Federal Deficits Don't Work Like Credit Cards
(Bloomberg Opinion) -- The Joe Biden administration has pledged to deploy fiscal stimulus to get the stricken U.S. economy back on its feet, as well as increase government investment to boost long-run growth. This means the Republican opposition in Congress is back to arguing that austerity is the best way to compensate for the economic damage done by the pandemic.
Even before the election, I wrote about the need for more government spending — a lot more — to hasten a post-Covid recovery. With a Democrat now in charge, fiscal conservatives will be hitting hard on the claim that it's irresponsible to deepen the nation's already-hefty debt. So it's more important than ever for people to understand why some of the more emotionally appealing of those arguments are specious.
Two common pro-austerity refrains, for instance, are that the government should stay out of debt like a prudent household, or be run efficiently and profitably like a business. But the federal government is a unique entity, with different objectives and more borrowing capacity than any private entity — or even state governments.
Let’s debunk the business analogy first. Political candidates, especially conservative ones, sometimes vow to run government like they would run a company. And there are some ways in which experience from the latter sphere can absolutely be applied to the former, usually in the realm of operational efficiency. But there are more important ways that the government isn’t like a business.
The biggest is that a business is beholden to shareholders, while government is beholden to the public good. If a company consistently fails to make operating profit, it’s a money-losing, value-destroying operation and needs to be shut down or reorganized. But government doesn’t exist to make a profit; when a government service loses money, it can still be worth it if it improves things for the public overall.
For example, when government spends money on basic research, it typically doesn’t capture the monetary value that research creates. But the eventual economic benefits, which are reaped by companies downstream of government-funded research, tend to vastly outweigh the cost. The government doesn’t need to be the one that gets paid, as long as society gets paid. The same is often true of environmental cleanup, road networks and anything with a positive externality.
It also applies to fiscal stimulus during recessions. Even if the government doesn’t recoup the full cost of emergency spending programs in terms of increased tax revenue, the economic activity generated by stimulus often outweighs the costs. In the long term, the government can run deficits forever, as long as the economy grows faster than the debt. In the short term, it can run up debt even faster than that and still be OK, as long as it’s a temporary thing — like Covid relief, or the stimulus in the Great Recession. All of this is very different from how a business operates.
Another myth is that the government is like a household. Politicians worried about deficit spending sometimes liken it to people relying too heavily on their credit cards and demand that the government live within its means. This is an emotionally powerful argument, because most people’s experience with debt is that when they borrow too much, bad things happen.
But government just isn’t the same. When the government borrows, it does so by issuing Treasury bonds, which — despite a rise in foreign purchases of U.S. debt — are still mostly bought by American citizens and businesses.
In other words, a large portion of government debt is mostly just money that American taxpayers owe to American bondholders. That means that borrowing money often doesn’t mean a nation will be poorer in the future, since paying that money back will just involve a reshuffling of wealth between different groups of citizens. And because Treasuries are of core importance to the U.S. financial system, lenders are much more willing to keep lending to an indebted federal government than to a household that maxes out its credit cards.
And unlike a household, the federal government can also set the interest rate at which it borrows. Even without printing money to pay for government borrowing directly — a practice known as seigniorage — the central bank can hold interest rates at or near zero for a long time in order to make it very easy for the government to roll over its debt.
Nominally the Federal Reserve is independent, but if federal debt gets too high, it may be forced to keep rates low. If inflation never results, it can keep rates low indefinitely, as Japan has. Neither the massive borrowing in the Great Recession nor the equally enormous deficits from Covid-19 relief have caused any hint of inflation so far, so it seems like the U.S. is nowhere near its borrowing limits.
And while you shouldn't expect the federal government to act like a business or a household, it's not like a state government, either! State governments are typically bound by balanced budget amendments that make it very hard for them to borrow. Even when they can borrow, they can’t set interest rates like the central bank can. And their power of taxation is more limited as well.
All these differences will be important to remember in the coming years as the Biden administration pushes for fiscal stimulus and government investment, and deficit hawks use false equivalencies to try to prevent it. Understanding why the federal government is unique — both in its mission and in its ability to borrow — will be key to countering those arguments. This is an issue I’ll be coming back to again as the battle over government spending commences.
This column does not necessarily reflect the opinion of the editorial board or Bloomberg LP and its owners.
Noah Smith is a Bloomberg Opinion columnist. He was an assistant professor of finance at Stony Brook University, and he blogs at Noahpinion.
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