The Truth Revealed About Debt and Deficits
It’s hard to open a newspaper or turn on the TV without being bombarded with narratives suggesting that fiscal policy didn’t work and that we therefore need discipline in the form of balanced budget amendments and debt limits. Even those who see themselves as moderates on the issue are embracing a commitment to “eventually” slash deficit spending once recovery gets underway.
But most of this talk arises from a fundamental misunderstanding about the way debt and deficits actually operate.
Private v. Public Debt
When people talk about reducing the deficit, the message is that the U.S. government is running out of money. Virtually everyone in Washington accepts this idea—from the progressive think tanks to the nuttiest free marketeers; from the politicians to NPR’s reporters; from Pete Peterson’s hedge fund cronies to organized labor. All present a unified front against budget deficits—particularly those that supposedly result from “entitlements.”
They all warn we have to cut excessive debt. But what kind of debt? Public or private? And excessive in relation to what? Time? Some threshold?
The truth is that a holder of private debt, like a household, has a very different relationship to debt than a government like the United States, which issues its own currency. For families and businesses, paying back debt means they have to sacrifice current consumption (spending). But the government doesn’t have this same constraint. You’ll rarely hear this stated, but the government’s ability to spend now is actually independent of how much debt it holds and what it spent yesterday. That situation can never apply to a household or business firm.
In today's economy, private debt loads --those carried by families and businesses -- remain too high while income and employment continue to fall, and delinquencies and foreclosures continue to rise. Even at current depressed prices, assets are overvalued. And because people are continuing to have trouble servicing their private debt loads, that means they can’t spend money, which will further slow down economic activity.
But federal government debt is a different story. Unlike private actors who don’t have the capacity to create money, the government can issue money at the tap of a keystroke, which means that debt service per se is never an issue. The federal government can always create the dollars to ‘fund’ its spending. Consequently, it can spend much more freely to get the economy going. In troubled economic times, that’s just what government needs to do.
Wait—what about inflation? True, if the economy is running closer to full capacity and the government still continues to spend aggressively, this can lead to real resource constraints (and, hence, inflation). And we don’t want that. But this issue, while important, is distinct from the issue of national solvency in the U.S., despite the claims of many disingenuous economists and politicians to the contrary.
Budget Deficits Simply Reflect Economic Activity
Think of federal budget deficits themselves as barometers of economic activity: when economic activity declines, tax revenues plunge and social welfare expenditures rise as more people are thrown out of work. As a consequence, in bad economic times, there are higher deficits; conversely, when prosperity returns, deficits decrease. This dynamic means that social welfare expenditures are even more necessary during difficult economic times because they help people buy goods and services, which has to happen unless we want the economy to come screeching to a halt and head towards another Great Depression.
Let’s take a look at the onset of the current crisis. In the aftermath of the Great Recession of 2007, the U.S. government budget moved sharply to large deficits. While many attributed this to various fiscal stimulus packages (including bail-outs of the auto industry and Wall Street), the largest portion of the increase in the deficit came from what economists call “automatic stabilizers”—things like unemployment benefits that have to kick in when a downturn occurs. They had little to do with discretionary spending.