On Tuesday, Fitch, one of the three largest credit rating agencies, startled many observers by downgrading U.S. debt. Biden administration officials weren’t the only people who were shocked and angry; quite a few economists, including some who had warned strongly against big spending, pronounced the decision “inept,” “bizarre,” “absurd” and worse. Indeed, it was hard to think of any way in which the U.S. fiscal outlook had deteriorated since last year, when Fitch gave us a clean bill of health.
Nonetheless, U.S. borrowing costs jumped, with the interest rate on 30-year government bonds surging from 4.03% on Monday to 4.32% on Thursday. Did Fitch do that? What was the market thinking? I have no idea.
But it is worth asking what it even means to downgrade U.S. debt. America is not a corporation, which can simply run out of cash. It isn’t even a country like Greece, which owes money in a currency it doesn’t control. America issues debt in dollars, which it can also print. That doesn’t necessarily mean that we can’t have solvency problems or that the level of government debt is necessarily irrelevant. But it’s much harder to tell a plausible story about a U.S. debt crisis than many people realize, and both arithmetic and history suggest that such a crisis is unlikely to happen for the foreseeable future.
I’ll come back to the conceptual issues later. For now, let’s note that most economists believe that there is some limit to how much debt the U.S. government can take on as a percentage of gross domestic product. (Pro tip: The ratio is what matters, not the absolute dollar value. Never take anyone who rants about TRILLIONS OF DOLLARS seriously.) But history and the experience of other countries suggest that we’re still a long way from that limit.
The most obvious example is Japan, which has accumulated a lot more debt relative to GDP than we have, but which has defied predictions of an imminent debt crisis for decades.
An even more striking example is Britain, which spent much of both the 19th and 20th centuries with debt levels far above that of the United States today, without ever facing a debt crisis.
So what might make people suddenly concerned about U.S. debt? One thing that has attracted considerable attention lately is rising interest payments. The Federal Reserve has been raising rates to cool off inflation, and this has translated into a spike in government interest payments both in absolute terms and as a percentage of GDP.
Even now, interest payments are substantially lower relative to GDP than they were in the early 1990s, but they’re up a lot from recent years. This has led some people to worry about a debt spiral: Higher interest payments lead to rising debt, which leads to even higher interest payments, adding even more debt, and we enter a sort of fiscal doom loop. Is this something to worry about?
No, not really. To see why, we need to do a bit of math. Sorry, I’m going to write down a simple equation here.
Bear in mind that we’re talking about the ratio of debt to GDP, not simply the level of debt. Deficits, which lead to more debt, increase the numerator of that ratio. But both inflation and economic growth increase the denominator, which, other things being equal, reduces the ratio. Do a bit of algebra, and you get this expression for debt dynamics:
Change in debt/GDP = primary deficit/GDP + (r-g)*(debt/GDP)
The primary deficit is the budget deficit not counting interest payments, r is the interest rate on government debt, and g is the economy’s growth rate. You can get a debt spiral if r is significantly larger than g; in that case rising debt leads to faster accumulation of debt, and we’re off to the races.
But a few years ago, Olivier Blanchard, one of the world’s most respected (and, dare I say, respectable) macroeconomists, gave a presidential address to the American Economic Association in which he showed that historically, r has generally been less than g. Hence, no debt spiral.
Have rising interest rates changed this conclusion? Not much. Even after the rate surge of the past few days, the interest rate on inflation-protected 10-year U.S. bonds was 1.83%, which is close to most estimates of the economy’s sustainable growth rate. If you take the low end of such estimates, we could possibly face a debt spiral, but it would be a very slow-motion spiral. Put it this way: If r is 1.8, while g is only 1.6, stabilizing the debt ratio with debt at 100% of GDP would require a primary surplus of 2% of GDP; increase debt to 150%, and that required surplus would increase only to 3%.
So if we do face the prospect of large future increases in debt — which we do — interest payments on existing debt aren’t a major culprit. The problem instead lies with those primary deficits.
Which means that the issue is essentially political. As I said, you should ignore people who rant about TRILLIONS OF DOLLARS. You should also ignore people who rant about wasteful government spending. The federal government is basically an insurance company with an army: It spends mainly on things the public wants, like the military, Social Security and health programs. But we have an effective blocking coalition against raising taxes enough to pay for those programs. So we’ll keep accumulating debt until that impasse is resolved.
As I also said, however, history suggests that America still has considerable running room. And there’s even a reasonable argument to the effect that the level of debt doesn’t matter at all.
No, I’m not talking about Modern Monetary Theory. Trying to talk with MMT types feels like intellectual Calvinball — whenever you try to pin down what they’re saying, they insist that you just don’t get it. I do, however, see considerable merit in the doctrine of “functional finance” — which may or may not be part of MMT — as laid out by Abba Lerner in 1943. Lerner declared that the size of the debt doesn’t matter: “As long as the public is willing to lend to the government there is no difficulty, no matter how many zeros are added to the national debt.”
I’m not entirely convinced by Lerner’s argument, but this column is already getting too long, so I’ll reserve that discussion for another time. What is true is that when you look at countries that borrow in their own currencies, it’s extremely hard to find historical examples of the kind of crisis debt doomers tend to predict. In fact, I’m aware of only one example: France in the 1920s, which was more or less forced by a loss of market confidence to inflate away part of the debt it ran up during World War I.
And even that wasn’t a catastrophe for the real economy; the French economy actually grew quite rapidly during the 1920s.
Bottom line: Is the United States likely to face a debt crisis anytime soon, or even in the next decade or two? Almost surely not. And if you’re worried about the longer run, I’d suggest that you pay less attention to the possibility of runaway debt and more to what increasingly looks like runaway climate change.
Paul Krugman | The New York Times (CREDIT: Fred R. Conrad)
This article originally appeared in The New York Times.