Rahul Pothi Vinoth Bala Nagaraj
"Why are we bankrupting our kids and grandkids?" - Senator Ted Cruz
Such statements reflect common accusations leveled against the United States national debt. While such fiery remarks are usually confined to Congress, certain members of the academic community are also concerned about the sustainability of the current public debt (Reinhart and Rogoff, 2010; Mian et al., 2020; Mian et al. 2021). As Congress just recently shifted the debt ceiling up once again, there is renewed public scrutiny over the growth of U.S. sovereign debt. The national debt has repeatedly been accused of posing an economic threat to the United States. I will present four pieces of evidence to prove there is no cause for concern around current debt levels. First, I will establish the exact conditions of debt that would warrant concern. The national debt is an economic risk only if there is a risk of default and/or debt is unsustainable.
Exhibit A: Debt to GDP Ratio vs. Interest to GDP Ratio
Figure 1 Federal Debt vs. Federal Outlays
The debt to GDP ratio is a common measure of default risk, and it has been used to spark concern over current debt levels. The debt level has now surpassed the GDP, and the WWII debt to GDP ratio has been surpassed as well. The European Union's Maastricht Treaty caps member states' debt as a percentage of GDP at 60%. Exceeding a 90% threshold has been argued to slow economic growth in advanced and emerging economies (Reinhard and Rogoff, 2010) [1]. Empirical studies have found a positive correlation between the ratio of external debt to GDP and defaults in emerging economies (Reinhart and Rogoff, 2009). However, the correlation to default risk is contingent on the idea that lenders will begin to demand a risk premium as the debt to GDP ratio increases. Interest rates are a critical lurking variable. Even as the debt to GDP ratio has reached "staggering" proportions, interest rates on U.S. bonds and the natural rate of interest have been falling over the last several decades. As such, debt has become easier to finance, and many now argue that federal outlays in interest payments as a percentage of GDP is a better benchmark of debt burden (Bivens, 2021; Office of Management and Budget, 2021; Federal Reserve Bank of St. Louis, 2021). Figure 1 informs us we are at outlay levels similar to the year 2000 and that there is no immediate crisis of debt sustainability or risk of default (Eichengreen et al., 2021).
Interest rates, not the debt to GDP ratio, dictate debt sustainability.
Exhibit B: The Debt Ceiling
The U.S., unlike the E.U., does not use a debt to GDP ratio cap but utilizes a gross cap on debt. The debt ceiling is arguably even more arbitrary than the E.U.'s rules, and the risk of default lies in whether or not Congress raises the limit every few years. Congress just recently raised the debt ceiling by $2.5 trillion but only after a lengthy and heated debate. The debt ceiling "crisis" that plays out repeatedly is a side effect of growing political polarization, but there is no real risk that Congress will allow the U.S. to default (Rappeport, 2021). The consequences of a default would be politically devastating to all those involved. One concern is that even debating over raising the debt ceiling can cause credit downgrades and risk premiums. In 2011, the S&P downgraded the U.S. from a AAA to an AA-plus level citing political polarization as a concern (Staff, 2011). Even still, an empirical test shows that while a small default risk premium was charged for the first two debt crises since 1996, this did not persist in later years (Liu et al., 2009). Even though the public debt is close to the debt ceiling, there is no need to be alarmed.
Exhibit C: Negative Interest Rate to Growth Rate Differentials Figure 2 Interest Rate to Growth Rate Differential Over Time
The interest rate to growth rate differential is an important piece of data that speaks to debt sustainability. The safe rate, r, measures nominal interest rates on sovereign debt. To construct Figure 2, I borrowed economist Olivier Blanchard's adjusted interest rate data set, which considers the debt's maturity composition and tax payments on interest received by holders of public debt (Blanchard, 2019). Subtracting the year over year nominal GDP growth rate, g, from r produces the r - g differential. When r < g, what is essentially a "free lunch" is feasible (Mian et al., 2021). The government can raise the deficit without having to raise taxes. This is because interest obligations will rise more slowly than the government's capacity to meet interest payments (Eichengreen et al., 2021).
I am by no means making a statement supporting Modern Monetary Theory (Kelton, 2020)[2] . At a certain point, the free lunch policy will no longer work. Unhindered expansion of public debt would push r to a point equal to and ultimately beyond g. If r > g, debt will become unsustainable without the intervention of fiscal measures that run significant primary surpluses for debt consolidation. One model suggests that r will rise above g at a debt to GDP ratio of 220% (Mian et al., 2021).
Figure 2 shows it is clear that r has remained less than g for significant periods of time. However, an empirical analysis of interest-growth rate differentials for 55 countries over 200 years argues against attaching value to a negative differential. Low differentials are not associated with a lower frequency of sovereign defaults (Mauro and Zhou, 2020). Even still, when considering the U.S. national debt in isolation, it is clear that even economic shocks such as the global financial crisis cannot cause a sustained positive differential.
COVID-19, an episode of even greater expansions of debt, has shown a weaker increase in the differential. To be clear, the GDP growth rate is currently negative, but interest rates have not jumped as aggressively as in 2008. Withdrawing fiscal stimulus and imposing austerity measures to reduce the debt would be counterproductive. Reducing public spending usually causes interest rates to fall, encouraging private expenditures. However, with rates already near the zero lower bound, borrowing less could actually depress aggregate demand (Mein et al., 2020; Furmann and Summers, 2020). This was seen in Japan in the 1990s and 2000s (Eichengreen et al., 2021). The GDP growth rate could remain negative for a longer period, slowing the return to a negative differential and increasing the national debt. One could lament the counterproductivity of fiscal austerity even in times of economic growth, but the key takeaway is that debt consolidation is unnecessary right now.
The probability that r remains past g for extended periods of time is low. If fiscal stimulus, at the cost of an expanded debt, continues, as it is probable to continue if some form of Biden's Build Back Better Plan is passed into law, the return to a negative differential will occur. As such, the risk of sudden debt unsustainability in the near future is low.
Exhibit D: The Worst-Case Scenario
Exhibit C rests on the belief that interest rates will continue to be low. However, the one
potential weakness of my argument is that there is no complete understanding as to why interest rates are low [3] . Without pinpointing and monitoring the factors causing low interest rates, structural change might shift rates higher for longer periods of time. This would be the worst-case scenario. But even in this situation, there is still an "exit strategy," as economist Keneth Rognoff would say.
The U.S. government could sell very long-term bonds and lock in low interest rates. This could buy time for the necessary debt consolidation (Mian et al., 2021; Eichengreen et al., 2021). For example, the government can use inflation-indexed bonds and lock in a real rate of 1.1% over 30 years (Blanchard, 2019). This rate is lower than the most pessimistic forecasts of growth (optimistic forecasts of inflation). Then, debt consolidation will need to use a combination of maintaining stable financial conditions, running primary budget surpluses, and allowing for moderate inflation. An extensive study of sovereign debt consolidation in history concludes that overlying on one of those three approaches can increase the debt (Eichengreen et al., 2021). At this point, it must be noted that financial repression, a tool often used in America's past, is largely irrelevant now and cannot be relied on (Blanchard, 2019; Eichengreen et al., 2021).
Closing Arguments
America is at no risk of default. America can and should expand its current national debt to avoid the zero lower bound. Current and expanded levels of debt are sustainable. I submit to the jury of this proceeding, you the reader, and to the overbearing judge of this proceeding, the United States Congress, that the national debt is not a matter of concern right now. I rest my case.
Foot Notes
[1] A counterargument to Reinhart and Rogoff, 2010 is Irons and Bivens, 2010
[2] See Mankiw, 2020 for a critical review of Modern Monetary Theory
[3] Some have pointed to rising life expectancy in advanced economies resulting in increased savings - the "savings glut" hypothesis (Bernanke, 2005; Teulings and Baldwin, 2014; Bean et al. 2015). Others subscribe to the idea that the need for physical investment has declined with the shift to digital platforms - the "secular stagnation" hypothesis (Summers, 2014). Still others believe higher global demand for safe assets by domestic and to a greater magnitude foreign investors plays a role (Glick, 2019). Chinese financial integration, after effects of the financial crisis, economic inequality, and a host of other factors have also been considered (Bean et al., 2015; Eichengreen et al., 2021).
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