Budget Deficits Still Matter

(Bloomberg Opinion) -- People from across the political spectrum are challenging a bit of long-held conventional wisdom: that if the U.S. government runs big, sustained budget deficits, its mounting debts will eventually cause grievous harm to the economy.

They have a point — but it is important not to push that point too far.

The arguments come in different forms. Some mainstream economists — such as Olivier Blanchard, former chief economist at the International Monetary Fund –- note that sovereign debt is more manageable in a world where economic growth exceeds governments’ very low borrowing costs. On the more extreme end, proponents of Modern Monetary Theory argue that because the U.S. borrows in its own currency, it can always just print more dollars to cover its obligations.

Turning first to Blanchard, I agree that deficit spending looks less problematic than in the past. The government’s debt burden, measured as a percentage of gross domestic product, remains stable as long as debt and GDP grow at the same rate. This is easier to do now because the long-run nominal growth rate (around 3.5-4.0 percent) is well above the U.S. government’s borrowing cost (around 2.5 percent). So the government has some leeway: The debt can grow at nearly 4 percent per year, or 1.0 percent to 1.5 percent net of interest expense, without increasing the debt-to-GDP ratio. The low level of interest rates might help explain why markets have proven more tolerant of large, persistent budget deficits around the world, with Japan the most notable example.

How and when the government spends the money also matters. Infrastructure investment, for example, can actually pay for itself by boosting the economy’s productive capacity. This is particularly relevant in the U.S., where dilapidated roads, ports and other public works desperately need an upgrade. (Imagine the benefits of a second rail tunnel between New York City and New Jersey.) Deficit spending in recessions can also be self-funding, because it engages unused resources — for example, by employing people whose abilities and skills would otherwise be wasted.

Yet Modern Monetary Theory goes one big step further. It suggests that a government like the U.S. needn’t worry about debt at all. As long as it borrows in its own currency, there is no risk of default or bankruptcy. It can spend as much as it wants on any projects, such as education and health care, and just create additional IOUs to cover the cost.

Alas, there is no free lunch. For one, the economy might not have enough resources — in the form of workers and industrial capacity — to meet the combined demand from the government and the private sector. The result would be inflation, as too much money chased too few goods and services.

Beyond that, America as a whole consumes considerably more than it produces — and depends heavily on foreign investors to lend it the money needed to keep doing so. But they don’t have to make dollar-denominated loans or buy U.S. Treasury securities. If U.S. debts were to keep growing, at some point the Fed would face a dilemma. It could increase interest rates to maintain foreign (and domestic) demand for dollar assets, at the cost of damping U.S. economic growth. Or it could keep interest rates low and allow the dollar to weaken, which would push up inflation as imported goods and services became more expensive. Neither outcome would be pleasant.

MMT hasn’t worked out well for other countries. Consider Germany in the 1920s, or Venezuela and Zimbabwe more recently. The U.S. tried a milder version in the 1960s and 1970s, when the government tried to pay simultaneously for the Vietnam War and Lyndon Johnson’s Great Society programs. The result was inflation, America’s withdrawal from the gold standard and the demise of the Bretton Woods system of fixed exchange rates. The Fed had to increase interest rates to double digits in the late 1970s and early 1980s, at great economic cost, to get inflation back under control.

It’s no fun to be a budget scold. If you worry about deficits, you have to choose between increasing taxes or cutting spending. Desirable social goals such as better roads and universal health care are much more attractive if you can argue that they don’t need to be paid for. But the constraints are real. The U.S. economy is operating pretty close to capacity — especially in the labor market — and the government is already running a sizable deficit that is projected to keep getting bigger. So, if we want to spend more and, at the same time, keep our economy in good health, we need to find sustainable sources of revenue to do so, not engage in wishful thinking.

This column does not necessarily reflect the opinion of the editorial board or Bloomberg LP and its owners.

Bill Dudley is a senior research scholar at Princeton University’s Center for Economic Policy Studies. He served as president of the Federal Reserve Bank of New York from 2009 to 2018, and as vice chairman of the Federal Open Market Committee. He was previously chief U.S. economist at Goldman Sachs.

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