Are we too concerned about public debt and a balanced budget?

The clarion call among many of our country’s deficit hawks (specifically those who believe we need to amend the constitution to force the government to “pay as we go”) is: “families and businesses can’t spend more than they make, so how can the government continue to borrow and run deficits”. First, families and businesses can and often do, for periods of time, but for the sake of discussion let’s say they can’t. Families and businesses are not a federal government. The federal government has an implied, and in some cases an explicit, covenant with its citizens to provide services. Services they expect to receive regardless of how they are paid for. You can argue it never was the intention of the founding fathers to have the government provide the depth of social support it does today and maybe they didn’t, but it doesn’t matter. The constitution was designed as framework within which new laws are interpreted. Time moves on.

The U.S. dollar is also the world’s reserve currency and as such must be supported even when the U.S. is in a recession. Being the world’s reserve currency offers benefits to the U.S. and along with that comes responsibility. This status offers stability and liquidity to international markets. The U.S. and U.S. firms benefit when the world is a stable place to do business. You can argue whether the extension of American influence is good or bad, but on balance I believe, it has been relatively positive. Given that responsibility U.S. policy makers must take international implications into account.

In the last recession the ability to deficit spend kept the economic contraction from becoming excessively deep. During the Great Depression the government raised taxes and balanced the budget and a recession turned into a global depression. They also raised inordinate trade tariffs which made matters even worse.

As mentioned above the idea of a balanced budget amendment to the constitution is being floated. The idea of a balanced budget amendment confuses me. Why would we do that? We have elected a congress that is supposed to manage our resources prudently. If you want a balanced budget elect people who will balance it. Why let them off the hook for doing one of their most important jobs. There, however, will be consequences for mandating a balanced budget. First, the philosophical argument: laws are not supposed to be suicide pacts. Second, without the ability for the government to spend in an economic contraction we know from history, recessions turn into depressions. The 2008 recession saw unemployment peak at 10%, in the Great Depression it reached 25%.

Since the 2008 recession there has been no shortage of analysis on what happened and who is to blame. Research revealed some interesting insights questioning whether we should be so obsessed with government debt levels.

The argument has always been that high levels of government debt discourage more productive private investment. Maybe that is not the case. Real interest rates have been falling for decades (see chart 1). Had there been an abundance of private sector projects to tease investors, rates should have risen as debtors sought to attract creditors with higher yields.

Chart 1

Another supposed truism is: high debt levels discourage investors. Japan’s debt (see chart 2) has reached what would seem to be unsustainable levels and yet even with yields near zero they have no trouble finding creditors. This is the case across the world. There is no shortage of government creditors for developed economies. It seems as long as the economy is growing faster than the interest rate on the country’s debt then managing the debt becomes routine (rolling the debt over at maturity).

Chart 2

Of course, interest rates have been known to rise, but typically growth rates exceed the rates of interest on public debt. Oliver Blanchard in his paper Public Debt and Low Interest rates noted: “Since 1870 the nominal average interest rate on U.S. debt has been 4.6% while average growth was 5.3%”

Nicholas Crafts in Reducing High Public Debt Ratios: Lessons from UK Experience posited that the delta between growth rates and interest rates did what budget surpluses never did: reduce British debt. Politicians have never met a surplus they did not want to spend.

It has been said that growth cures all ills. In the case of public debt that may be true. That isn’t to say that we shouldn’t be prudent and avoid wasteful spending, but the shrillness of the deficit hawks seems to be a solution in search of a problem. Neither should this be taken as a rule to follow blindly. Situations change and policy makers should be vigilant and flexible.

Many issues are too complex for simple solutions like a balanced budget amendment or a rule we chisel in stone and follow like lemmings over an economic cliff.