Debt and deficits: How much is too much?
By D. Eric Schansberg, Ph.D., and member of the Bluegrass Institute Board of Scholars
During the depths of the Great Recession, Kentuckians focused on unemployment and the ineffectiveness of fiscal “stimulus” policies. But now, as the economy has limped forward, the dominant topic is the federal budget: annual deficits, the overall debt and how much is too much.
Across the world, including in Kentucky, trouble with deficits and debt is commonplace as governments too often succumb to the political temptations of using debt (or inflation) to cover their bills.
But until recently, federal budget deficits have rarely been an important topic in the U.S.
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 military spending increased deficits to then-alarming levels. Still, deficits faded in the 1990s with the end of the Cold War and strong economic growth.
It’s only been since 2001 that tax cuts and increases in all types of spending brought big deficits back. After the financial crisis in 2007, the deficit ballooned to historic levels.
So, just 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.
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 rates. But if you’re perceived as a credit risk because your income-to-debt ratio is too high or you haven’t been good about paying back your loans, then you’ll have to pay higher interest rates to acquire loans.
Likewise, if investors perceive a loan to government as risky – given its debt and debt-like obligations such as Social Security, Medicare and government pensions – then investors will require higher interest rates.
And with both personal finances and government debt, higher interest rates are a dangerously slippery slope. Increasing interest rates – combined with the limited financial discipline that led to the problem in the first place – make bankruptcy or default all the more likely.
- Second, some argue for a balanced budget for the sake of itself.
According to this 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: Most people don’t balance their budget in this sense; anyone with a mortgage exceeding their income can attest to that.
Further, spending on certain infrastructure projects can reasonably be financed over long periods of time by incurring debt. After all, should a bridge really be built exclusively by current taxpayers when future taxpayers will also reap the benefits?
Unfortunately, most government borrowing is not for infrastructure projects, but rather for transfer payments and other current services. So, though we might not insist on a balanced budget per se, this point implies that small deficits – for infrastructure only – are most desirable.
The other problem with arguments in favor of a perfectly balanced budget is that it completely ignores vital questions about the size and role of government.
It’s entirely possible to have a government which consumes the entire private sector – which is bothersome ethically and ineffective practically – with absolutely no budget deficit. What good is that?
At the end of the day, the greatest use of a balanced-budget guideline is that it grounds political temptations 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 can pay for its spending in only three ways: 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 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.
Eric Schansberg, Ph.D., is professor of economics at Indiana University Southeast in New Albany, Ind., author of “Turn Neither to the Right nor to the Left” and a member of the Bluegrass Institute Board of Scholars. Reach him at DSchansb@ius.edu