How Much Should You Fret About Rising Federal Debt?

It’s hard to know how much to worry about the federal debt of the United States. Believers in Modern Monetary Theory, most of whom lean liberal, say deficits and debt aren’t a threat so long as they don’t cause the economy to exceed its speed limit. Republicans in Congress worry a lot about the debt now, but many of them were more tolerant of it when a fellow Republican occupied the White House.

This isn’t purely a political matter on which one person’s opinion is as good as another’s. Either the United States can continue to run big deficits and skate along with no harm done or it’s at risk of losing investors’ confidence and having to pay higher interest rates on its debt, which would suppress economic growth. Fortunately, academic economists have been putting some serious work into figuring out which scenario is more likely. Several of them presented their work during this past weekend’s online annual meeting of the Allied Social Science Associations, which includes the American Economic Association and the American Finance Association.

My reading of the evidence presented is that the huge increase in federal debt incurred during and after the past two recessions — those of 2007-09 and 2020 — has used up a lot of the “fiscal space” the United States once had. In other words, the federal government is closer to the tipping point where big increases in debt finally start to become a real problem and interest rates rise. Unfortunately, it’s impossible to know precisely where that tipping point is. It may not become apparent until things have begun to tip.

The American Finance Association session that I attended virtually on Jan. 7, “Government Debt: How Much Is Sustainable?,” was chaired by Annette Vissing-Jorgensen of the Haas School of Business at the University of California, Berkeley, who recently became a senior adviser for research and policy at the Federal Reserve Board of Governors. It included presentations by some heavy-hitters, including Nellie Liang, under secretary for domestic finance at the Treasury Department. I followed up with several of the presenters.

The puzzle all of them are trying to solve is why interest rates on Treasury securities are so low (currently less than 1.8 percent for 10-year notes, below the expected 10-year inflation rate of 2.5 percent), given the huge and persistent deficits the government is running. To some people, debt issuance by the federal government looks like a Ponzi scheme, where new lenders must constantly be found to provide the funds that pay off old lenders.

The saving grace for the government is that any given amount of debt becomes easier to sustain as long as the growth rate of the economy (and thus the growth rate of tax revenue) is higher than the interest rate on the debt. In that scenario, interest payments gradually shrink relative to tax revenue. Evidence presented in the Jan. 7 session is that the growth rate has been higher than the risk-free interest rate 70 percent of the time since 1870. Under those circumstances, the government can run a modest annual deficit without ever raising the ratio of debt to gross domestic product. That’s the closest thing there is to a free lunch in economics.

That’s nice, but it doesn’t explain how much more the debt can grow. Lately, because fresh deficits have increased the debt, the annual expense for interest and principal payments has grown faster than tax revenue. One risk is that investors will get nervous and drive the interest rate above the economic growth rate, Liang said. “There are clearly fiscal limits,” she said.

Amir Sufi of the University of Chicago’s Booth School of Business, another panelist, said the government can get in trouble even if the interest rate remains below the economy’s growth rate. The reason, he said, is that the interest rate isn’t fixed. It tends to rise when the debt level rises, because investors become satiated. The government has to pay a higher interest not only on its new debt but also on all existing debt. Past a certain point, there’s a double whammy of more dollars of debt plus higher interest costs on each dollar.

Sufi and two other economists, drawing partly on work by Vissing-Jorgensen and others, estimate that the United States still had some fiscal space — i.e., was short of the tipping point — in late 2019. There’s been a huge increase in debt since then, but the authors aren’t prepared to say that the increase has pushed the United States past the tipping point. One offsetting factor is that the pandemic caused people to spend less, leaving abundant savings for the bond market. In the longer term, increased inequality increases savings rates (since rich people save more than poor people), so it allows the government to borrow more without satiating lenders.

Markus Brunnermeier of Princeton University said one explanation for the low-yield puzzle is that Treasuries are in demand because of their unique role as “a safe asset that hedges against uninsurable risk.” Ricardo Reis of the London School of Economics said, “there’s a lot more fiscal space out there than might have been appreciated before,” but it’s not unlimited.

I followed up with Atif Mian of Princeton, who is collaborating with Chicago’s Sufi and Ludwig Straub of Harvard University. Mian said that in celebration of the new year he had T-shirts printed for himself and his co-authors featuring their mathematical formula for debt sustainability. (He said they’re not for sale, alas.) Mian said that the three of them are trying to put debt sustainability into quantifiable terms so that people from the left, center and right of the deficit debates “stop talking past one another.”

In a now-famous article published in the American Economic Review in 2010, Carmen Reinhart, then of the University of Maryland, and Kenneth Rogoff of Harvard reported that the average growth rate of countries with public debt exceeding roughly 90 percent of their gross domestic product was several percentage points lower than it would have been at lower debt levels. But a 2014 paper by researchers at the International Monetary Fund questioned the 90 percent threshold and found that “countries with high but declining debt appear to grow equally as fast as countries with lower debt.”

Modern Monetary Theory says that the federal government of the United States never has to worry about paying what it owes because it can always print more money. The only concern of adherents of the theory is that too much government spending (or too little taxation) could overheat the economy, causing inflation. Mian said supporters of the theory have “an intuition that is correct under certain conditions. But because it’s not spelled out, we don’t know what the limits of that intuition are.”

In a sharp economic downturn such as in the spring of 2020, “you can always run a big deficit temporarily,” Mian said. In fact, he said, it’s exactly the right thing to do. “The problem is with long-term, steady-state projections.” To retain the faith of investors that the debt is sustainable, the government might have to cut spending or raise taxes. The scary though relatively unlikely scenario, Mian said, is that a dysfunctional government in the future would fail to do those things. “Anyone who claims they know exactly how those dynamics will happen would be lying.”

Reis reminded me that sovereign debt crises tend to be self-fulfilling prophecies: Investors get nervous about a government’s ability to pay, so they demand higher interest rates, which raise borrowing costs and produce the bad outcome they feared. It’s a dynamic that Argentines are familiar with — and that Americans had better hope they never experience.

Elsewhere

In 1810, nails — for carpentry and such — were as big a share of the U.S. economy as personal computers for household use or personal air travel are today. So writes Daniel Sichel, an economist at Wellesley College, in a National Bureau of Economic Research working paper released last month, “The Price of Nails Since 1695: A Window Into Economic Change.” In the 1700s, nails were so expensive that people would burn down old buildings to make it easier to recover the nails from them. Nail prices fell about 1.5 percent annually from the late 1700s to the middle of the 20th century compared with overall consumer prices, Sichel calculates. Since then, he writes, inflation-adjusted nail prices have risen, “reflecting in part an upturn in materials prices and a shift toward specialty nails in the wake of import competition, though the introduction of nail guns partly offset these increases for the price of installed nails.”

Quote of the day

Rudi Dornbusch “was a very funny, colorful speaker of English, with a gift for offbeat but perfect turns of phrase. He had a classification system for economists, depending on their research style. ‘Goldsmiths’ were careful, meticulous workers — which Rudi admired. ‘Pigs’ just sort of jumped into an issue and wallowed around. But that was OK too, if it was done with sufficient vigor and originality. Rudi described Larry Summers as a ‘fearful pig’ — and it was a compliment. On the other hand, ‘plumbers’ were economists who devised intricate contraptions with no clear purpose. I won’t tell you who he described as ‘dreadful plumbers,’ but he was right.”

— Paul Krugman, “Remembering Rudi Dornbusch” (2002)

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