Why the recession, not the fiscal deficit, should scare us right now
Despite a lagging economy and another spike in coronavirus cases, it looks like a stimulus package will not be passed before the election. Congress remains largely divided — a stark difference from the unity shown in April, when the $2.2 trillion CARES Act passed in the Senate with a 96–0 vote. So, what has changed?
America’s Big Debt Problem
Although there is a general agreement in Congress about the need for a new stimulus deal, fears about the national debt have risen to the forefront. According to Senate Majority Leader Mitch McConnell,
“Given the extraordinary numbers that we are racking up to the national debt…We can’t borrow enough money to solve the problem indefinitely.”
This is in sharp contrast to calls from Jay Powell, Chairman of the Federal Reserve, who continued to appeal to policymakers about the risk of not doing enough:
“Too little support would lead to a weak recovery, creating unnecessary hardship for households and businesses. By contrast, the risks of overdoing it seem, for now, to be smaller. Even if policy actions ultimately prove to be greater than needed, they will not go to waste.”
In this context, how should we reconcile the fiscal costs of another stimulus package with the very real economic consequences of its absence?
The Deficit Myths
To help sort through the roots of our concerns about debt, it would be helpful to revisit a few myths about the government deficit that — despite its popularity — actually do more harm than good.
Myth #1: The government should budget like households
The old-fashioned view that governments — like people — must tighten our budget during tough times is misleading for a number of reasons. First, this view neglects the multiplier effect of government spending, which states that spending helps to boost income and growth by kicking off a chain of reaction throughout the economy.
To understand how this multiplier works, suppose that the government invests into a public road project by hiring unemployed workers. These workers now have income to spend at local businesses, who then, to meet this extra demand, decide to hire more workers. And so while the initial investment may have an initial fiscal cost, this multiplier ultimately boosts economic growth through these knock-on effects.
The fiscal multiplier effect becomes even more powerful during a recession: During the 2008 Financial Crisis, a dollar in government spending effectively created $1.50 for everyone else, as shown in the figure below.
Second, while cutting spending does reduce economic burdens for households, there is little evidence that this is true for governments as well. In fact, past austerity measures — meaning budget cuts — have actually slowed growth by slashing everyone’s spending at the same time.
For an example, look at Europe’s response to the Financial Crisis, where fiscal tightening reduced GDP growth by 10% compared to the US, according to the Institute of International Finance. While the US increased government spending to pull ourselves out of the recession, Europe tightened its purse strings — to dire consequences.
Myth #2: High debt is unsustainable in the future
Perhaps an even more popular myth is that that the deficit will become unsustainable in the long run, a result of rising interest rates that lead to a higher debt burden. According to Rand Paul:
We’re paying for our debt at historically low interest rates…But many of us have lived through a time when interest rates were much higher…If interest rates go back to the historic average we will be swamped in debt.
While this is a logical intuition — after all, interest rates are an important consideration when thinking about debt — the reality is that interest rates will most likely remain at historic lows for the foreseeable future; even the Federal Reserve re-affirmed this fact with their recent change in monetary policy. This means that the debt burden will be significantly less than it would be in the high-interest environment predicted by deficit hawks.
So Is Debt A Good Thing?
The answer is no, but it isn’t necessarily bad either. This is not to say that Congress should have unlimited spending power, but the decision on how much to spend should be guided by economic realities rather than premature worries about the national debt. Sadly, deficit hawks seem to have missed — or downright ignored — this conclusion.
Meanwhile, what is harmful is Washington’s overblown concern about runaway debt. While austerity measures masquerade as fiscal responsibility, in practice, they get in the way of effective policymaking.
Given that the economy, not the fiscal deficit, should be our immediate concern, I have two alternatives for how to rethink our debt problem.
Solution #1: Invest Effectively
Rather than shooting down any spending programs on the basis of its fiscal costs, a program should be evaluated on its ability to benefit the economy. Similar to how corporations make investment decisions, if a project can be funded cheaply and generate high returns, then we should go ahead and borrow.
In terms of policy, this means prioritizing areas where spending will have the highest impact:
- State/Local Government Funding
This cost-benefit analysis also helps to promote sound debt management, ensuring that the degree of spending is justified by its potential benefits to the economy. More importantly, this conversation will reflect meaningful policy debates about how to prioritize our investments rather than a misconception about the national debt.
Solution #2: Embrace the business cycle
Fears about the deficit always peak at precisely the wrong time: when the economy is weak and the fiscal cost of debt is lowest. This is understandable, since high unemployment and lower tax revenues will automatically shrink the budget, even without the added costs of a stimulus deal.
Yet despite our concerns about excessive spending, it’s also important to think about the counterfactual. With monetary policy reaching its limit, 12 million people still unemployed, and the economy at a standstill, now is not the time to act on those concerns.
It’s like that old driving lesson: when your car begins to swerve, that’s when you should steer into the skid.