Our national fear and misunderstanding of debt, deficits, and borrowing is understandable, given their role in the etiology of the Great Recession that continues to choke our economy. But such confusion is also terribly destructive. It helped lead us into the recession, and it’s preventing us from recovering from it.
Over the last decade, too many households, governments, firms, and banks borrowed recklessly, nudged by financial “innovations,” negligent underwriting, and pure disregard for their ability to meet the liabilities they were taking on. Then, in September 2008, the system snapped. One particularly overleveraged investment bank, Lehman Brothers, went bankrupt, and the global debt bubble popped. Millions of people lost, and continue to lose, their homes. Unemployment is rampant, and just under half of the unemployed have been jobless for more than half a year. The debt burdens of sovereign nations, Greece in particular, pose existential threats.
And yet policy-makers seem frozen in place, unwilling to take the necessary actions for one basic reason: doing so would mean deficit spending. Indeed, those at the helm in the advanced economies seem intent on shifting into reverse, pursuing austerity measures that, like medieval bleeding, only make the patient sicker. We recently inflicted more wounds on our already injured economy by arguing about whether or not to default on our own sovereign debt. This frustrating and destructive debate would have been a pitiful sideshow had it occurred during a period of full employment. For it to happen in the midst of the worst jobs crisis in decades amounts to malpractice by the policy-makers involved.
None of this was inevitable. A precious few economists warned of the housing bubble, which was the root cause of the recession. Had borrowers and lenders treated debt more responsibly, we arguably wouldn’t be stuck where we are today. Years ago, the economist Hyman Minsky warned about exactly the situation we were in before the bubble burst—the debt-driven instability of financial markets in economic expansions. Had we listened to him instead of Greenspanian notions of “self-correcting markets,” we’d also be a lot better off.
In other words, there are very high opportunity costs to misunderstanding and misusing debt, both in booms and busts. Economists have a solid understanding and story about the “identities” involved in public debt—the basic relations among deficits, savings, and debt. But we disagree on their implications. Financial market participants seem to regularly relearn lessons regarding the instability cycle associated with overleveraging, a cycle identified by Minsky years ago. Politicians deeply fret (and scaremonger) about deficits and debt, while neither exhibiting much of an understanding of their functions nor doing much about them. In some cases, these pols are motivated by an ideological strategy to shrink government, but in others, they fail to understand important nuances regarding the purpose, timing, and magnitude of public borrowing.
We clearly need a better understanding of the role of and threats associated with debt, which means internalizing a crucial point: Controlling for the state of the economy and assuming mature capital markets and the ability to service the debt burden (and those are not unrealistic assumptions—they exist in this and most other advanced economies), there’s little empirical evidence that we should be particularly alarmed at “high,” yet stable, levels of federal debt, such as the current U.S. level of around 70 percent of GDP. On the other hand, if you can’t effectively and reliably tax your citizens, as in Greece, any level of debt is a foundational threat. (Note that I distinguish between levels and trends here. The projection that under current policy the federal government will, year in and year out, spend a lot more than it takes in is obviously unsustainable.)
We need to take a “debt sobriety pledge.” We need the insight and wisdom to understand when borrowing is useful and productive and when it’s reckless. For governments, that means getting past irrational or ideological fear of borrowing, especially at a time like the present. For households, it means not substituting unsustainable borrowing for income growth. For financial markets, it’s recognizing the predictable tendency toward instability and the necessity of regulation.
I cannot emphasize enough the stakes of getting this right, and quickly. Global credit markets are behaving exactly as we would expect, offering historically low borrowing costs to finance the essential fiscal expansion that must take place if we are to avoid the mistakes of Japan in the 1980s and Europe now. But conservatives use debt aversion as a weapon in the ideological fight to shrink government, while too many liberals essentially agree, arguing for perhaps smaller cuts.
The First Step: Understanding Debt
The concept of debt is so poorly understood that it makes sense to start from first principles. Debt is what a person, firm, or government accrues when it borrows financial resources from a lender to be paid back over time. In the case of so-called sovereign debt—that of governments—there are a few wrinkles. When government outlays surpass receipts, the difference over the course of a year is known as the annual deficit. And when you add up all the deficits we’ve run since we became a nation and subtract the occasional surpluses, you’re left with the debt.
Personal and corporate debt are also straightforward. A family might borrow to invest in a child’s education. A startup needs physical capital—machines, offices, computers—and might borrow to finance those purchases, as does a factory owner upgrading aging machines. These are investments—that is, they are expected to return a stream of payments, a stream from which debt liability will be serviced. But households, firms, and governments also borrow to boost short-term consumption, to meet payrolls, or to pay the annual Medicare bill.
And there are different markets with different structures and prices to accommodate all of the above borrowing. Banks finance short-term credit card debt and long-term mortgage debt. Larger corporations often borrow short-term directly from investors, like money-market funds, through “commercial paper” loans. Governments borrow from anyone and everyone, including other governments, with the United States, China, and Japan the most prominent examples. (The Chinese and Japanese together hold more than $2 trillion in U.S. securities.)
I’m sure that if you could look at the electrical impulses in the typical person’s brain and say “debt” or “deficit” the synapses that fired would be ones associated with negativity. Yet debt has obviously been an economic mainstay since before money existed—members of bartering economies constantly owed one another goods and services. Without debt, very few people would own homes or go to college. But it has a bad reputation right now chiefly because there’s so damn much of it.
People have for centuries borrowed to buy homes, but in the 2000s, they overdosed. Three key factors combined to move people into homes they couldn’t afford (in economic terms, risk was underpriced, and underpriced risk is always the breath in the straw that inflates the debt bubble). The first was financial engineering, in which mortgage loans were bundled together and sold to investors, which led lenders to be less concerned about the borrower’s ability to service that loan. Second was bad underwriting—an unwillingness by lenders to realistically assess the amount of debt people can safely carry. And third was an often overlooked but crucial backdrop to all of this: the lack of middle-class income growth. The real median income of working age households fell 10 percent from 2000 to 2010, from about $61,600 to about $55,300 in 2010 dollars. And that isn’t just a recessionary story—it fell from 2001 to 2007 when the economy was expanding. These are middle-class, working-age households. And when earnings are flat or decreasing, their only recourse is to tap credit markets, especially when credit is cheap and easy.
The Deficit and Its Discontents
Along with the mortgage-debt overdose and the recession it caused, another reason debt has a bad rep has to do with the way politicians have talked about and managed deficits and debt for years now. We should not lose sight of the political and ideological motivation against deficit spending. In an era when tax hikes are verboten, deficit reduction can be achieved only through spending cuts, and it has thus become a way of arguing for less government.
One of the most common refrains in today’s debate is that the federal government spends too much. There’s little substance to this claim: For decades, federal outlays have hovered around the historical average of 21 percent of GDP. Ronald Reagan and George H.W. Bush averaged around 22 percent; Bill Clinton and George W. Bush came in around 20 percent. And President Obama’s somewhat higher outlays are a function of the deepest recession in decades—take out that spending and he’s in the same historical ballpark.
What’s different—what’s largely behind the structural deficits in recent years (controlling for the cyclical downturn)—is the decline in revenues from the Bush tax cuts and their extensions, not to mention the wars in Iraq and Afghanistan. Since their introduction in the early 2000s, the tax cuts have diminished the nation’s tax bill by hundreds of billions every year. Over the next ten years, they are expected to add $3.6 trillion to the debt. Without these cuts, our medium-term budget (say, over the next decade) would be sustainable.
As long as new revenues are off-limits, attacking the deficit is equivalent to attacking the functions of government. That gives the anti-deficit argument strong ideological support from small-government advocates. But there are others who are not motivated by anti-government ideology but are misguided nevertheless. These are the conceptual mistakes they make:
Little attention to what the borrowing is for: Earlier, I noted the distinction between borrowing to consume and borrowing to invest. While both are legitimate reasons for governments to accrue debt, their implications are quite different. Borrowing to invest in productive infrastructure, for example, is different from borrowing to support inefficient health-care spending. Or think about it on a more personal scale: Borrowing to send a kid to college is an investment that, on average, produces lasting economic returns. Borrowing to finance a weekend in Vegas does not. Our deficit comes from both types of spending: investments with longer-term payoffs and those that feed current consumption. But few deficit hawks make the distinction. They should, because in cost-benefit terms, there are times when borrowing to invest in infrastructure or education will leave the country with better growth prospects, while deficit spending to finance high-end tax cuts has little, if any, positive impact on growth.
Little understanding of time horizons: When borrowing is truly temporary, it has little impact on longer-term deficits and the growth of the debt. Even large deficit spending, if temporary, is quickly absorbed by economic growth. The Recovery Act, with a price tag of about $800 billion, was a historically large stimulus, and it was wholly paid for by borrowing. But by 2012 it will add less than 0.5 percent to the deficit-to-GDP ratio, and nothing to the growth in the debt (it does add to the level of debt, of course; in other words, it raises the share of debt to GDP, but it does not contribute to the growth in that share). The Bush tax cuts, on the other hand, which are essentially permanent in terms of ten-year budget windows, keep adding to both annual deficits and the growth of the debt—on the latter point, they add 20 percent to the debt-to-GDP ratio this year and, if they remain in place, 34 percent by 2019.
There’s another timing point here, made forcefully in recent commentaries by Yale economist Robert Shiller. Economists and official budget scorekeepers like the Congressional Budget Office judge the sustainability of budget plans by whether the debt-to-GDP ratio is rising or falling. Shiller points out, however, that this conflates an annual measure—GDP—with a debt measure that is decidedly non-annual. We don’t have to refinance government debt all at once in a given year. For example, it might seem intuitive that if public debt were 100 percent of GDP, we’d be insolvent, but of course that’s not the case. During World War II, that ratio exceeded 100 percent, and for good reason. A decade later, it was 52 percent.
Again, timing matters. Temporary deficits, say, to offset a downturn, make a lot more sense than permanent, or structural, deficits in a recovery (“structural” in this context means that even with a healthy economy, the deficit would persist). Seemingly large debt burdens in a given year can be dealt with over the course of many years. But while Keynesian stimulus (such as the Recovery Act) is temporary by definition, the aging of the population and the rise of health care costs are not. The problem, once again, is not borrowing—it never is. It’s what are you borrowing for, how long you will need to pay for it, and how you are going to pay it back.
Cost of borrowing: As I write this sentence, five-year Treasury bills carry an interest rate of about 1 percent, a near historic low. Why so low? Because the economy is so weak, inflationary pressures are low, stocks are volatile, Europe is a mess—all of which make hyper-safe securities like T-bills a highly desirable investment. That’s actually an important and salutary dynamic in an advanced economy with mature capital markets. It signals that government should borrow and deficit-spend on temporary measures to stimulate growth.
At such low rates and with so much economic slack, fiscal policy needs to focus on increasing the denominator of the debt-to-GDP measure, not lowering the numerator. If we borrowed 1 percent of GDP at the current interest rates to make investments in the economy, and assumed a (conservative) multiplier of 1.2 (meaning every dollar spent creates $1.20 of growth), debt-to-GDP would, under plausible assumptions, barely budge as the boost to growth would at least partially offset the increment to the annual deficit. And a lot more people could get back to work.
The point is that when borrowing costs are low because of a recession and all the slack it causes—which is precisely what we’ve seen in recent months—that’s an important signal to the government to engage in temporary fiscal expansion. To do so has the benefit of reducing unemployment and boosting growth at comparatively little cost to the federal budget. To fail to respond to this signal is to consign millions to joblessness under the false pretense of fiscal rectitude.
Little distinction in magnitudes: There’s a difference between “small” and “large” federal budget deficits. But when all debt is evil, such distinctions get lost. The concept of “primary” balance is important here. A deficit that is in primary balance is small enough that the government is raising adequate revenue to pay its operating budget—that is, everything it spends money on except the interest on the debt. Once the budget deficit is at least in primary balance, the debt-to-GDP ratio stabilizes—it stops growing. Deficits below about 3 percent of GDP right now would constitute primary balance. Indeed, the budget plan recently released by President Obama gets deficits down to below 3 percent by 2014 through the rest of the decade. Sure enough, the debt-to-GDP ratio peaks in 2013 at 76.9 percent, then falls to 73 percent by 2021.
Again, the point is that the failure to make this distinction contributes to austerity frenzy, such as the pervasive calls for a balanced budget amendment and aggressive budget cuts. When the economy is on a solid expansion trajectory, we want the deficit-to-GDP ratio shrinking each year, but it doesn’t have to go to zero or surplus right away. Primary balance is a fine intermediate goal.
“Tighten our belts”—an awful analogy: Beware simple, folksy metaphors that emanate wisdom but convey exactly the wrong message. My candidate for the most destructive of all is that old saw about deficit reduction: “Hey, families have to tighten their belts when things get tough…government should too.” President Obama himself has made this mistake.
Sounds right, but it’s totally backwards. When the economy stumbles and family income stumbles with it, then sure, families have to tighten up. But this is precisely why government has to loosen its belt. That’s the whole point of countercyclical policy: When the private sector is contracting, the public sector temporarily expands, and vice versa. The analogy is wrong on both ends: When the private sector is humming along, and working families can maybe loosen their belts a bit, that’s when the government needs to tighten its belt.
Who owns the debt?: It’s always important to remember that one person’s debt is another person’s asset. When it comes to the budget deficit, while we owe about half of it to foreign holders of Treasuries (China and Japan being the most prominent lenders), we owe the other half to ourselves. That doesn’t mean we can afford to ignore unsustainable borrowing. But from a macroeconomic perspective, it doesn’t necessarily hurt the economy to borrow from ourselves to invest in productivity-enhancing initiatives that increase the future wealth of our progeny.
Taken as a whole, these misguided beliefs combine to distort our fiscal policy, and they do so in one direction: against deficit spending. This bias is preventing us from taking corrective action. It is also contributing to a dangerously misguided—and bipartisan—effort to reduce the size of government in an era when we’ll need increased federal outlays to meet coming challenges, such as environmental pressures and the health and retirement security of the baby boomers. It’s one thing to take aim at wrong arguments like those above. But that does raise the question: What impact do federal budget deficits have on the economy? Was Dick Cheney right to argue that “Reagan proved deficits don’t matter”?
For economists, the issue comes down to “crowding out.” Under certain conditions, by running large deficits, the government can be in competition with private firms for capital, and the extra demand for loans pushes up interest rates. Higher interest rates mean less investment and slower private-sector growth than would otherwise occur. Crowding out makes sense in theory, and research has found some evidence of it. But the whole story is not so simple. In fact, neither interest rates nor investment have responded during this crisis the way the crude view predicts (interest rates haven’t risen with deficits, and neither investment nor capital stock consistently fell). The reason is that there is no competition for scarce funds right now—to the contrary, firms are sitting on trillions in cash reserves, and capital is flowing freely to the United States as a safe haven in uncertain times.
Economists’ focus on crowding out, given the lack of compelling evidence, is doing more harm than good. None of this is meant to signal indifference to budget deficits. I was as elated by the surpluses of the latter 1990s as I was discouraged by the growing deficits of the 2000s. But at the same time, I was not at all worried about the deficits of the last few years. Well, that’s not totally accurate—I worried that they weren’t large enough to help the economy get moving again. Over the long run, we have to live within our means. We cannot continue to spend increasingly more than we take in or we will be unable to both service our debt and provide the goods and services we want and need from the public sector. But the more immediately serious problem, the one we’re not even trying to deal with, is the fact that our system is so irrationally nervous about public debt that we’re actively under-spending on countercyclical policy. To do so is to accept implicitly a huge amount of slack in the current economy, most portentously the high un- and underemployment in the labor force.
When Debt Matters
Earlier I mentioned the need for a debt sobriety pledge, something akin to the Serenity Prayer adopted by Alcoholics Anonymous. Whereas AA invokes a deity to grant the wisdom to know and accept what we can and can’t control, we’d invoke Adam Smith, John Maynard Keynes, and especially Hyman Minsky: Help us to understand when borrowing is useful and productive, and when we are overleveraging.
I mention these three because each understood the extent to which market failure recurs in financial markets. Though Alan Greenspan and others have pointed to Smith’s insights on market incentives, it’s fascinating to contemplate the dressing down Smith would deliver to the “maestro” regarding contemporary theories on self-correcting financial markets. As recounted in John Cassidy’s essential book How Markets Fail, “Smith and his successors…believed that the government had a duty to protect the public from financial swindles and speculative panics, which were both common in eighteenth- and nineteenth-century Britain.” Today’s policy-makers conveniently ignore this Smith, who wrote in The Wealth of Nations:
Such regulations may, no doubt, be considered as in some respects a violation of natural liberty. But these exertions of the natural liberty of a few individuals, which might endanger the security of the whole society are, and ought to be, restrained by the laws of all governments…. The obligation of building party walls, in order to prevent the communication of fire, is a violation of natural liberty, exactly of the same kind with the regulations of the banking trade which are here proposed.
Keynes, ever the realist, was well aware of Smith’s insights, and would have been particularly skeptical of the “rational expectations” hypotheses that undergird modern market theories. While these theories are built on the belief that market participants are aware of all the relevant information needed to make rational economic choices, Keynes recognized that “human decisions…cannot depend on strict mathematical expectation.” Sometimes we have the information we need to make rational economic decisions, but at other times we’re forced to fall back “on whim or sentiment or chance.” That means we will sometimes borrow to speculate on bets that don’t make sense, like taking out mortgages that we can afford only if home prices continue to rise. If enough of us do so at the same time, as was the case in the 2000s, we introduce a level of instability into the system with the potential for precisely the consequences confronting us today.
But it was Minsky, a Harvard-trained economist well versed in Keynesianism, who most deeply understood and articulated the way contemporary debt cycles spin out of control. If we’re ever to avoid these pitfalls that have plagued us since Adam (Smith, of course), then we need to pay close attention to Minsky’s work and think long and hard about how to map it onto public policy.
Minsky proceeded from two key insights, both of which diverged sharply from the orthodoxy of the day (he died in 1996): first, the centrality of debt to a functioning economy, and second, the tendency of financial markets toward instability. As I stressed at the beginning of this essay, the basic idea of debt is not only sound but essential to growth. Borrowing from the future to invest in the present is one way to improve that future. And some of the economic gains that flow from the investment will be used to pay down the debt.
Minsky’s second insight, about instability, was once nicely summed up by the great game theorist Yogi Berra, who pointed out, “It’s tough to make predictions, especially about the future.” So uncertainty and risk must be accounted for, and in a rational market, the rate of interest would put a price on the loan that accurately reflected its risk. And in fact, that’s often the case at the beginning of economic recoveries. Growth is newly back on the scene, businesses and households start to get active again, and lenders tend toward a reasonable degree of caution in evaluating their loan prospects.
However, as the recovery ages and growth picks up speed, risk aversion diminishes. Loans that didn’t seem creditworthy a year ago start looking pretty good. Minsky also recognized that new forms of lending often begin to sprout up at this stage—“innovations” that enable their inventors to lend into the accelerating cycle ahead of their competitors. These innovations may be poorly understood, and not just by the borrower, but by the lender as well. They may involve gambles that can’t possibly end well, such as loans whose repayment is wholly dependent on a price bubble in the underlying asset, or even outright fraud, like what came to be called “liar loans,” where lending intermediaries ignored or falsified documentation to create the appearance of credit worthiness.
Minsky’s model could be viewed mistakenly as simple common sense: a) Debt financing is pro-cyclical, and b) lenders get sloppy (or cryptic) as the cycle proceeds. But his model says more than this. As Cassidy puts it, “At the risk of oversimplifying, Minsky’s argument can be reduced to three words: stability is destabilizing.” Under this model, debt can be like a virus in the body of a business cycle. It starts out supporting the organism in ways salutary and safe, but is unable to modulate its growth, and it ultimately infects the system under the weight of leverage.
Our failure to understand this dynamic has led to our current pass: a fixation on debt when the system needs more of it, and complacency about debt when we need vigilance. Minsky would have recognized the signs that something was amiss as the 2000s debt cycle shifted into overdrive. The underpricing of risk, financial innovations, leverage ratios that were multiples of their historical averages, and the shadow banking system—all signaled that the virus had been activated and would soon destabilize the system.
Where Does This All Leave Us?
As I’ve stressed throughout, debt is not just important—it is an essential tool of economic growth. Neither families nor firms nor governments can adequately help themselves or their constituents without the ability to borrow from the future to spend or invest in the present. Yet market and political failures have undermined this essential function, and the politics of budget deficits have devolved to the point where, at least rhetorically, any debt is bad debt. It is impossible to overemphasize the lasting harm done by this anti-deficit fervor.
The good news is that—putting politics aside—all of this is fixable. The United States still hosts mature, flexible, adequately capitalized credit markets. In fact, credit markets are working exactly as they should be right now, with interest rates signaling us—if not screaming at us—to borrow and apply fiscal stimulus. Over at the Federal Reserve, the interest rate has been stuck at zero. But households are still deleveraging and still on insecure economic ground, so they’re not much moved by the low rates. It’s the same with firms that are flush with cash reserves but not moved to use them unless they see a profitable reason to do so.
What’s needed is more demand, more customers, more factory orders. Absent those, monetary stimulus—the Fed’s Operation Twist, quantitative easing—risks “pushing on a string.” But if more folks could get back to work and increase their hours and paychecks, then businesses would see more foot traffic and investors could see some profitable openings. As Vice President Biden’s chief economist, I saw up close that the Recovery Act helped significantly in this regard. Upon its passage, the loss rates of both GDP and jobs began to diminish; GDP turned positive in mid-2009 and employment began to grow in the spring of 2010. But while the Recovery Act (along with aggressive monetary policy by the Federal Reserve) arrested the decline, it only helped shift the economy from reverse into neutral. We’re stuck in the doldrums with deep excess capacity, and monetary policy alone can’t get us out. We need temporary measures that would borrow a lot more; I liked the President’s jobs plan but I’d have gone twice as large (though truth be told, in today’s climate it’s actually an ambitious plan). But we won’t do it because we’re too damn scared of deficits and debt.
We also have the means to take a solid stab at fixing the instability cycle in financial markets. That’s the purpose of the Dodd-Frank financial reform legislation, which I view as the first real attempt at “Minsky insurance”—that is, of protecting against the next financial instability cycle-debt bubble—in decades. It’s not perfect, but it has the right attributes, all of which could be fine-tuned if we can only fight back against the amnesiacs who can’t remember what happened a few years ago.
But “Minsky insurance” can’t be the only thing we learn from the debt bubble and the great recession it caused. A key insight from the 2000s, when the debt bubble was inflating, is that in the midst of the lost decade for middle-class income growth, debt acquisition became the only way for too many families to get ahead. We can and should impose regulations to break the financial instability cycle—public policy doesn’t do people any favors when it supports unsustainable loans in place of earnings. But we must recognize that absent income growth, if channels of overleveraging are blocked, middle-class living standards will be that much more vulnerable to stagnation.
That suggests an investment and jobs agenda that would take me well beyond my scope. My point here is simply that we will be unable to support that or any other progressive agenda, in the short or long run, if we fail to understand the role that debt can and should play in our economy and society. But I’d go further. Our misunderstanding and irrational fear of debt and deficits prevents us from resolving the most important policy question we face: What should be the size and role of government? As long as Republicans want to cut deeply into government spending and Democrats’ main distinguishing feature is the desire to cut less deeply, we will never answer this question.
The debate on this foundational issue cannot begin from “How quickly do we get to primary balance?” or “At what year in the budget window does your plan have the debt-to-GDP ratio declining?” That is government by accounting, motivated more by fear than vision. And it is a debate structured to shrink government.
My analysis of future challenges—demographic, economic, and environmental—leads me to believe that in coming years we will need a stronger and larger government sector than we have had in the past. Others see the future differently. Our two sides must debate this question from the bottom up: from what we expect and need in terms of investment in public infrastructure, retirement security, health care, defense, safety net protections, education and other mobility enhancers for the disadvantaged, countercyclical policy, innovation, and so on. To begin this debate from a position of deficit reduction—no new taxes, only spending cuts—is to tilt the result against progressives from the start. It is to begin from the assumption that we can’t afford the above functions, that we’re broke, or worse: We’re Greece!
Despite what so many people say, we are neither. We are fully capable of paying for, in a sustainable manner, a government that meets the functions enumerated above. But to do so requires a rational rethinking of debt and its role in the economy and society. I recognize that rational thought on matters economic, especially this one, is in short supply these days. But while its supply is down, demand is up, and the more we’re promoting that discussion, the better.