Wednesday, 17 April 2013

Is Our Debt Really That Dangerous?

Perhaps the most frequently asked question Perhaps the most frequently answered question by policymakers relates to the paradox of preempting our long-term debt burden while continuing to stimulate our currently depressed economy. (The asking part is usually omitted).

The deficit hawks assert that we need to cut spending, and cut it now. This, of course, is the intuitive response. For the more money we borrow and spend now, the worse our interest burden becomes in the future. More tax revenue will be used to service our interest payments; we might even borrow to pay off interest on other loans. To compound the issue, entitlement spending is ballooning as social security and healthcare costs continue to grow.

With more and more tax revenue being directed toward interest payments and entitlements, investments in our future—like R&D, education and infrastructure— will increasingly diminish. This combination of slowing growth and dwindling revenue could mean that we are unable to service our current interest burden, resulting in soaring interest rates and even a default on our sovereign debt. The medicine that many prescribe for preventing the chaos is an unpleasant decrease in spending—otherwise known as austerity. Sound logical? Sure it does.

But wait a minute. We happen to be in the worst economic downturn since the Great Depression. Although spending cuts may appear to be the intuitive course of action, the reality may be quite different. In fact, many economists assert that the immediate need for stimulus must supersede the hysteria about our long-term debt.

Why? Because contractionary policies will put us back into recession. The different outcomes between the policy responses of the United Kingdom and the United States offer valuable insight in to what works.

The UK plans to cut the overall spending of government agencies by 10% by next year. While the object of this policy is to bring the deficit to 0%, it has instead only managed to hamstring growth. As a result, the UK is currently about to consummate its ongoing flirtation with a triple-dip recession.

The coalition government in the UK fails to understand that Britain’s primary problem is not growing deficit spending, but a revenue decrease attributable to a depressed economy—of which a growing deficit is a symptom. Foisting contractionary policies on a beleaguered economy cripples recovery. Austerity has left the UK with a sclerotic negative growth rate of -.3%, a far cry from the 4.8% the government expected.


During a debate with Joe Scarborough on Charlie Rose, economist Paul Krugman forwarded the viewpoint that the immediate need for stimulus must take precedence over the long-term debt challenge. He remarked that focusing on improving employment now would generate sufficient revenue to offset our deficit and to prevent a long-term debt crisis. Scarborough himself conceded that during the Clinton administration the Republican Party spent years trying to cut deficit spending, only to find that once the labor force was fully utilized, the deficit was evaporated by the additional revenue

However, many deficit scolds are worried that in an effort to stimulate the economy, accumulated debt will reach a point of no return—a danger zone at which public debt-to-GDP will alarm investors who will then view US debt as riskier and lose confidence in US credit.

If the US were to hit that tipping point, the Treasury will have to offer higher-interest rates to compensate investors for their risk, effectively making borrowing more costly. With a more severe interest burden, our debt would worsen leading to a vicious feedback loop in which confidence would plummet, interest rates would sky-rocket and large capital outflows would abound. With a current debt-to-GDP of 75%, some argue that we are close to that danger zone and marginal increases in debt grow increasingly more pernicious.

However, there is no clear consensus about where this danger zone is. Neil Irwin cites a paper by David Greenlaw, James D. Hamlton, Peter Hooper and Frederic S. Mashkin who state that this tipping point is around a debt-to-GDP of 80%. Carmen Reinhart and Kenneth Rogoff published a frequently cited paper asserting the tipping point to be around 90%.

However, many economists—including Eric Rosengren and Jerome Powell—impugn these findings, charging that they ignore key factors that allow the US to safely sustain a much higher debt-to-GDP ratio, such as its ability to set interest rates and borrow in its own currency.

In fact, Krugman asserts that a debt-to-GDP of 100% is acceptable, and notes that both Japan and the UK have sustained ratios of around 200% without a serious rise in interest rates. If there is a danger-zone, it is far above current level of 75%, which according the CBO, is expected to remain steady. The perception of where that danger zone is will influence policy. A higher danger zone implies more room for fiscal stimulus.

Nevertheless, this still fails to mention the icing on the cake. Because of the instability in the Euro Zone, investors are flocking to US Treasuries, which have seen their highest demand since 1995. The real yield on US Treasury bonds remains negative—meaning we are borrowing without any real interest. In other words, we can continue to borrow cheaply in order to stimulate the economy and get employment back to a healthy rate. Instead, however, we are fighting tooth and nail to cut a deficit that is accompanied by historically low interest rates. As the global economy improves, and investors find other safe investments, this opportunity will dissipate.

The deficit scolds have spun a touching narrative by framing the depressed economy as a generational responsibility. But economic forces seem to lack a corresponding empathy. Moreover, this argument ultimately falls into a logical trap. By failing to stimulate our ailing economy now, we are only succeeding in exacerbating both our long- and short-term challenges. It is akin to skipping the midterm so we can study for the final.

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