To Prepare for Emergencies, Keep Fiscal Order

The tragic events of the past week highlight the wisdom in maintaining a fiscally sound house, rather than a highly indebted government, before emergencies strike. Russia’s barbaric invasion of Ukraine and the West’s response will likely drive inflation even higher. At home, expect calls for more government spending to help Ukrainians defend themselves and enable us Americans to better deal with supply-chain disruptions. No matter what lawmakers decide, they’ll be hindered in one way or another by past fiscal mistakes.

The United States finds itself with an inflation rate not seen since the early 1980s, thanks to too much COVID-19 relief spending and significant Federal Reserve accommodation piled onto already outsized deficits. As a result, government debt has now reached 100% of gross domestic product, and our fiscal year 2022 deficit will be $1.4 trillion. If Congress’ lack of interest in repaying any of it isn’t worrisome enough, our high debt will make controlling inflation more difficult. Any increase in interest rates by the Fed will translate quickly into higher government interest payments and more deficit spending.

Even if we ignore the Fed’s failure to see inflation coming, let’s at least dispense with the trendy idea that debt can be increased without damaging the government’s fiscal sustainability. Indeed, for years now, academics have floated several scenarios under which increasing the debt doesn’t threaten our fiscal health. The most reasonable take two main forms.

The first is based on the idea that real interest rates are historically low and forecast to stay that way for a long time. As such, the government can carry high debt levels without worrying about debt sustainability, especially if the higher debt is used by government for sensible and productive investments.

In addition to the folly of counting on interest rates to stay low indefinitely, this first scenario requires immense faith in legislators’ willingness to spend money in ways that produce high and consistent economic growth. A review of the academic literature reveals that such spending typically crowds out healthy private-sector spending.

The second and more interesting scenario argues that in countries where real interest rates are lower than the real rate of economic growth, a one-time deficit increase — even a large one — won’t have any cost over time. It’s a new twist on the old idea that under the right conditions, economic growth can outpace debt. Suppose the Treasury borrows $3 trillion to finance the next Build Back Better plan. If all Congress does is allow the Treasury to borrow new money to pay interest on the debt — and as long as interest rates stay below the rate of GDP — then debt will grow, but the ratio of debt to GDP (a key metric reflecting our ability to absorb the borrowing) will fall slowly.

Unfortunately, as appealing as this scenario sounds, it’s not in the cards for our country. My Mercatus Center colleague Jack Salmon and I explain in a new study why that is. This scenario only works with a one-time deficit increase followed by decades of taxes large enough to pay for our spending. What economists call the “primary deficit” (the difference between the current fiscal deficit and interest payments on previous borrowings) needs to be balanced for years.

This condition is a must if we wish growth to outpace interest payments, and it’s nowhere to be seen in today’s and future U.S budgets. A quick look at Congressional Budget Office analysis reveals decades of large primary deficits and growing debt-to-GDP ratios, mostly driven by the explosion in spending on programs like Social Security and Medicare. This outlook would get much worse if the next round of emergency spending comes without a real repayment plan.

Politically, of course, there’s a lot of blame to go around. Politicians of all stripes long ago stopped caring about ballooning spending and growing indebtedness. It was particularly enlightening to see Republicans give up all past pretenses to care the moment former President Donald Trump announced he wouldn’t touch Social Security and Medicare.

Yet even in a turbulent time, we must face the reality that the debt does matter. As the Hoover Institution’s John Cochrane noted recently, big borrowing has to be followed by big consequences like big spending cuts, big tax increases, big inflation or worse, a big debt crisis. It will also be followed by greater difficulty in responding to emergencies like the one in Ukraine.

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