As the amount of a debt grows larger, the payment of interest it promises to lenders increases. If it grows faster than the borrower’s income, the burden grows as a share of his or her income. If the burden grows too large, the promise must be broken, leaving those who lent the money holding the bag. As the prospect of default increases, bondholders demand higher interest rates to compensate for the risk. No one knows exactly where the default cliff is and thus when to dump bonds, but everyone knows when you have driven off it.
The national debt of the U.S. federal government as a percentage of its gross domestic product—a measure of its capacity to service its debt—fell from 120 percent at the end of World War II to about 35 percent in 1982. This heartening decline resulted from the reduction and occasional elimination of the government’s annual deficit (the annual addition to the outstanding debt) and growth in GDP (the denominator of the ratio). The federal government’s tax revenue fluctuated around 18 percent of GDP during most of the post WWII period and the average annual deficit was 1.1 percent between 1950 and 1982, but GDP grew 7.8 percent per year on average over the same period (3.6 percent of which was real and 4.2 percent of which was inflation). Thus the rapid and steady fall in the ratio of the debt to GDP reflected the low annual deficits and rapid economic growth over the period.
Since 1982, the debt ratio has risen steadily (except during the Clinton presidency during which government spending as a share of GDP declined) to 83 percent in 2009 and is projected to rise to an astounding 94 percent this year. In dollars and cents, the gross federal debt is now $12.4 trillion ($113,194 per taxpayer). The Congressional Budget Office baseline forecast projects that this amount will increase by $8.5 trillion to $20.9 trillion by 2020. This does not include the huge unfunded Social Security and Medicare liabilities of over $99 trillion that will need to be paid for in the future. The Federal debt is projected to exceed 100 percent of GDP within two years.
The failure to address this problem, i.e. the failure to limit the growth in the debt to or below the growth in GDP, reflects the unwillingness of those who want government to do more to cut spending (generally Democrats) and of those who want government to do less to raise taxes (generally Republicans). Combined with the political reality that it is easier for our representatives to increase rather than reduce spending and to lower rather than increase taxes, our political system has been biased toward deficit financing.
Deficit financing can be preferable to reducing spending or increasing taxation during recessions. However, in the long run financing spending by borrowing comes at the expense of investment. The funds lent to the government come from savings and capital markets at the expense of other uses of those funds. Moreover, as the size of public debt as a share of GDP rises, the risk of the government’s default rises as well driving up the interest rate the government must pay to attract additional funds. At some point, the risks perceived by the public become too high to be compensated with higher interest rates and the public stops lending. This has happened to a number of mismanaged and reckless countries in the past. Russia, for example, famously defaulted on its foreign held debt in 1998.
Many supply-siders seeking to promote investment and more rapid economic growth with better (i.e., more neutral) and lower taxes, also tried to use tax cuts and deficits as a tool to restrain government spending. It hasn’t worked. Rather than restraining spending, deficits simply got larger. The idea that we can “starve the beast” by forcing government to borrow if it spends more has been convincingly challenged by former CATO Institute Chairman William A Niskanen, in the Cato Journal 26 No 3. There is also a lot of evidence that taxing the rich to pay for larger government, an approach favored by some Democrats, would reduce investment and growth, thus undermining the goal of reducing the debt to GDP ratio.
Greater honesty here would be helpful. As a society we need to decide what we want the government to do (the size and nature of government) then pay for it with the most economically neutral, efficient and just taxes possible. There should be no fiscal deficits on average over the business cycle. The optimal size of government is both an objective economic issue and a political one. It is useful to know, for example, that from the perspective of maximizing economic growth, the basis of poverty reduction, government spending of around 25 percent of GDP would be optimal for OECD countries. They actually average 41 percent (see the study by the Institute for Market Economics, Sofia, Bulgaria). The U.S., which has enjoyed higher growth rates than other OECD countries and thus greater wealth and economic importance in the world, has averaged around 35 percent (Federal, State, and local) from 1955 to 2007. Federal government expenditures over that period fluctuated around 19 to 20 percent. In the current year federal government spending is projected to rise above 25 percent of GDP, well above the norm. Outside of the Civil War and WWI, Federal government spending did not rise above 5 percent of GDP until the Great Depression and WWII, never to return.
Everyone knows that we have a deficit problem but neither side has been willing to yield in a political game of chicken. The United States, all of us, will be the losers if a bargain is not struck soon. Each side must compromise and new, simple rules for making such compromises might help. The Senate has already rejected “The 18-member commission proposed by Democratic Senator Kent Conrad and Republican Senator Judd Gregg [which] would weigh tax increases, spending cuts and other approaches needed to prevent the ballooning national debt—currently at $12 trillion—from compromising the United States’ long-term strength.” (Reuters, Dec 9, 2009). President Obama will go forward with his own version of the commission by executive order but it will not bind the Congress. The President’s proposed three-year freeze of a small share of the government’s spending is barely serious. According to The New York Times on Jan. 26, 2010: “The payoff in budget savings would be small relative to the deficit: The estimated $250 billion in savings over 10 years would be less than 3 percent of the roughly $9 trillion in additional deficits the government is expected to accumulate over that time.”
The Senate rejected the proposed commission because it would remove the political process of prioritizing government expenditure from the political body meant to make such decisions. The President’s freeze gesture leaves out the largest parts of the budget where exactly such prioritization is required to have any real effect. The Economist called it “comically insufficient.”
Another approach that deserves serious consideration is for the president to broaden his freeze to the total aggregate budget and allow Congress to fight out the distribution of that total among individual line items. The share of the budget’s total assigned to entitlements (Social Security, Medicare, welfare, etc.) would reflect Congressional Budget Office forecasts based on the rules in effect or that will be in effect over the budget period. Since the fiscally conservative years of President Clinton, the Federal government has grown beyond its optimal size. Thus the total nominal spending freeze should remain in effect until the economy’s growth reduces this level of spending to the 18 percent of GDP share we enjoyed when Clinton left office, which would take several decades. This would match the average tax revenue over most of the past 60 years. Whether the public is satisfied with what its government is doing is likely to have more to do with the care with which it selects its programs and determines their scope and scale, than with the level of spending. Thus within this spending cap Congress and the administration have their jobs cut out for them and will be judged by how well they perform them.
Taxes should be adjusted to balance the budget over the business cycle once spending has reached the 18 percent of GDP level. If the tax rates that produce that result do not produce a long run steady state debt ratio that is satisfactory (say 40 percent of GDP), they will need to be raised for some years until they do. PAYGO should be restored to insure that any new government programs that are not financed with savings from cuts to existing programs are tax financed. This might apply, for example, if increased war expeditors justified temporarily increasing government spending above the freeze level. If we go to war, we must pay for it. Once achieved, the 18 percent ratio might be reviewed every 10 years to account for changes in technology and public tastes. Trying to eliminate deficits with discriminatory tax increases, such as taxing the rich or nominal (not real) capital gains disproportionately, is likely to fail by reducing economic growth and thus the tax base. This, or a comparable plan to address the deficit problem, is needed now but will operate gradually over many years. It should not and is not meant to start reducing the debt ratio this year or next in the midst of recession.
Current policies will increase our debt to unsustainable levels. The global imbalances resulting from encouraging China and other surplus countries to help us finance our huge deficits are also unsustainable. These policies, especially unsustainable entitlements, must be changed, but Congress has been at an impasse over whether to cut spending or raise taxes. We should begin by finding agreement on what we as a society want the government to do—the size and nature of government. And we must commit to paying for what government does with taxes. Assigning the right things to the government (those things that only it can do best) and doing them efficiently will increase the productivity and efficiency of the entire economy, thus easing the burden of financing the government. Instituting more economically neutral and fair taxes at the same time would increase growth rates even further while restoring the public’s sense of justice in the system.
Warren Coats retired from the International Monetary Fund in 2003, where he led technical assistance missions to central banks in over twenty countries. He is Senior Monetary Policy Advisor to the Central Banks of Iraq and Afghanistan. His most recent book, “One Currency for Bosnia: Creating the Central Bank of Bosnia and Herzegovina,” was published in November 2007. He has a Ph.D. in economics from the University of Chicago and lives in Bethesda, Md.