Does the debt actually matter?
We asked two economists with different opinions.
Over the last few months, one of the most common questions that has arrived in my inbox has been: “Does the debt actually matter?”
Readers of various political backgrounds have asked versions of this question — whether we can keep spending, keep printing money, if inflation is actually coming, or if the fears are all overblown.
I thought about addressing it in a standard Tangle format and even thought about reporting out a deep dive. But instead, I got the idea to do something a little new for Tangle: I decided to find two economists with different public-facing opinions on this question. Then, I planned to call them up, ask a few similar questions, and compare their responses.
To my delight, I was able to get two of the most well-known and mainstream thinkers on this issue. The first person I spoke with was Brian Riedl, an economic policy expert at the Manhattan Institute who has been sounding the alarm about our growing debt for some time. Riedl served for six years as chief economist to Senator Rob Portman (R-OH) and as staff director of the Senate Finance Subcommittee on Fiscal Responsibility and Economic Growth. He has also helped draft plans for Sens. Marco Rubio (R-FL) and Mitt Romney (R-UT) to address the debt.
During our conversation, which happened on Tuesday, Riedl repeatedly referenced the work of Noah Smith, who got his PhD in economics from the University of Michigan and now works as assistant professor of finance at Stony Brook University. Smith is one of the most-read columnists at Bloomberg, perhaps the most influential financial news outlet in the country. Unlike Riedl, Smith has repeatedly questioned widespread fears about the debt and instead suggested that the United States will almost certainly have the time and warning to address it with fiscal tools before it gets too dangerous.
So, after speaking with Riedl, I called up Smith on Thursday and posed some of the same questions to him.
Below, I’ve put together their responses in a sort of call and response format, where you can see how they each respond differently (and similarly!) to my questions and how they describe each other’s positions. Together, I think they’ve helped me bring you a really informative, holistic look at this issue. I know for a lot of people this kind of economic analysis is complicated and boring, but I think Riedl and Smith made it really fascinating and easy to follow.
Interestingly enough, I found both Riedl and Smith seemed to fundamentally agree about the biggest dangers around our debt and the tools best suited to address it, despite often being pitted against each other in the public discourse.
Their responses, as well as my questions, have been lightly edited for clarity and length. I’ve also annotated parts of their responses with asterisks* in places where I thought it was helpful to add additional context.
Isaac [to both Brian and Noah]: Maybe we can just start with the basics. In your words, can you explain to my readers what the debt and the deficit are and how they change?
Brian Riedl: The budget deficit is the annual shortfall between taxes and spending for the federal government. If in a given year the federal government collects two trillion in taxes and spends three trillion dollars, then that year they have to go borrow a trillion dollars. And that is the annual budget deficit. The national debt is the accumulation of all of the annual budget deficits. So if you borrow a trillion dollars a year for 10 years, at the end of those 10 years, the national debt is 10 trillion dollars.
And the national debt is important because that's the total amount you're paying interest on, that's the total amount you borrowed, and that is at least theoretically the total amount you have to pay back.
Noah Smith: Well, when the U.S. federal government spends, it has a rule. And the rule is that it has to borrow whatever the difference is between spending and taxes. So if you spend $100 and take in $50 you have to borrow $50. Now, that's not some sort of physical law of the universe. The government has the power to create money, so they could just spend fifty dollars of new money if they wanted to. But they restrain themselves from doing that. They have a law that says they have to borrow it instead of just creating new money. So that is what our debt is. It is money that we insist that we borrow when we spend.
Isaac [to Brian]: Got it. So when we talk about the importance of the debt and the deficit, I think a lot of Americans sort of struggle to make it tangible. As you know as someone who cares about this, I think a lot of conservatives feel like they're kind of screaming into the void these days because there is so little attention paid to it. So I'm wondering if you can try to make it tangible for my readers. Why is it risky to run up the debt? What's the top thing that comes to mind for you that concerns you?
Brian Riedl: The thing about debt is it's not a problem until it is. Usually, as the debt builds and builds and builds, you may not feel it happen very much until it reaches a certain threshold, at which point it can devastate an economy. And at that point, it's very hard to get out of. It’s kind of like the termites in your house. You don’t notice it until your house collapses.
I think the traditional economic argument, which I actually don't think is as big of a problem anymore, is that government borrowing reduces investment in the economy. What I mean by that is if you believe there's only so many savings out there that can be borrowed for home loans, business loans, car loans and student loans — the things that help the investment that makes our economy grow — you can say, “well the more money the government borrows to finance its consumption the less money is available for home loans and business loans and car loans and student loans.” The things that really help the economy grow. And so what happens is you end up getting higher interest rates and less investment in what the economy needs.
Now some people dismiss that right now, because interest rates are low and the world is awash in capital. I would argue that's not going to be the case long-term. To me, the more immediate concern that I have with all of this is that the interest costs are going to grow out of control at a certain point for the federal budget. If we kept the debt at its current level, I wouldn't be worried as much. The problem is that the debt is projected to grow, even if we do nothing, just on the baseline by a hundred trillion dollars over the next 30 years. Just to say for current programs. On top of that, interest rates are certain to rise from their current level, the only question is how much? And when you add a hundred trillion dollars in new debt, plus rising interest rates, you get to the point where in 30 years, half of our tax dollars would go to paying interest on the debt.
You get to the point where the national debt becomes 200 percent or 300 percent of the size of our economy. And the danger there is that's uncharted territory. A lot of countries have run debt about a hundred percent the size of their economies, maybe 120 percent. But an economy as large as ours pushing its debt up to 200, 300 or more percent of the economy — at that point you're borrowing so much money out of the private sector. Or in some cases, you're just running the printing press. And at that point, the interest costs to the taxpayers are so huge that what happens at a certain point is the people who lend us the money stop lending it to us. They start to say, “you guys aren’t good for this. We don't think you have the ability to pay this back.” And then they stop lending you money, and then interest rates go even higher, and then the costs go even higher. That's the outcome we're trying to avoid.
So I would say that the debt is not a huge concern if it stayed at its current level, which is about 100 percent the size of the economy. But we risk a big debt spiral over the long term that will not only take investment money out of the economy, but it could force us to double taxes just to pay the interest on the debt.
Isaac [to Brian]: So all of that makes perfectly good sense to me. But I’m interested to hear if you can articulate what the opposing view to that is. How do people who disagree with you bat that away?
Brian Riedl: Well, the MMT* argument is we can just run the printing press. What the MMT people say is if we're going to run a deficit of $100 trillion over 30 years, we could just print $100 trillion. We won't default. Well, that's technically true. We could print $100 trillion, but most people believe that would cause really high inflation, which would in turn raise interest rates even higher.
Another argument some individuals make is, “well interest rates are low now and they’ll stay low.” This is the main argument you hear from Jason Furman and Larry Summers and Noah Smith that I very much disagree with.** What they will tell you is that since 1990, the average interest rate on the debt has dropped from 8.4 percent to two percent. And so they would tell you if interest rates are only two percent, then we could run up the debt really high and it won't cost very much to pay the interest because two percent interest rates are pretty cheap.
My concern about that argument is what makes you think interest rates are going to stay at two percent? The fall from 8.4 to two seems to be an unpredicted accident economically, and the assumption by the Congressional Budget Office and others is that they're at least going to go up to four or five percent over the next 30 years, in part because debt itself raises interest rates even as all else is equal. So I would say we're putting ourselves in a position where if interest rates ever hit four percent ever again, we risk a crisis at these debt levels. Furman, Summers and Smith will say interest rates will never reach 4% ever again, they’ve fallen and they're going to stay low. I think that's dangerous. I think we're gambling on the idea of low interest rates.
Specifically, Noah Smith says that the Federal Reserve will purposely keep interest rates as low as they can in order to avoid the federal government going bankrupt on interest payments. That's a monetary policy known as fiscal dominance, where instead of the Federal Reserve using interest rates to manage the business cycle, they will just permanently lock themselves into as low interest as possible in order to keep the treasury borrowing cheap.
But if you do that, you're cutting the Federal Reserve's arms off. You’re basically saying that if the economy overheats, they cannot raise interest rates because it would bankrupt the treasury. So that creates all sorts of problems. And so the main argument you hear from others is the interest rates are low, what do we have to worry about?
I would feel a lot better about that argument if the government was actually locking in low interest rates, but instead, we keep using short-term borrowing that's going to roll over into higher rates.
*MMT stands for Modern Monetary Theory, a growing but still fringe economic theory that we hope to cover in a future Tangle.
**I’m not sure this is Smith’s main argument, but you’re about to hear from him in a moment anyway.
Isaac [to Noah]: So I think for a lot of Americans, the kind of threat of the debt and the deficit is hard to wrap our heads around. And I know that you are coming from a position where you're not as concerned about it as someone like Brian, but maybe can articulate what does concern you if there is something that does concern you about running the debt up?
Noah Smith: So the question of debt is always a question of “how much can you borrow before you get cut off?” If your household is borrowing, you can get cut off by your credit limit or whatever, right? People can just stop lending you money and then you're done.
For the government, it’s a little different. The government does borrow money from private individuals and from foreign governments and a lot of different people. It's borrowing a lot of money from U.S. banks, from corporations that buy treasury bonds. And when you buy a bond, you're lending someone money, right? So if you issue treasury bonds and someone buys them, they’re lending you money.
And so the question is if those lenders decide that they want to stop lending us money, or they think the U.S. is too risky to lend money to, they'll cut back. And then the government will have to offer higher interest rates on its bonds in order to entice lenders to continue lending. And the problem with that is that when the government offers higher interest rates on government bonds, it means that corporations also have to pay higher interest rates on their own bonds to keep up. That means it's harder for companies to borrow money to invest, which is what grows the economy and keeps people employed.
In other words, if the lenders cut off the U.S. government and the U.S. government doesn't do anything about it, it just raises interest rates, that would really hurt the economy.
But! The United States has another weapon in its arsenal besides just interest rates: it also has the Federal Reserve. And what the Fed can do, is the Fed can buy bonds. Now the Fed isn't allowed to buy bonds directly from the government as they are issued, but it can have a sort of de facto agreement with banks: the banks buy the bonds, hold them for a week or a day, and then the Fed buys them up off of them, takes it off their hands, and then they don't really have to hold the U.S. bonds much. So essentially, it’s the Fed buying the bonds. And so if the Fed buys the government bonds, it can allow the government to borrow money while also preventing interest rates from rising.
Because remember: when the Fed buys bonds, it drives down interest rates. Remember that when demand for bonds goes up, interest rates go down. So the idea is that if private lenders and foreign governments or foreign lenders stop buying our bonds, our own Federal Reserve can step in and buy the bonds. So that can happen and then the interest rates stay low. Does that all make sense so far?
Isaac: Yes, that makes sense.
Noah Smith: So now the question is what's the danger of having the Fed step in and buy the bonds? And the answer is inflation. At some point, if the Fed buys up all the government bonds in the economy, it has to buy those by issuing money, and some people think that if you issue a ton of new money into the economy, that will cause inflation.
And if you keep doing it, it will cause more and more and more inflation and it'll cause a spiral of inflation as people realize that you're just going to keep doing that forever. Then prices go very, very high and get very, very volatile. And that is hyperinflation.
It's incredibly damaging to our economy, more damaging even than a sovereign default. It's one of the most damaging, horrible things that can happen to an economy. We're talking about blood in the streets, people eating rats. We're talking about absolute collapse and disaster. Plus, the fact that the U.S. is the pillar of the global financial system, and much of the global economy. We're talking about an absolute global disaster that would make the Great Recession in 2008 look like nothing in comparison.*
Now that's really scary, but we don't know how likely that is to happen, because when we’ve seen it happen, it's always in countries that have smaller or weaker economies and weaker institutions. So there's a strong idea of “it can't happen here,” no matter how much government bonds the government issues. No matter how much government bonds the Fed buys, it will never result in a hyperinflation in the United States of America, the mightiest industrial nation on the planet.
But we really don't know! And so the answer is we’re in uncharted territory,** and I liken it to walking down a long corridor and somewhere in the corridor, there’s a pit that you don't know where the pit is. It could be in 20 miles or it could be right in front of you. And so the real question is, can we see hyperinflation coming if it’s coming, in time to head it off and prevent that catastrophe?
And the answer is we don't really know, but when we look at the experiences of other countries, what we see is that usually before hyperinflation explodes, there are several years where inflation simply goes somewhat high. Hyperinflation can mean millions of percent of inflation. You typically see things like 5% inflation, 10% inflation, for a couple of years first. So that five or ten percent inflation in America would be by far the most inflation we've seen since the 1970s.
So it seems to me that if we borrow and borrow and borrow, and have the Fed buy up all the bonds, and then this causes inflation, we will get some warning. We will get some lead time, we’ll see inflation start to rise and everyone will freak out and say it's time to cut deficits, it's time to raise interest rates. So the reason I'm not super worried about debt is not that I think there's no possible negative consequences. I think there are and they could be catastrophic. But I think we'll get lead time to reverse course before that happens even if we do encounter that sort of lurking peril.
*I think it’s funny to note here that I came to Noah looking for a calming voice on the debt, and he ended up illuminating one of the more frightening possibilities I’ve heard yet!
**Also funny to note that both Smith and Riedl called where we are now “uncharted territory.”
Isaac [to Brian]: So given where we are now, I'm wondering how we get out from under this from your perspective? How do we move forward in a way where the debt is staying flat and we aren't blowing up these yearly deficits in a way that concerns you so much? Because it seems like right now, even in the Trump Administration, the federal government can’t really operate without spending a lot of money.
Brian Riedl: We're not going to pay back all of this debt, but if we can start to cut deficits down to maybe about two percent of GDP, and have the economy grow at two-and-a-half or three percent of GDP over that time, you’re pretty good.
You're actually going to stabilize the debt about where you are. You don’t have to balance the budget. You just want the debt to be growing not much faster than the economy, maybe about two percent.
The challenge we face policy level wise is we face a baseline deficit of a hundred trillion dollars over the next 30 years. That's just the baseline, and that's entirely driven by Social Security and Medicare shortfalls. A hundred trillion. On top of that, Biden has proposed $11 trillion in new spending that would only be offset by about $3 trillion in taxes. So to me, the first thing we need to do is, before we make new commitments, let's do a better job paying for the ones we have. Let's address social security and Medicare. Let's address healthcare and realistically, as part of such a deal, we're going to have to raise taxes. You kind of have to go to all sides.
And once we do that and start to get the debt under control over the long term, then I think it's more legitimate to look at what new investments are worth doing. One point I would caution is when someone says, “oh, well, we're going to increase spending by $2 trillion and going to raise taxes by $2 trillion, so that doesn't hurt.” I would disagree that doesn't hurt. Because I've run the numbers on this stuff. There's only so many taxes out there you can raise. In the plausible universe of all tax increases, if you add up everything proposed by the Democratic candidates if they got everything, it’s between $5 and $10 trillion over 10 years. Now, the baseline deficit is even more than that.
And so if you're going to use those tax hikes to pay for new spending you no longer can use those tax hikes to address the baseline deficit or anything else. And so my take is we need to save whatever tax hikes and spending cuts are the low hanging fruit to address the baseline deficit before we just use it for new spending.
Isaac [to Noah]: I guess the thinking then, is this idea that the Fed has enough tools in the toolkit to address this once we see the inflation tick up?
Noah Smith: Well, so, I wouldn't say that that is necessarily the first line of defense against inflation. I'd say the first line of defense is Congress itself. Congress will have to restrain borrowing, either spend less, raise taxes, probably both, in order to curb deficits and stop the inflation. I would say that would be job number one.*
But suppose that Congress can't do that because it's dysfunctional or because there's lots of political pressure to borrow. At that point, I think it's time for the Fed to step in and say, “guess what guys? We're not going to support your shit anymore. We're not going to just buy all these bonds you're issuing. We're going to stop even if it crashes the economy because it's going to crash the economy much less badly than hyperinflation would crash the economy.” We're talking about a recession versus a complete national collapse.
Obviously, a recession is less bad than a complete national collapse. So, I would say if we start to see higher inflation, then austerity** is the first line of defense. But if Congress won't do austerity, then the Fed will have to hike interest rates.
The problem with hiking interest rate, by the way, is that there's a complication here, which is something called fiscal dominance.
Do you know what this is? Have you ever heard of this?
*Again, worth pointing out that Riedl and Smith are both suggesting the same solution here.
**The definition of austerity, in economic contexts, is “difficult economic conditions created by government measures to reduce a budget deficit, especially by reducing public expenditure.”
Isaac [to Noah]: Yeah, Brian referenced this in our interview too, so I'm interested to hear how you explain the threat.
Noah Smith: Fiscal dominance means that when your stock of debt is so high that if you raise interest rates to quash inflation, what happens is the government's interest costs rise. Because remember: the government has to roll over some of its debt, and if you raise interest rates, then the portion of the debt that it rolls over will have to pay higher interest rates on that. Does that make sense?
Isaac: Yes.
Noah Smith: So if the interest costs rise, the government might be forced to borrow more just to cover the interest cost. And at that point, you're screwed. The Fed can raise interest rates all it wants but that just increases the government's interest cost, and forces the government to borrow even more. You can have massive austerity, but you'll need to have raised taxes enough not just to cover current spending but to cover the massively increased interest cost from the Fed borrowing money. And so if you get in this situation it’s called fiscal dominance, and what it means is that the fiscal debt is so large that it essentially ties the Fed’s hands and makes it so that a rise in interest rates is extremely economically painful. That's how we can get hyperinflation.
But so far we haven't seen anything like that. We haven't seen any rise. We have the $2.2 trillion Cares Act. We had the $0.9 trillion dollars Cares Act follow-up in December. We just had the new Biden bill for $1.9 trillion more. And guess what? We're not seeing signs of inflation. There's a few slight signs inflation is rising a little, but nothing like five or ten percent inflation. We're not seeing that. Nothing close. No indication yet that that's on the way, but everybody is thinking about it, which is good.
It’s good to be on the lookout for it. If it happens, then we have to reverse course. But since we don't know how much we can borrow before that starts to happen, there’s a strong argument that the dangers of doing nothing are higher than the dangers of borrowing a bunch of money, simply because we know we have the option to reverse course if necessary. Or at least, we think it's highly likely you have the option to reverse course.
Now, we're discussing the infrastructure bill. Now you may have heard that the infrastructure bill is like $2.15 trillion, something along those lines. But that is over 10 years. It's actually simply a 200-something billion dollar bill that is repeated ten times. And so, unlike the covid bills, which did all the spending at once, the so-called infrastructure bill, which contains a lot of different long-term economic priorities, this bill would spend money over the course of 10 years rather than over the course of a few months.
Does that make sense?
Isaac: Yes.
Noah Smith: What that means is that we'll have a lot more lead time to do austerity in case that's too much. We'll have years to see it coming because instead of spending $2.15 trillion dollars all in one year, we'll be spending $215 billion dollars year by year. The defense against inflation is really lead time. It's warning time. If we didn't have any warning time, if it was just the sort of thing where you hid the inflation trigger and then bam — you're dead, we’d want to be a lot more cautious than what we’re being. But other countries’ experiences suggest it doesn't work like that. In other words, the slowness with which we’re spending on the infrastructure bill will almost certainly give us a heads up.
Isaac [to Brian]: I have one last question for you and I'll let you go. Related to the historical context of this, has there been a moment or a period of time that you think we saw these tangible consequences of running up the debt? And could you talk a little bit about how it played out and how it informs your thinking now?
Brian Riedl: Well the U.S. has been fortunate that we haven’t had a debt crisis yet, because we’ve addressed the things before they got too bad. Like I said, after World War II, we did a very good job for the next 30 years preventing a debt crisis. There have been times, however, when you started to see interest rates inch up and costs inch up. During the 1992 presidential campaign, we had soaring deficits, interest rates were rising, the economy was slowing, and Ross Perot ran for president saying we have to fix this before the bond market panics and raises interest rates even more. And Bill Clinton came in and he put out a deficit-reduction package and I will say that by the late 1990s, the economy was on fire, interest rates were dropping, the economy was growing and we had a budget surplus. So to me, that's a really good example.
Otherwise, I think you have to look internationally for examples, and there are examples all over the globe. From Greece to the Weimar Republic to South America, there are so many examples of countries that drag themselves down into a debt of 200 or 250 percent of GDP and typically it results in their Central Bank just running the printing press, and then you get the Zimbabwe hyperinflation and the money is worthless. That's the outcome we're trying to avoid.
One of the dangers America has relative to those countries is a lot of those countries ended up getting bailed out by other countries, but nobody's going to bail out America. Europe and America can bail out Greece easily, but when we're in debt a hundred trillion dollars, there's no economy big enough to bail us out. So that's my worry.
Isaac [to Noah]: I have one last question for you and then I'll let you go. I asked Brian this too. Historically speaking, have there actually been any instances where high rates of government spending or federal spending actually blew up in our face and led to some of these worrisome outcomes that we’ve discussed here?
Noah Smith: Never. It has not happened so far. We borrowed a lot in World War II, but we paid some of it back, inflated some of it away, and grew out of it some. We had moderate inflation following World War II and that helped to erode the debt. Also, strong income growth eroded the debt. And we also paid a lot of it back. And so the one time we borrowed this much in World War II, it was fine in the end. No problem.
In the 1970s, we did have high inflation, which was not due to government spending, because we didn't have much of a deficit at all at that time. Instead, it was probably due to loose monetary policy in the face of shocks like the oil crisis and the baby boom generation and other sorts of things that were pushing prices higher. And the Fed just sort of accommodated that, kept interest rates too low for too long, and inflation started in the 70s.
So we have seen fairly high inflation once, and we've seen fairly high debt once. We've never seen these two together. So we've never seen this sort of thing that happens to poorer countries. It happens to a lot of Latin American countries and some countries in the Middle East and Central Asia, Southern Europe, etc. What we haven't seen is the thing where the government just borrows and borrows and the Fed supports that borrowing by buying all the bonds and then you get hyperinflation. We've never seen anything like that before.
But just because something like that hasn't happened before doesn't mean it can't happen to you now. That's a lesson of the financial crisis. We thought housing prices could never crash because they've never crashed before, but guess what? There is a first time for everything. And if you lean too hard on the fact that something never happened before, you might cause it to happen for the first time, and that's really the caution.
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One of the best Friday pieces I've seen yet. Really neat to see the insight and comparison. Sounds like they're on the same page on most things, just a difference in the correction time they think we'll have.
Thanks for this post! I think it would have benefitted from having a voice from the MMT community. Maybe a future deep dive!