Time to Stop Digging?

When the first Secretary of the Treasury Alexander Hamilton asked this nascent nation to accept over $74 million in debt, about a third of it based on state expenditures tied to the Revolutionary War, both federal and state officials complained it would doom the United States before it could take its first steps. Hamilton replied that a nation is not legitimate unless it can pay what it owes to bondholders, domestic and foreign; in the eyes of powerful countries, it will not be creditworthy. He also surmised that linking the national debt to the collective states’ responsibilities would financially unite the diverse 13 former British colonies into a united group of patriotic supporters.

Hamilton was so adept at brokering deals among the elite that he convinced enough of the leaders of Pennsylvania, New York, and Virginia to agree to the assumption of debt, at par value, if the states would agree to move the U.S. Capitol, and the inherent power within, to the District of Columbia, at the border of Virginia and Maryland. This Compromise of 1790 become one of the lesser known, yet very critical foundations of the nation moving forward, especially one bound and determined to battle unrepresentative taxation, and excessive Executive power.

Today, given that some project the U.S. debt to soon reach $33 trillion if Congress passes both the infrastructure and budget reconciliation bills, we ask the Battling Bobs, Mr. Litan and Mr. Love, to answer this pertinent question: What is an acceptable amount of debt the U.S. should carry? Some traditional economists believe that debt-to-GDP ratios are critical to determining that amount, others point to what a nation can afford in terms of servicing the debt. Some modern economists are beginning to question whether governmental austerity in times of bulging deficits and questionable economies is the right approach. In a Keynesian mindset, perhaps investing in the economy is always the right thing to do, debt levels be damned. Always ominously lingering: rampantly rising interest and inflation rates, which have toppled economies, and governments, alike.

When is it time to spend, and when is it time to stop digging that financial hole, drilling the country into deeper vulnerability? Read and learn from two economists who have spent decades contemplating this very issue.

How Much Debt Is Too Much?

Robert Litan

I don’t know the answer to this question, nor really does anyone else. But that doesn’t mean I don’t worry about rising federal debt.

I have been a “deficit hawk” through much of my professional economic life, like all my colleagues at Brookings -- except when the government is called on to pay for true national emergencies like wars and natural disasters, like the (continuing) COVID pandemic. But it’s not the amount of debt per se that we have been worried about, but the amount of debt in relation to our gross domestic product, which roughly measures our ability to service the debt.

The conventional concern always has been that as the debt-to-GDP ratio rises, then controlling for all other variables, it will cost the government, namely we taxpayers, if not now then eventually, more to borrow. Put another way, rising debt-to-GDP, again holding all other factors constant, should go hand in hand with higher interest rates. As interest rates rise, that makes it more expensive not only for the government to borrow, but for consumers and businesses, too. New equipment in manufacturing and in all kinds of services embodies newer technology – especially faster chips, better software, and the like – makes workers more productive, enabling faster growth in wages. Accordingly, any slowdown in investment due to higher interest rates means slower growth in wages. It is for that reason that my Brookings mentor Charlie Schultze, one of the best practical economists of his generation, frequently wrote that rising debt ratios are like “termites in the woodwork,” slowly eating away at the strength of the U.S. economy, or at the American Dream of rising wages and incomes for all.

Others fear high and rising debt ratios for a different reason: what they portend for inflation, and in a worst case, the risks of recession they pose. The inflation fear stems from the fact that unlike state and local governments, or you and I, the federal government doesn’t face a hard borrowing constraint. Although technically the Fed can’t directly “monetize the debt” that government issues to pay for what tax revenues don’t, it can and does so indirectly by buying such debt in the secondary market.

Throughout the past several years, especially during the pandemic, the Fed was doing, and continues to do. a lot of this through its “Quantitative Easing” (QE) program. Lately, Fed governors and Federal Reserve bank presidents have been urging the Fed to “taper” its Treasury bond purchases because of the recent spike in the inflation rate. But Fed Chairman Powell (who awaits reappointment as chair, and may get it by the time this piece is published) has argued that, I believe mostly correctly, the surge in inflation is largely temporary, given the bottlenecks in the economy caused by the pandemic. Once the delta variant wanes (which admittedly may take some time), these bottlenecks will ease, more firms will be able to ramp up production of items in short supply, and inflation rates will head back down.

I am well aware that there are those who still nonetheless adhere to “monetarism,” defined by Milton Friedman’s famous dictum that "Inflation is always and everywhere a monetary phenomenon in the sense that it is and can be produced only by a more rapid increase in the quantity of money than in output." But this statement only holds true if the “velocity” of money – or the rate at which it turns over -- stays constant. At least since the mid-1990s this has not been the case, as shown in the second chart compiled by the Federal Reserve Bank of St. Louis: https://avenueinvestment.com/insights/a-case-study-on-inflation-vs-the-velocity-of-money/. Declining velocity has essentially offset the rising money supply, keeping inflation contained – until the recent pandemic-related supply constraints, which have nothing to do with monetary policy.

Likewise, long-term interest rates have been falling over the past two decades despite high and rising debt ratios, which seem to directly contradict the economic conventional wisdom recited earlier. But remember the qualification I also stated: Only when all other factors are controlled for will rising debt ratios lead to higher interest rates. In fact, over roughly the past two decades, those “other factors” include things like rising savings rates around the world and declining profit rates, which have combined to increase the demand for government debt, pushing up its price, thereby lowering interest rates (which vary inversely with debt prices, since rates are calculated as the ratio of fixed interest payments divided by the price of debt).

All of this – relatively stable inflation, until its recent spike, and falling interest rates -- has led some economists and politicians to embrace a new economic theory, labeled “modern monetary theory.” MMT essentially says governments don’t have to worry about deficit financing at all – unless and until deficits cause inflation. That will happen when they lead to so much money creation that the additional money swamps declining velocity and makes Friedman’s famous aphorism about inflation come true.

MMT has a major flaw. It assumes government policymakers – not the Fed and its control over monetary policy, but Congress and the President who jointly control fiscal policy (government spending and taxes) – can and will respond to high and rising inflation by raising taxes and/or cutting spending. For anyone who has been awake over the past decade or more, they know the unrealism of that assumption. The federal government is essentially dysfunctional, especially as to macroeconomic management, largely because the country is so politically polarized. To count on Congress and President to bail us out from an inflationary spiral, should one take root, is fantasy.

That’s why we have a Federal Reserve, which although not totally immune from politics, still at least tries to adhere to its twin statutory objectives of maintaining price stability (which the Fed has recently redefined as inflation at 2% per year averaged over some period of time) and maximum employment. Unlike Congress and the President, the Fed has more calibrated tools at its disposal – setting interest rates on the reserves that private banks hold at the Fed (an increasingly favored tool), and essentially doing the same thing for short-term government debt by buying and selling government securities. However, the Fed has a big problem when it wants to fight inflation – by cutting back on the growth of the money supply (via debt purchases) and hence allowing interest rates to rise (as Paul Volcker did in the early 1980s). With few exceptions, Fed tightening almost always has caused the economy to fall back into recession.

But back to the question posed by the title: how much debt is too much, or more precisely, what ratio of government debt to GDP is too high? A decade ago, two well-known economists, Carmen Reinhardt (currently the chief economist at the World Bank) and Ken Rogoff (a professor of economics at Harvard) confidently wrote in their best-selling book at the time, This Time is Different (Princeton Press, 2011) that, after examining two hundred years of history across countries around the world, crossing a government debt-to-GDP ratio of 90 percent spells big trouble. The US government blew past that ratio around the time of their book and is now approaching 130 percent (see https://www.thebalance.com/national-debt-by-year-compared-to-gdp-and-major-events-3306287) -- and yet we have no financial crisis since then, other than the pandemic-induced economic crisis that has since eased (though because of delta we’re not out of the woods). Japan’s debt-to-GDP ratio hovered at 200% during the past decade, and since the pandemic has risen to 224 percent (https://www.ceicdata.com/en/indicator/japan/government-debt--of-nominal-gdp), and no financial crisis has gripped that country either.

Can we take comfort in these facts? Yes and No. Another famous statement by another (late) economist Herb Stein reminds us why: “If something cannot go on forever, it will stop.” Applied to the rising debt-to-GDP ratio, all we can say with any confidence is that as long as this continues, the risk of inflation getting out of control also increases, which also makes recession-inducing inflation fighting more frequent. That, in turn, lowers the long run growth of national income and personal wages, and makes both more volatile.

It used to be the case that politicians in both parties were more worried about this risk and acted accordingly. Annual government deficits hovered in the 2-3% of GDP range (don’t confuse annual deficits with the total stock or amount of federal debt). But those days seem like ancient history today. Republicans didn’t care much about increased debt triggered by the tax cuts of 1980 under Reagan, 2001 and 2003 under Bush 43, and 2017 under Trump. With some exceptions, Democrats today don’t worry much, or at all, about even higher deficits (as shares of GDP) caused by increased spending (not fully offset by likely tax increases).

Given everything else that has been happening lately, this should not be all that surprising. After all, if we collectively responded to future risks, we would have handled the pandemic, and now increased intense weather events triggered by continuing climate change, far better that we have. With debt, the same (non) response seems just as likely.

Robert Litan, a Wichita native now living in Lawrence, Kansas, is an economist with the Brookings Institution and a law partner at Korein Tillery in St. Louis and Chicago. His latest book is Resolved: Debate can Revolutionize Education and Help Save our Democracy (Brookings Press, 2020). You can find his regular blog posts (and subscribe) at roberlitan.substack.com.

Debt Limits are a Ponzi Scheme

Bob Love

"No amount of REAL DEBT is unreasonable and no amount of FIAT DEBT is reasonable." [This is my paraphrase of David Hume's "If all our present taxes be mortgaged, must we not invent new ones? and may not this matter be carried to a length that is ruinous and destructive?" Political Discourses, Of Public Credit 1752

The point is that our current debt escalation cannot be stopped ... it has become a Ponzi scheme of epic proportions.

· REAL DEBT is a contractual obligation that arises from REAL SAVINGS ... which arise from a REAL SURPLUS of REAL PRODUCTION in excess of REAL CONSUMPTION. REAL DEBT allows for but does not require MONEY ... it is REAL and reality has limits.

· FIAT DEBT arises from FIAT $AVING$ [ie. Federal Reserve Bank Notes] ... which are detached from any reality. FIAT DEBT requires FIAT MONEY ... because it is not REAL. FIAT DEBT becomes FIAT MONEY ... and because it is not real, it has no limits.

As long as the US$ was redeemable in something REAL ... which it was until 1971 ... there was a "limit" on DEBT. After 1971, there was NO LIMIT ON ANY DEBT other than the practical implications of any Ponzi scheme. The ramifications are mind-boggling, but we see them unfolding everywhere as debt is massively translated from private to public in a scheme that dwarfs all history:

· people are ecstatically paying off credit cards with stimulus funds

· renters are ecstatically paying rent with stimulus funds

· employers are ecstatically making payroll with stimulus funds

· ... ad infinitum.

Ponzi schemes are by definition unstoppable ... and there is NO LIMIT possible on FIAT DEBT once it begins to accumulate ... it will and must grow until the scheme collapses.

Tony Davies presented a "domino" analogy in a recent AIER article that is a helpful way of looking at what is facing us. He even "integrated" the dominoes showing us that all our various "policies" [which we like to manipulate as if they are separate] are really "organically" connected to one another. I think Tony answers your question, but not in the way you expected, when he concludes:

"Politicians eventually borrowed so much that the Fed’s monetary policy became a servant to politicians’ fiscal policy. All of this ends with significant and sustained inflation. The sequence of falling dominoes is too far along to stop."

I would disagree slightly with Tony in that I believe the Fed is the master, not the servant, of the politicians in an "inverted totalitarianism" ... but this totalitarianism is Hayek's serfdom nonetheless. The MMT domino has fallen and the powers behind the FED will, I think, soon outlaw all commerce conducted without using their "currency" [in an attempt to crush Gresham's Law by outlawing "good money"]. But I do agree with Tony that it is too late to avoid collapsing into this abyss, so maybe this is a distinction without a difference.

Also visit this link to dig deeper: Fiat Credit = Debt Delusion

Steve WitherspoonOctober 3, 2021