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To reduce our fast-growing national debt, the U.S. needs a coherent fiscal policy
By Thomas Grennes
In the U.S., government debt continues to rise. At the end of fiscal year 2020, debt held by the public reached 102% of GDP, the highest level since the end of World War II. Meanwhile, the latest $1.9 trillion spending proposal by President Biden would further exacerbate the problem.
Some government agencies, such as the Government Accountability Office and the Congressional Budget Office, now consider the federal debt to be at a crisis level. So does the International Monetary Fund. However, the only people who have the authority to resolve the problem, our elected officials, essentially act like it doesn’t exist. Historically, Democrats have been more open to budget deficits and debt than Republicans. But during the Trump years, Republicans joined with Democrats in advocating spending hikes that, combined with Trump-era tax cuts, dramatically increased the debt. Former deficit hawks were converted to deficit doves.
For much of American history, there was an implicit understanding that increases in debt during wars would be offset by decreases during times of peace. But now, the country lacks such a coherent fiscal policy. Decisions about spending are made as if they are unrelated to the tax revenue that pays for projects, with the result that spending has been increasingly financed by borrowing rather than taxation.
Meanwhile, the budget process is broken. Instead of the government setting a target for the deficit over a certain period, the deficit is simply what remains after values for spending and tax revenue are determined independently. Fiscal policy can be more accurately described as fiscal chaos.
Buy Now, Pay Later
Members of Congress have a strong bias toward spending that provides current benefits to constituents without taking account of future costs. This bias toward the present produces budget deficits that are part of a broader public-sector failure. Shortsightedness is one reason public trust in government is near an all-time low, according to a recent survey by the Pew Research Center.
Rising interest rates on bonds used to finance the deficit would normally provide a warning about future inflation, but because the Federal Reserve has artificially kept those interest rates near zero, this alarm bell has not gone off. Likewise, the federal debt limit is intended to counteract the bias toward current spending, but it has been suspended and increased so frequently that it is no longer binding on Congress.
Government debt can be expected to rise in the future, as both parties demonstrate a lack of fiscal discipline. The day after Congress passed a stimulus bill of more than $900 billion in December 2020, incoming President Biden called it a “down payment” on additional stimulus spending, a view seconded by Democratic congressional leaders.
The aging of the general population has contributed to deficit bias in budgets. In 1960, only 9% of the population was over 65, but today the figure is 16%. Aging has increased spending on Social Security and other entitlements, and the Social Security Trust Fund will be exhausted in 11 years. Without reforming Social Security and other entitlement programs, more money will have to be diverted from the discretionary budget to pay benefits to retirees.
Too Much Debt Hurts the Economy
Why is excessive debt a problem? New debt requires issuing bonds, and if they are purchased by the Fed with newly created money, the result may be higher inflation. Recent extreme examples of debt-induced inflation are Zimbabwe and Argentina. Zimbabwe experienced over 400% inflation in the past 12 months, and the inflation rate in Argentina during the same period was 50%. Skeptics might say that these are developing countries and the U.S. is not Zimbabwe or Argentina. While the U.S. is certainly not in the same situation as those countries, it could be moving in their direction; many of our institutions, including the Fed, are growing more politicized, which in turn threatens the strength of the rule of law.
Other unfavorable results of excessive debt may include slower growth in productivity and real GDP. If the low-interest policy of the Fed creates an excessive demand for credit, and rationing favors older, highly indebted firms that have trouble repaying debts (often called “zombies”), this credit market distortion could reduce real growth. This is already happening, with Fed corporate bond purchases favoring large and old corporations over more productive startups. Sheila Bair, former chair of the FDIC, has warned of the adverse effects of distorting the allocation of credit. The U.S. growth rate dropped from 3% to 2% prior to the pandemic, and there is evidence that the slowdown was a result of a U.S. debt overhang, similar to those experienced by Japan and recently by Europe.
The debt crisis cannot be ignored. The U.S. needs to return to a sustainable debt limit. A fiscal rule such as those adopted by several European countries could restore fiscal discipline. Both Sweden (1995) and Switzerland (2003) have adopted balanced-budget rules over the business cycle. Both countries have demonstrated success with fiscal rules, but political will is necessary for such rules to succeed. America has achieved sustainable fiscal discipline in the past, and order could be restored to debt policy if leaders summon the political will to act.