National Debt Issues

The size of the national debt, as it rises inexorably, has suddenly become the latest focus of fear amongst those who want to find any reason they can for attacking current economic policy. They are wrong to worry. But there seems to be a lot of them, so they are able to stir up emotions and create a debate where there should be none.

Robert Reich tackles them today in his column at TPM, but David Leonhardt adds grist to their mill in his article at the New York Times.

So what’s the deal?

Take a look at Leonhardt’s fancy chart: the change in fortunes for the Federal budget could not be more stark. In a few short years we have gone from an estimated surplus of $846 billion to this year’s forecast deficit of $1,215 billion. That’s about a $2 trillion switch. Expressed as a percentage of GDP it is a nosedive of around 15%. Very ugly. And totally unsustainable.

“The Reagan/Bush legacy turns out to be the elimination of options, and a faux destitution that appeals to the bond market and other centers of anti-government sentiment.”

Reich is correct that the best way to look at the national debt is not in absolute dollar terms, but as a percentage of GDP. By that measure it has risen to well over 70% and continues to rise. The highest it ever reached was just after World War II when it topped out at about 120% after which it came down very quickly in the long post-war boom of the 1950’s and 1960’s. In that light we have a very long way to go. Even with the gloomy outlook that still pervades I doubt that we will go above 100% of GDP any time soon. So in that respect we have plenty of room for maneuver.

OK. So what’s the deal?

The bond markets. Keeping close to their famous tradition of skittishness the bond markets are beginning to throw a hissy fit at the prospect of endless amounts of government debt. If the red ink flows for ever it will be impossible to sell all that debt: the number of buyers will eventually dry up. Nearer term the fear of such a future is showing up in rising bond yields. The ten year government bond yield has risen quite quickly to around a little under 5%, a level it has not seen for a while. This sudden rise is interpreted by some observers as a warning shot: the bond market, we are told, will not tolerate much more of the current ‘fiscal irresponsibility’. The financial press has jumped on the band-wagon and now there seems to be a rising flood of articles all predicting doom. The dollar will collapse, interest rates shoot up, and the US will fade into the kind of financial oblivion we normally reserve for the likes of Argentina or any one of the infamous ‘banana republics’ of Central America.

Apparently the Obama administration has no choice but to buckle before the desires of the bond market and turn back from its profligate ways. The alternative is disaster.

Not.

As Reich points out there seems to be a small irony here. The bond market was completely quiescent throughout the Bush era. Rates were mundanely low. Ridiculously low in fact. So low that they encouraged our borrowing boom and contributed to the real estate bubble. National debt back then was not regarded with the combination of breathless fear and doom laden fatalism that pervades the press today. Why not?

Even a cursory look at the numbers will show that the majority of the turn around in our budgetary fortunes stems from two factors. Neither of which has anything to do with Obama:

1. The recession itself has hammered government revenues. There is no surprise here. Of the $2 trillion downturn in the budget, fully $770 billion, or about 39%, is directly caused by the shrinkage of tax revenues due to recession. The interesting point here is that there are two chunks within this number: $291 billion of the shrinkage traces back to the recession of the early 2000’s. Because the recovery of the mid 2000’s was so weak, and because taxes were cut so aggressively at the same time, revenues never rebounded. That $291 became part of the ongoing or ‘structural’ deficit. The bond market should have panicked at this figure. It didn’t. It embraced it. That’s odd. Especially since the lost revenue from the current recession, at $479 billion, is not structural but ‘cyclical’: it will go away as soon as activity picks up, incomes improve, and taxes rise back. Obama had not cut taxes as aggressively as Bush did, on the contrary he has announced tax increases as soon as the economy recovers. That announced fiscal tightening should have re-assured the bond market that this portion of the debt is temporary and therefore not inflationary. It didn’t. That’s also odd.
2. Of the $2 trillion collapse in our budget approximately $673 billion, or another 34%, is due directly to the tax cuts that Bush made. Those tax cuts failed to generate offsetting revenue – that notion was always bogus – and so permanently added to the deficit. At no time did the Bush administration attempt to address the gaping hole it opened up in our finances. On the contrary Dick Cheney famously declared that deficits don’t matter. That proclamation of fiscal profligacy should have been enough to send bond prices through the floor, and thus yields through the roof. Here was a US official stating that the government cared not one whit about the yawning gap in the budget and thus the rapidly accumulating national debt. Did the bond market react that way? Not at all. Very odd yet again.

The combination of these two factors, neither of which has anything to do with Obama’s agenda, contribute just over 70% of the downturn in our fortunes. Only 30% flows from all the bail out and stimulus activity of the past few months.

And it is the 30% that apparently has now scared the bond market, and which has now captured the attention of all the commentators who are now piling in on the debt fear mongering.

But do they have a point?

Let’s press on with our analysis.

The bond market clearly didn’t worry about the Bush deficits even though they had all the appearance of permanence. Let me repeat: at no time did the Bush administration offer even a hint of a suggestion as to how we were going to deal with those deficits. On the contrary they punted the entire problem of fiscal policy forward in one of the most irresponsible acts of bad government in history.

I spent much of my time during both the Reagan profligacy and the Bush mega-profligacy arguing that deficits do indeed matter. For exactly the reason being cited today by the right wingers as they attack Obama: governments should fund their activities wisely and fully. Neither Reagan nor Bush was wise. But they knew full well what they were doing. They were trying to eviscerate government. It was the ‘starve the beast’ strategy in its full glory. The Republican thinking was that by destroying the government’s revenue stream it would hobble any attempt by a future Democratic regime to expand social programs. More to the point: if the starvation was sufficient the result would be an inability to fund the existing programs and thus enable their rolling back. Don’t forget that the GOP is still fighting a war against FDR and all he stood for. The Reagan/Bush years of disastrous fiscal policy were simply the latest weapons in that war.

But our issue here is the bond market. Where was the prediction of gloom and doom back then? Why wasn’t every uptick in the ten year bond yield seen as foretelling the end of the world as we know it – the way today’s rate increases are. The case for doom was much stronger back then. No one had any policy to reverse the tide of red ink. They didn’t want to.

I recall being extremely frustrated as I tried to explain to audiences that the rising deficit would eventually trigger a revolt in the bond market, and that we would either have to rein in spending or expand revenues in order to prevent that. But nothing happened. I was told that the US is able to issue endless streams of debt and that worrying about funding was a trivial problem. Yet here we are, and many of those self same folks are tearing their hair out over exactly the same issues.

So the current hissing sound you hear in the bond market seems very political to me. Not economic. It seems that Republican deficits truly don’t matter – Cheney judged the bond market well – but that Democratic deficits are the road to perdition.

Nuts.

Let’s look at some old fashioned economics.

• Deficits do matter. In the long run. No country can deficit spend permanently. Structural deficits are like rotten floorboards: they eventually cause a cave in. Not even the US. Eventually the cost of debt will rise to unsustainable levels and the economy will implode.
• But temporary, or cyclical, deficits don’t matter. On the contrary, they are helpful. They plug the gap in the economy left by the loss of private spending. That’s Keynes 101. That’s why the stimulus is relatively unimportant in terms of its debt impact. The idea is to spend freely up to the point that the economy kicks back into gear. In fact a cyclical deficit acts as a self-correcting device at the heart of an economy: by moving into deficit as a recession begins a rising government deficit pushes against the downturn. Money still flows. the chances of a depression are mitigated.
• But. At some point the budget must come back to balance and even surplus. A cyclical deficit must be cyclical not permanent. The Reagan/Bush nonsense should never be tolerated.
• So fiscal policy should be mildly counter-cyclical: pulling back in good times and pressing on in bad times. Old fashioned, but successful.
• Finally: adding to the money supply by issuing tons of bonds does not ‘assure’ future inflation. As long as the economy is operating well below its capacity – which it is right now – the extra money will be absorbed as additional spending. Inflation only rears it ugly head when money is added while the economy is at or near capacity. That’s why the Federal Reserve Board raises interest rates as the economy gets going. That’s monetary counter-cyclicality. Also old fashioned. Also successful.

Obviously the current flood of debt is horrendous. But, equally obviously, it is necessary. There is a cyclical urgency that preempts longer term considerations here. What the Obama critics are doing, successfully judging by the fearful articles now being written, is to muddle the structural deficits created by Reagan/Bush policies with the cyclical ones created by the recession and thus to sow confusion. They attack Obama policies by pointing to the consequences of Reagan/Bush policies. As if they are the same.

This is the latest incarnation of the ‘starve the beast’ strategy. The huge residual problems bequeathed to us by Bush are now being used as the reason we should not press on with health care reform, add to the stimulus, or bailout the banks. Supposedly we can’t afford it.

Again: Nuts.

We need to fight the near term battle before we can turn our attention to the longer term problem of restoring fiscal responsibility.

Meanwhile we will hear that health care reform is simply not affordable given our impecunious state. Our penury, courtesy of Reagan/Bush, is supposed to act as a bulwark against reform. So we are told by the wise heads in the financial world to stop, not because we discuss reform and decide not to go ahead, but because we simply don’t have the money – whether we want reform of not. The Reagan/Bush legacy turns out to be the elimination of options, and a faux destitution that appeals to the bond market and other centers of anti-government sentiment.

One last thing: yes, bond rates have indeed moved up. The bond market appears to be anticipating recovery, and given its normal worry ridden nervousness it has started to fall prey to fears of things that that don’t exist yet, but which may. Inflation is one. High debt loads are another.

Oddly, structural deficits didn’t seem a concern in the Reagan/Bush era, but now they do.

Yes they do.

One of the dominant themes of the Obama era must be fiscal sense and balance. The administration appears to have heeded the message: that’s why Bernanke already talks about targeting inflation at between 1.5% and 2% and has started to urge restraint on Congress. That’s why Obama’s budget contains tax increase down the road. That’s why ending the Iraq war is so important. And that’s why the focus of health care reform is on cost inflation control. Given this mix of policies the structural deficit can be dealt with even as we reform.

Ultimately, the difference between the two eras is that Reagan/Bush were willing to play dice with the nation’s finances in order to make a political point. But the grown ups are back in town. The new era is one of reconstruction, reform, and stability. That means sustainable growth and, gasp, perhaps even the reduction of debt.

Apparently the bond market hasn’t figured that out yet.

That’s their problem. Not ours.