In “The Real Cliff,” Chris DeMuth argues that Keynesian thinking represented an important intellectual advance, but one that rested on a particular cultural foundation:
Keynes introduced the idea that government could legitimately borrow not only for production but also for consumption. Just as a creditworthy individual may take out a mortgage to purchase a home with future earnings, so government could borrow a share of tomorrow’s wealth to meet urgent current needs. There had always been cases, such as natural disasters, in which governments had spent liberally, and if necessary by borrowing, to sustain incomes in the face of widespread emergency losses. Writing in the 1930s, Keynes in effect generalized the proposition to encompass economic emergencies of the magnitude of the Great Depression. His postwar apostles made refinements—such as “countercyclical stabilization” and “the full-employment balanced budget”—to moderate more routine fluctuations in the business cycle.
These were important intellectual advances. Although subject to many objections and qualifications, they were admirable efforts to respond to hardship and harness the modern economy more tightly to individual well-being. But, like many such advances, they emerged from a particular milieu and then reshaped that milieu in surprising ways. The Keynesian nostrums were conceived in an era when the balanced budget was the universally accepted norm: They assumed that debts incurred during depressions and downturns would be balanced by surpluses during booms and upturns. And the prospect of balance over the course of business cycles seemed unproblematic during the Depression, when the economy had been roaring in the recent past, and during the three postwar decades (through 1974) of bracing growth marred by only moderate recessions. [Emphasis added]
As DeMuth goes on to argue, however, what had been a universally accepted norm that budgets should generally remain balanced was badly undermined by the political potency of borrowing, which allows legislators to gloss over contentious questions concerning how benefits and burdens will be allocated across a diverse population. The result has been persistent deficit spending:
These political dynamics quickly left formal Keynesianism in the dust. In the 52 years since 1960, the federal budget has been in balance or surplus only five times (although the deficits before 1975 were mostly small); the cumulative deficits have far exceeded the surpluses, and there has been no correlation of fiscal balances to economic cycles. Each new year has brought its own unique and compelling reasons for borrowing just a little bit more for a little while longer—with the effect of shifting consumption further ahead of production from every new baseline. Even the economic expansions of the mid-1960s and mid-1980s were treated not as opportunities for budget surpluses but instead as evidence that deficit stimulus was working. The exceptional surplus years of 1998-2001 may be chalked up to the steely discipline of President Clinton or Republican Congresses (or to the virtues of divided government and the dot-com bubble), but it should be noted that they began as a surprise—Clinton’s 1998 budget proposed a deficit and projected deficits through 2002.
As we’ve discussed, however, structural deficits have tended to be manageable for most of this era, thanks in large part due a favorable demographic picture. That is, the growth in public debt was generally exceeded by economic growth, thus preventing the debt-to-GDP ratio from spiraling out of control. And so I’d disagree with DeMuth very slightly: for most of the period he describes, deficits haven’t been too much of a problem, but the cumulative deficits have reduced our room to maneuver in the current economic climate, which is reason enough for policymakers to be cautious going forward.
DeMuth’s biggest anxiety is that what he calls the “debt-for-consumption project,” in which the federal government borrows to finance social transfers (and, in effect, tax expenditures) will eventually lead to a painful fiscal reckoning:
The federal government’s public debt is now about 75 percent of annual GDP and growing rapidly, and already more than 100 percent if one includes the Treasury Department’s intra-government debts to Social Security and other programs. These amounts put us in the range where, historically, government debt has seriously depressed economic growth and risked sovereign defaults and wrenching fiscal contractions, even when interest rates were low. But our true indebtedness is much higher than that, much higher than our peak debt during World War II, and not far behind that of the crisis-wracked EU. Accounting for the chasm between projected Social Security and Medicare payments and revenues (which the government’s official debt figures unfortunately ignore) puts the federal debt at more than five times GDP. Generational accounting suggests that future generations will be paying nearly all of their lifetime incomes in taxes, which obviously cannot happen.
Calculations such as these point to the real harm of financing current consumption with ever-increasing public debt. Substantial segments of the population become accustomed to levels of government benefits that cannot be sustained. With time, an inheritance of continuous stimulus can be withdrawn slowly, permitting private adjustments and, with luck, resumed economic growth. But the longer the stimulus continues, the greater the likelihood that personal expectations will be shattered by an emergency that an insolvent government is no longer in a position to respond to. That will certainly mean widespread losses and hardship, and perhaps political instability as well, and, worst-case scenario, temptations for Kirchner-style confiscations.
I am sympathetic to DeMuth’s line of thinking. One might point out that Japan has a gross debt of 235.8 percent of GDP, which suggests that the U.S. could remain on its current path for some time to come. But that is not exactly an encouraging line of thinking. Peter Boone and Simon Johnson write:
Modern financial systems also permit governments to borrow large sums from investors, and as finance has evolved, that borrowing has become easier and cheaper. In the most-advanced countries, governments have increasingly taken advantage of expanding markets for short-maturity debt, whose principal is due soon after the loan is made. This has allowed them to borrow far more, and at cheaper rates, than they otherwise would have been able to do. Typically, these governments then take out new loans as the old ones come due, “rolling over” their debts. This year, for example, the Japanese government needs to issue debt amounting to 59.1 percent of GDP; that is, for every $10 that Japan’s economy generates this year, the government will need to borrow $6. It will probably be able to do so at very low interest rates—currently well below 1 percent.
So where is the harm? Boone and Johnson offer a scenario for a Japanese crash before turning to the U.S.:
The immediate problem is not Social Security: that program’s promises can still be covered by modest taxes, and significant immigration has helped prevent a demographic decline like the one Japan is seeing. Nonetheless, the U.S. needs to issue government debt worth about 25.8 percent of GDP this year, to roll over its debts and finance the deficit. About half of the federal government’s debt is already held by foreigners. And a tax revolt has been building since the mid-’70s. Today, one side of the political spectrum refuses to consider rebuilding revenue to the pre–George W. Bush levels—and proposes to cut taxes further. The other side resolutely defends spending programs and middle-class tax breaks. Health-care spending, meanwhile, keeps rising—largely because powerful lobbies can veto meaningful cost control.
Perversely, interest rates on U.S. government debt are lower than at any other time in living memory—the result, largely, of economic dangers elsewhere. The Europeans have ruined their economies—and we have benefited from the consequent inflow of capital to our government debt, which has pushed rates down. When Japanese investors begin abandoning their home country, we will benefit again.
These benefits are temporary. Yet politicians have a hard time paying serious attention to fiscal deficits while foreign capital floods in. Even once the U.S. economy recovers, will the government really get its debt under control?
One barrier to doing so, according to Boone and Johnson, is that the financial sector profits from the expansion of public debt. This doesn’t seem like an insurmountable challenge, particularly if the issue is being deficits to a more sustainable level rather than eliminating structural deficits entirely. But it is part of the complex puzzle.