On the heels of the announcement that the U.S. economy shrank in the last quarter of 2012, largely due to reduced government spending, questions remain about the strength of our economic recovery. What is to blame for our persistently feeble economic performance? Our obsession with reducing deficits and government debt.
You won’t get very far today reading about the failures of Washington politics without coming across the failure to address America’s “debt crisis.” This debt crisis is often described as imminent, the forces of which are waiting to strike at any moment; the need for reform dire, the hour late, and the solution staring us in the face: reduce spending or suffer the consequences. These debt warnings sound sincere, and are sold with a plea to our common sense: we have taken on large budget deficits that have driven up the national debt, therefore the only proper course is to reduce those deficits now and shrink the debt burden.
The flaw in the deficit scold’s argument is that there doesn’t appear to be much evidence that substantiates it. Such arguments are based on a narrative that one day bond market investors will abruptly shift their risk assessment of the U.S. debt burden and attempt to influence fiscal policy by manipulating interest rates, which would suddenly and dramatically increase the costs of borrowing, increasing deficits and debt, leading to a downward spiral and a Greek-style default. While such narratives are provocative, fears about the debt burden are misplaced, for several reasons.
The Debt Burden Isn’t as Large as You Think
Concerns about the market suddenly shifting its views on U.S. government debt are based on the idea that investors will begin to view the national debt as so large that there is increased risk in investing in government debt. However, this view overlooks some of the finer points of the make-up of U.S. government debt.
The national debt, or total U.S. government debt, is about $16.4 trillion. However, some $4.8 trillion is money that the government has borrowed from itself, called intragovernmental debt, and is borrowed from government accounts, most significantly from the Social Security trust funds. The remaining $11.6 trillion is categorized as debt held by the public.
As explained by the Congressional Budget Office,1 debt held by the public is seen as the appropriate focus of those concerned with the sustainability of the U.S. debt burden. It is this classification of debt that is borrowed from, and therefore owed to, the public. If investors were interested in evaluating the sustainability of U.S. debt, they would therefore focus on this type of debt, as it is this debt burden that would carry with it the potential risk of default. This is why U.S. debt-to-GDP is appropriately valued at about 73 percent instead of the more provocative, but ultimately misleading, 100+ percent figures.
New Debt Is Really Cheap
The United States currently enjoys some of the lowest interest rates in generations. Indeed, interest rates are so low—and government debt is in such high demand—that investors are essentially paying the U.S. government to hold onto their cash, and have been doing so since 2011. There are a number of reasons for these low interest rates, but what is important for us to consider is that, in spite of predictions of impending crisis, investors still believe that U.S. debt is one of the safest investments in the entire global economy.
Furthermore, one of the benefits of historically low interest rates is that the burden placed on the budget by interest payments has actually been falling as a percentage of GDP and is near its lowest point in decades.
We’ve Already Done a Lot of Deficit Reduction
You might be surprised to learn that we’ve already reduced the deficit by $2.4 trillion since 2011. This was done through a series of legislative agreements that reduced spending and increased revenue over the next decade at a ratio of three-to-one, respectively. The deficit has actually fallen faster than at any time since World War II.
The Center for Budget Policy and Priorities (CBPP) estimates that, without any further deficit reduction, the U.S. debt-to-GDP level will rise about 6 percent in the next decade. While this shouldn’t be seen as a positive, it is nowhere near crisis levels. The CBPP also shows that further deficit reduction of about $1.4 trillion would stabilize U.S. debt-to-GDP at its current level over the next ten years. And this figure doesn’t take into account sequestration cuts or equivalent alternatives (sequestration would cut $1.1 trillion over the next ten years).
For his part, President Obama has suggested a willingness to enact a further $1.5 trillion in balanced deficit reduction in lieu of the sequestration. As we can see, growth of the debt burden over the next decade has been largely neutralized.
There Is No Substance to the “Bond Vigilante” Argument
Thus, we return to the centerpiece of the deficit scold’s argument: the bond vigilante narrative. What is left to account for the supposed sudden increase in government borrowing costs? The long-term debt issues are not secret; investors have known about these issues for some years, and yet they continue to buy government debt at negative real yields (paying the government to hold their money). And even when U.S. credit was downgraded in the summer of 2011 due to dangerous political tactics, interest rates continued to fall. Simply put, there is no evidence to suggest that markets fear U.S. debt. And, while it should go without saying, we aren’t Greece.
So why is it so clear to a few individuals that investors will suddenly turn on U.S. debt? There is simply no clear economic or financial explanation for why such a chain of events would occur. The bond vigilante argument seems to be based instead on a political opposition to spending rather than actual economic or budgetary consequences of that spending.
The Wrong Time for Deficit Reduction
The United States has a long-term debt problem, overwhelmingly driven by the growing proportion of the elderly population and the projected increase in health care costs over the next few decades. However, this particular debt problem is still far in the future and should not be a legislative priority at present. And what is perhaps more important to point out, our debt obsession has only resulted in reducing government spending in ways counterproductive to short-term economic growth, without resolving any long-term debt issues.
Considering the prolonged economic malaise that we have yet to escape, reductions in government spending are exactly what aren’t needed in the short-term. Reduced government spending leads to slowdowns in economic growth, which translate to slowdowns in job growth or job losses. Therefore, in the short-term, deficit reduction is bad for the economy. This is something we’ve known for quite some time. Both deficit hawks and doves agree that spending should increase in the short-term to promote economic growth.
We must break out of our debt obsession driven by this false narrative about an impending debt crisis. We should be concerned about the task of strengthening our recovery by promoting economic growth and job creation. As it turns out, pursuing such a course of action comes with the added benefit of reduced deficits and debt burden.
1. Congressional Budget Office, The Long-Term Budget Outlook, June 2009, Box 1-3, “Why Is Federal Debt Held by the Public Important?”