the following. To control inflation, the Federal Reserve would raise rates and reduce its balance sheet and persist in this policy over time to restore confidence in its ability to achieve its goals. Higher rates would increase the cost of rolling over federal debt when it comes due, but also slow the economy, squeezing the budget on both sides. Unlike in the 1980s, monetary contraction could not be offset by fiscal expansion; unlike the 1990s, the budget restriction could not be compensated by a drop in money. Instead, the economy would find itself stuck between a rock and a hard place, with little policy room to manoeuvre.
What is the probability of this scenario? It’s impossible to say for sure – and there are plenty of ways things could improve. Inflation may turn out to be transitory and pandemic-related after all, and the current robust recovery may turn out to have considerable fallout. The Fed may be able to reduce its balance sheet without long rates falling significantly, so interest costs may remain fairly subdued. In this case, we would have plenty of leeway for new spending, despite the high nominal amount of debt.
If we want to improve our chances, however, the most important thing to focus on is sustaining economic growth. Our federal debt as a percentage of GDP has reached uncharted territory during the pandemic, but this ratio has declined with the economic recovery even as debt has continued to grow. Policies that can prolong and broaden this recovery in a fiscally neutral way – through regulatory reform, productive investment matched by tax increases, and an immigration and child welfare system that encourages population expansion – would improve the debt situation directly by increasing federal revenues and indirectly by spreading the burden of debt service across a larger economy.
The right answer to high debt is not austerity. It is abundance.