It seems that government spending, even at unfathomably large levels, has lost its power to shock us. Last month, President Biden signed a $1.9 trillion spending package that was partly aimed at coronavirus relief. He’s now promoting another $2.3 trillion in federal spending, with much of the money going to infrastructure. Supporters of proposals like these argue that big government spending is not a cause for concern, particularly as the economy recovers from the pandemic. But their arguments are mistaken: Piling up our $28 trillion mountain of debt even higher is sure to hurt the U.S. economy. Let’s take their arguments one by one.
False argument #1: With interest rates so low, increased government spending carries almost no cost.
This fallacy involves looking away from the government’s crippling debt-to-GDP ratio and instead focusing on the ultra-low interest rates to justify spending more at a “lower cost.” It’s the equivalent of ignoring your $300,000 unpaid credit card balance and telling yourself it’s okay to keep spending because the interest rate is lower than normal.
This was the false argument that informed Greek and Italian economists and policymakers in the early years of this century, when interest payments on debt had fallen to all-time lows. They ignored the fact that their debt exceeded the total size of their economies because they were so content with spending just 3% of GDP on interest payments. This mistaken thinking culminated in the European sovereign debt crisis and a decade of stagnation from which these countries are still recovering.
Some economists argue that because U.S. debt is so popular with foreign investors, a similar debt crisis can never happen here because demand for Treasury securities will keep interest rates low forever. This claim ignores the premium that investors will demand as a growing debt burden incurs greater risk, eventually driving up the cost of lending. Foreign holdings of U.S. Treasurys would have to exceed 70% of GDP by 2050, up from 33% now, just to counteract the upward pressure on Treasury yields caused by our mountain of debt.
False argument #2: So long as the rate of growth is higher than the interest rate, we can simply grow our way out of debt.
By this logic, if interest on the debt were 2% and nominal GDP growth were 5%, then the interest rate minus the growth rate would be −3% and we could keep borrowing and grow our way out of debt. This is the Olivier Blanchard view of debt dynamics. However, this view overlooks the budget deficit. With the deficit expected to total 15.6% of GDP this fiscal year, the interest rate/growth differential is meaningless; nominal GDP growth would need to be more than 15.6% to “grow our way out of debt.” This is unrealistic because nominal annual GDP growth has averaged around 3.5% since the Great Recession. And that’s just today; looking at long-term projected deficits, GDP growth would need to be even higher in 30 years to grow our way out of debt.
The national debt is now greater than the size of the entire U.S. economy. If we are to take seriously the deleterious impact of that, and the growing risk of fiscal crisis, then we should be looking at the total amount of debt (as a share of GDP) and not the current interest rate on debt, which is largely meaningless.
False argument #3: The fiscal spending multiplier is larger than 1, so we should stimulate the economy with more government spending.
This decades-old fallacy made a significant comeback last year, with economists and academics claiming that the fiscal spending multiplier was in the range of 1.5 to 2. This means that for every dollar spent by the government, economic output would be boosted by $1.50 to $2. Last summer my colleague Veronique de Rugy and I compiled a decade of economic literature on fiscal multipliers and found that a more accurate value for the fiscal multiplier was between 0.3 and 0.7. In other words, far from producing $2 in economic stimulus, each dollar of spending actually produces less than $1, partly reflecting a decline in private capital investment.
Looking at some recent “stimulus” spending bills, the Congressional Budget Office estimated that CARES Act spending resulted in an average fiscal multiplier of 0.58, while Penn Wharton estimates that the just-enacted American Rescue Plan will generate a total output multiplier of around 0.1 in 2021. In other words, the CARES Act is the equivalent of the government taking $100 from your right pocket and placing $58 in your left pocket, while with the American Rescue Plan, the government puts only $10 in your left pocket.
This isn’t the first time policymakers have fallen for this fallacy. We saw the same bogus theory in action during the Great Recession when government economists claimed that stimulus spending would create a fiscal multiplier of between 1.1 and 1.6. These large multipliers were deployed to argue that the 2009 stimulus bill would boost employment by 3 million to 4 million by the end of 2010. In reality, more than 2 million jobs were lost, according to government figures.
If a multiplier of greater than 1 is typically seen as a full-throated endorsement of interventionist government stimulus, a multiplier of less than 1 indicates that the government should cut its spending. Yet every time a financial crisis arises, policymakers fall for the same old fallacies for increased spending that never turn out to be remotely true.
False argument #4: We have a large output gap, so the government must spend more to close that gap.
Funnily enough, those who argued that the fiscal spending multiplier was 1.5 or larger suddenly turned quiet on the subject of fiscal multipliers as they endorsed the latest $1.9 trillion spending splurge to close a $380 billion output gap—that is, the difference between the economy’s actual and potential output.
Economists have widely propagated the output gap argument to stress that the pandemic has left the economy lagging far behind its potential. But there are problems with using the output gap as a measure of economic performance.
First, there is the issue of measuring the gap. Output data are generally revised over time, and potential output estimates are based on trends that rely on ever-changing endpoints.
More importantly, there is the underlying assumption that large and oftentimes wasteful government spending is the only way to close the output gap. We know from the fiscal multiplier literature that government spending does not stimulate private spending and investment but actually crowds them out. Why, then, do so many economists jump in excitement at the idea of government stimulus closing the output gap?
Past experience demonstrates that government spending doesn’t close the output gap. The U.S. had a large output gap in the early 1990s. By 1996 the output gap had been closed. Similarly, in the early 2000s, real output lagged behind potential output, but the gap was closed by 2005. It wasn’t government stimulus spending that closed the output gaps—actually, government spending as a share of GDP fell during these periods. Growth driven by the private sector is what closes output gaps, not government spending.
False argument #5: We can reduce the deficit with tax increases, so more spending won’t add to the debt.
In the real world that never happens. Before the election, President Biden’s plan was to spend an additional $11 trillion over the decade and hike taxes on corporations and high-income earners, which was estimated to reap between $2.1 trillion and $2.8 trillion in new revenue over the decade. In other words, for every $5 or $6 of additional spending, the administration would finance just $1 with new revenue; the remainder would go on the national credit card.
But raising taxes even higher to cover the whole tab for new spending would be worse. A majority of studies find that tax increases reduce GDP by two or three times the increase in revenue. This explains why our own analysis reveals that cutting the debt-to-GDP ratio by cutting spending is much more successful than reducing debt by raising taxes, which often causes deep and long-lasting recessions.
False argument #6: A high debt ratio means nothing—just look at Japan; it’s doing fine.
Proponents of this argument are not making an apples-to-apples comparison—debt dynamics in Japan are very different from those in the U.S. Japan’s debt is 240% of its GDP, well over twice the U.S. ratio. But it’s traditionally had a very high savings rate, constituting about a third of its GDP, while the U.S. savings rate is about half of that—typically around 17% of GDP. In Japan, 90% of the nation’s debt is held domestically, reducing risks from international volatility, while U.S. debt held domestically has averaged less than 60% of total public debt since the Great Recession. Japan remains the world’s biggest creditor nation, while the U.S. is the biggest debtor.
Additionally, Japan’s fiscal trajectory is hardly a model that others should be following. We know that debt crowds out investment and growth. While the U.S. has averaged real growth of 2.1% since 2000, Japan has averaged just 0.9% over the same period. Due to this lack of growth, wages have stagnated in Japan for the past two decades, while in the U.S. wages have continued to grow.
Lastly, even though Japan is somewhat of a unique case, and its interest rates on debt have been ultra-low for years, the country still spends 4.4% of GDP on national debt service—almost a quarter of all government spending. This hardly seems like an inspiring fiscal model.
These six arguments for increased government spending are popular, but they are fundamentally wrong. Policymakers should not be seduced by their seeming attractiveness; rather, they should find ways to cut government spending and thus avoid another fiscal crisis.