Debt and Deficits: How Much Is Too Much?

Thursday, April 4th, 2013

We had an invigorating conversation on Kentucky Tonight a couple of weeks ago regarding the nation’s on-going debate about the debt and the deficit.
One of our guests continued to think about the topic on his drive back home that evening.

Indiana University Southeast Professor of Economics Eric Schansberg has written a very thoughtful piece which raises some provocative questions for all of us. I offer it as a guest column. Let me know what you think.

“Macroeconomics has been a hot topic for the last five years. During the depths of the Great Recession, the dominant topic was unemployment and the ineffectiveness of fiscal “stimulus” policies. As the economy has limped forward, the dominant topic has become the federal budget—annual deficits, the overall debt, and how much is too much.

Across the world, trouble with deficits and debt is commonplace. It’s always difficult to forgo the political temptation of using debt (or inflation) to pay for government spending. Especially in less-developed countries, leaders often succumb to the temptation.

In the United States, federal budget deficits have rarely been an important topic. In wartime, debt has been used as a temporary emergency measure with relatively little long-term impact. In the 1980s, the growth of domestic and especially military spending increased deficits to then-alarming levels. Deficits faded in the 1990s with the end of the Cold War and strong economic growth. Since 2001, tax cuts and increases in all types of spending brought big deficits back. And after the Financial Crisis in 2007, massive increases in spending have led to historically large deficits.

So how much is “too much”? There are three ways to answer this question. First, it’s clear that excessive debt will lead to higher interest rates—or even default on the debt. Higher interest rates stem from the basic investment relationship between risk and rates of return. If a debt is perceived as relatively risky, then lenders will require higher interest rates to assume that risk.

An analogy to personal finance is useful here: If you have good credit, you can borrow at standard market interest rates. But if you’re perceived as a credit risk—e.g., because your income to debt ratio is too high or you haven’t been good about paying back your loans—then you’ll pay higher interest rates to acquire loans. Extended further, you’ll end up in riskier loan arrangements, such as credit cards, payday lenders, or pawn shops. Likewise, if a government’s debt is perceived as risky—given its debt and debt-like obligations (e.g., Social Security, Medicare, government pensions)—then investors will require higher interest rates.

With both personal finances and government debt, higher interest rates are a dangerously slippery slope. With a high level of debt, increasing interest rates, and the limited financial discipline that led to the problem, paying back debt becomes increasingly difficult. Bankruptcy or default becomes more probable. Obviously, individuals and countries should take great care to avoid this scenario.

Second, many people want the government to have a balanced budget. In their view, any deficit is too much. Again, this has some intuitive appeal from the personal finance analogy: Don’t spend more than you earn. But the analogy fails in at least one way. Spending on infrastructure projects can reasonably be financed over long periods of time, incurring debt to pay for them today. For example, should a bridge be built exclusively by current taxpayers? Note that many people don’t balance their budgets in this sense either — most notably, if one has a mortgage which exceeds income.

All that said, most government spending is for transfer payments and other current services, not infrastructure. So, we might not insist on a balanced budget per se, but this point implies that small deficits—for infrastructure only—are most desirable.

The other problem with a balanced budget is that it completely ignores vital questions about the size and role of government. One might have a huge government— which is bothersome ethically and ineffective practically—with no budget deficit. What good is that?

At the end of the day, the greatest use of a balanced budget guideline (or law) is that it grounds the political temptation in an objective but imperfect norm. And maybe that’s a good idea. If followed, it would certainly prevent default and limit spending shenanigans.

So again, how much is too much?

Let me suggest a third and most valuable answer. In “Economics in One Lesson,” Henry Hazlitt notes that government must pay for all of its spending—through taxes, inflation, or debt (and thus, higher future taxes). So, the relevant question is: When should we use higher future taxes to pay for current spending? In other words, when should we borrow from the future’s prosperity and harm those in the future—in order to enrich those in the present?

The personal finance analogy is again helpful here. When should we use credit cards—to be paid off by future generations—to pay for stuff today? When should we make our children pick up our tab?

If we’re not comfortable with the answer to those questions, then we have too much debt.”

D. Eric Schansberg
Professor of Economics, Indiana University Southeast (New Albany, IN)
Adjunct Policy Scholar, Indiana Policy Review
Adjunct Policy Scholar, Bluegrass Institute for Public Policy Solutions

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