Is the World Undergoing A Fiscal/Debt Revolution?

The need to go into debt to support the economy during the pandemic has a broad consensus of agreement. Even after adding 10-15 percent of GDP to debt levels, though, some economists are arguing that the world needs to keep expansionary fiscal policy for at least the next decade. In today's era of ultra-low interest rates, they believe that monetary policy is pushing on a string. They further argue that so long as growth and interest rates are so low, fiscal stimulus is near riskless. The argument claims that it is more appropriate to compare debt stocks to the present value of future GDP or interest rate flows to GDP flows.

This thinking implies, for example, that the reasoning that went into the formation of the Maastricht Treaty or various debt-reduction efforts in the United States is no longer relevant for the advanced economies. Some advocates go so far as to argue that in light of dynamic scoring, borrowing to finance appropriate categories of Federal spending "pays for itself in budgetary terms based on "reasonable" assumptions. Therefore, some economies may be less constrained by fiscal limits even properly benchmarked because fiscal expansions can raise GDP more than they raise debt and interest payments.

Is the global economics profession truly undergoing such a revolution? Is it--like many revolutions--likely to end in tears, or something to be applauded? Or is it like China's Premier Zhou Enlai said about the French Revolution, too soon to tell?

J. W. MASON

Assistant Professor of Economics, John Jay College-CUNY, and Fellow, Roosevelt Institute

The old orthodoxy on public debt and deficits has collapsed not from any new developments in economic theory or research, but from its own incoherence and events in the real world.

Economists had long asserted that high government debt was costly and dangerous, but this opinion never had a solid foundation. There was no logical way to reconcile the claim--central to mainstream macroeconomics--that the central bank can set the economy-wide interest rate at whatever level it chooses, with the idea that sovereign borrowers are at the mercy of fickle bond markets. Nor was there ever a way to reconcile the view that sustained deficits are in themselves inflationary with the idea--again, a staple of textbooks--that inflation depends on demand running ahead of supply.

Conventional wisdom said that the central bank should manage demand, while the budget balance was set to stabilize public debt. But this was a political preference dressed up as economics. As a matter of logic, it's just as possible to imagine the opposite assignment, with the budget balance set at whatever level is called for to maintain full employment and price stability, and the central bank holding interest rates low enough to keep public debt under control--as the Fed, for example, did during World War II.

The insistence that debt is a constraint on public spending was always, in Nobel laureate Paul Samuelson's words, a taboo, an "old-fashioned religion" with "myths to scare people into behaving." Like all taboos, this one loses its power once it's been seen broken without consequences. Over the past decade, public debt in many advanced countries rose to unprecedented levels with none of the retribution that was supposed to follow--rising interest rates, runaway inflation, collapsing exchange rates. Meanwhile, central banks' ability to maintain full employment is clearly more limited than we used to believe. Under these conditions, the case for throwing out the old fiscal limits is overwhelming.

A growing consensus among economists on this point does not, of course, remove the institutional barriers to deficit spending that have been built up over the decades, from pay-as-you-go rules to the Growth and Stability Pact. But it does free us to consider two other big questions about public spending.

First, how big is the gap that fiscal policy is expected to fill? How far are the U.S. and other advanced economies from their supply constraints, and how will we know when they start to bind? Second, what substantively are the activities we want the public sector to carry out? Let's say the government can afford to fully replace the incomes of unemployed workers, provide free higher education for everyone, or build millions of units of new public housing: should it do so?

Fears of public debt have been a powerful prop for those who prefer a limited public sector on other grounds. Removing the prop does not make those preferences go away. What is the appropriate scope and role for the public sector? Which activities should be organized around the pursuit of profit, and which are better handled by public employees following democratically agreed-upon rules? Unlike the debate over public debt, where real progress has been made over the past decade, the debate on this question has barely begun.

LAURENCE M. BALL

Professor of Economics, Johns Hopkins University, and Research Associate, National Bureau of Economic Research

Anew view of government debt is rapidly gaining currency. This view holds that levels of debt that once scared economists--100 percent of GDP or more--are benign, because interest rates are low. We once thought that government debt is a burden on future generations because they must pay taxes to service or retire the debt. But if the interest rate on debt (r) is less than the long-run growth rate of the economy (g), as it is today, the government can run a Ponzi scheme. It can issue debt to finance its spending and then perpetually roll over the debt and accumulating interest. With r less than g, the debt naturally falls as a percentage of GDP without the need for new taxes.

Does such a free lunch really exist? Maybe, but let me suggest two reasons for caution.

First, interest rates and growth rates fluctuate and we do not know what the future will bring. While r has been less than g since the 2008 financial crisis, r exceeded g by an average of 1.2 percentage points from 1980 to 2000. Looking forward, the Congressional Budget Office forecasts that nominal interest rates will rise to 4.1 percent in the 2040s, when nominal GDP growth will be 3.5 percent. Largely because r is greater than g, the Congressional Budget Office predicts that government debt in 2050 will be 195 percent of GDP. If that proves true, we will face a choice between painful increases in taxes or the risk that ever-rising debt will eventually spark a financial crisis. Some economists believe the Congressional Budget Office is overly pessimistic about the path of debt, but it is a gamble to assume these economists are right and the Congressional Budget Office is wrong.

Second, a high level of debt damages the economy even if this level is stable and debt is rolled over without higher taxes. The reason is the one stressed in economics textbooks: the crowding-out effect. When savers buy government debt, they use funds that would otherwise be invested in new capital. With less capital accumulation, the economy is less productive and wages and living standards are lower. The crowding out implied by a debtto-GDP ratio of 100 percent is substantial compared to the total U.S. capital stock, which is valued at 300 percent of GDP.

Some economists suggest that low interest rates mean crowding out is not costly. In their view, if firms are not investing more despite the low cost of borrowing, new investment must not be very productive. However, interest rates on government debt are a poor guide to the economic benefits from new investment. The safety of government debt pushes its return below the return on capital (as measured, for example, by the average return on corporate debt and equity). In addition, the private return on capital is less than its contribution to the economy because firms in many industries have market power. With market power, firms choose levels of output and capital below the social optimum, which implies that the value of a marginal investment project exceeds the cost of capital.

PAUL RYAN

Former Speaker of the U.S. House of Representatives, and former Chair, House Budget Committee and Ways and Means Committee

Covid-19 has temporarily changed every facet of American life. Our nation's fiscal policy is no exception, and our debt trajectory has not been immune to the devastating impact--both short-term and long-term--of this virus.

To respond to a once-in-a-century health crisis and a once-in-a-generation economic crisis, the federal government appropriately surged an unprecedented amount of taxpayer dollars to communities so businesses could stay afloat, so front-line workers could deliver care to those suffering, and so Americans could survive significant economic shocks. Though the federal response was far from perfect, because of the actions taken by the Federal Reserve, the Administration, and Congress, our economy--which had been growing steadily prior to the pandemic, thanks to tax and regulatory reform--is positioned to get back on track.

Mitigating the immediate economic turbulence caused by Covid-19 was critical and necessary, but in the long term, lawmakers cannot turn a blind eye to our fast-growing debt and deficits. Interest rates cannot stay at historic lows forever, nor will inflation, and we can't tax our way out of this problem without cannibalizing economic growth and hurting hard-working families. As it stands, our monetary policy and our fiscal policy are on a collision course.

If the economics profession successfully advances this notion that debts don't matter (or that they matter much less than previously believed), and if policymakers continue to take the easy path of kicking the can down the road, then this course will surely end in catastrophe.

The advancement of digital and crypto currencies alone will bring a level of accountability to fiat currencies that cannot be ignored, not to mention that the assumptions and projections upon which fiscal stimulus policies rest...