economics
How many more trillions before the debt triggers a crisis?
Stanford University
Stony Brook University
2
1
Genesis
Response
Penultimate
March 13th, 2022
According to the latest estimates of the Congressional Budget Office (CBO), the federal debt is projected to grow from $21 trillion at the end of 2020 to $36 trillion at the end of 2031—or by $15 trillion. The CBO projects the debt to GDP ratio to be 106 percent in 2031—equal to the peak recorded way back in 1946 at the end of World War II.
Basic economic theory and tested empirical models imply that such high federal government debt has a cost: it reduces real GDP growth and income per capita. In fact, according to the CBO’s projections, real GDP growth will average 1.6 percent per year from 2026 to 2031, compared to 3.3 percent per year when the debt was less than 40 percent of GDP in the decades from 1980 to 2005. While one may not want to call that a crisis, cutting the growth rate in half would have a devastating effect on living standards and severely set back key goals such as poverty reduction.
So there is a real need for a fiscal consolidation strategy. Under such a strategy spending would still grow, but at a slower rate than GDP, thereby reducing both spending and debt as a share of GDP. Such a fiscal strategy would greatly benefit the American economy. Experience and research with economic models shows that such a fiscal consolidation plan would raise GDP growth and increase income per household. These are not new ideas.
Yes, critics of fiscal consolidation say there would be negative impacts on GDP. But modern structural economic models that incorporate opportunity costs, forward looking expectations, and incentives confirm the above historical comparison. GDP would rise because households understand that the spending plan helps to avoid future tax increases. Lower taxes encourage work, investment and production relative to little or no fiscal consolidation, and thus generate higher economic growth. To realize these benefits, it is important that the consolidation plan be credible.
One reason why some argue against such a plan is a concern that consolidation would remove needed stimulus from the economy. But that is not what economic theory says about a return to policies that worked well in the past.
Another view questioning such a consolidation plan is sometimes called “Modern Monetary Theory.” To move the resources from one part of the economy to another, controls over prices and wages are often suggested, thought the basic idea behind this theory is that money could be used to finance the budget deficit, thus avoiding the debt increase. But as the increase in inflation over the past year makes clear, such a monetary policy would be inflationary. Here history can be a guide: In the 1970s the United States imposed wage and price controls and the Federal Reserve helped finance the federal deficit by creating money. The result: a terrible economy with unemployment and inflation rising.
1 Comment
Oct 2
I don't understand why the Fed raising interest rates is the sole tool for controlling inflation. Seems like if demand is too high for goods and services it would be less intrusive and destruction to raise taxes and cut spending or a combination of both. Seems like what the Fed is doing now, raising interest rates rapidly and evaporating people's wealth from stock market losses (and bond funds, like those pesky ones the working class get sold in their 401, 403 plans!), and increasing the cost of government debt, is much more naive and destructive than the government taking that wealth and actually using it for something, like paying off debt, or redistributing it to the lower class so we don't end up with even more homeless and starving little kids.
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