Will the Run-Up in Government Debt Doom Us All?

By Stephanie Kelton

Arthur Laffer has taken aim at Chairman Bernanke and President Obama, warning that somewhere down the road their policies will exact a huge price on the American economy. With respect to the Chairman’s handling of monetary policy, Mr. Laffer predicts “rapidly rising prices and much, much higher interest rates.” I am not going to critique Laffer on this point, because Paul Krugman and Mark Thoma have already done so in fine form.

Instead, I want to address Mr. Laffer’s fiscal concerns. He said:

“Here we stand more than a year into a grave economic crisis with a projected budget deficit of 13% of GDP. . . With U.S. GDP and federal tax receipts at about $14 trillion and $2.4 trillion respectively, such a debt all but guarantees higher interest rates, massive tax increases, and partial default on government promises.”

I believe that he is wrong on each of the above points, and here is why:

1. Increases in the federal deficit tend to decrease, rather than increase, interest rates. This is because deficit spending leads to a net injection of reserves into the banking system. (And big deficits imply big injections of reserves.) When the banking system is flush with reserves, the price of those reserves – in the U.S. the federal funds rate – is driven to zero (yes, zero!). Unless a zero-bid is consistent with Fed policy, the central bank will begin selling bonds in order to drain excess reserves. The bond sales continue until the fed funds rate falls within the Fed’s target band. The Federal Reserve sets the key interest rate in the U.S., and it can always hit any nominal interest rate it chooses, regardless of the size of the budget deficit (or debt). And this isn’t just true of the Fed. Just look at the Japanese experience:

Thus, despite a debt-to-GDP ratio in excess of 200%, the Bank of Japan never lost the ability to set the key overnight interest rate, which has remained below 1% for about a decade. And, the debt didn’t drive long-term rates higher either. The chart below shows that rates on 10-yr government bonds trended sharply downward as Japan’s public sector debt exploded:

Laffer’s prediction about what will happen to U.S. interest rates as a consequence of the Obama stimulus package are based on a faulty understanding of the relationship between deficit spending, bank reserves and interest rates. The Japanese experience serves as prime example of his flawed logic. (My fellow bloggers, Scott Fullwiler, Randy Wray and I have all published numerous articles that lay out the technical details surrounding the coordination of Treasury Fed operations and the management of U.S. interest rates.)

2. Increases in the federal deficit (and the subsequent run-up in outstanding debt) do not mandate higher taxes in the future. Taxes do not “pay for” the deficits we ran in the past. Taxes drain reserves (an important function) and constrain aggregate demand. Tax revenue obviously moves endogenously, with the business cycle, but revenues can also change as a matter of policy. What Mr. Laffer is apparently arguing is that today’s deficits will require “tomorrow’s” leaders to raise marginal tax rates (or impose new taxes). But this isn’t the U.S. experience.

Corporate taxes, as well as taxes on the wealthiest Americans, have trended downward for decades, even as the U.S. debt quadrupled in size.

And, while payroll taxes have risen steadily over the past 40 years, tax revenues, as a percentage of GDP have hardly budged in more than 50 years.

Thus, Laffer’s assertion that the current run-up in government debt will require “massive tax increases” isn’t borne out by our experience. And, it wasn’t the case in Japan either:

Despite an explosive increase in the government debt in both the U.S. (throughout the 1980s and again under George W. Bush) and Japan (especially in the late 1990s and early 2000s), taxes in both countries are among the lowest in the developed world.

3. Laffer contends that a “partial default on government promises” is an inevitable consequence of the Obama administration’s “ill-conceived” fiscal policies. A statement like this is at best misleading and at worst intellectually dishonest.

As any serious macro economist knows, a government like the United States – i.e. one that controls its own currency – can meet any and all outstanding financial obligations, provided the debts are denominated in the national currency. This is a point that Alan Greenspan made several years ago, when he wrote that “the U.S. government, by virtue of its ability to create money, can never become insolvent with respect to obligations in its own currency.”

12 responses to “Will the Run-Up in Government Debt Doom Us All?

  1. This was a very interesting article and analysis that uses limited statements to make an argument. For example, in the last paragraph the author stated that the United States can never become insolvent or bankrupt since it can legally print as much money as it needs. While the statement is true it takes a very legalistic view of being insolvent. If the US can always print more money it can never be insolvent. However, regardless of the amount of money created if it becomes worthless for international transactions then the US is essentially insolvent.While I find the article interesting intellectually I strongly disagree with the analysis taken since the author is using statistics to draw the wrong conclusions.

  2. Dear AnonymousThank you for the comment . . . the first on the site!Respectfully, it seems you are now the one using limited statements to make a rather complex point, as you are assuming there will be inflation . . enough to make the currency "worthless" . . . without any discussion regarding precisely how this happens or how much inflation this would create (is there 5% inflation? 10%? 100%?) Furthermore, if there is the chance of rising inflation at some point in the future, the government can (and should) obviously run smaller deficits (even surpluses) at that point to reduce that likelihood, no?Best wishes,Scott

  3. I think most people understand that sharply higher federal debt will require some combination of three facilitating responses:A) increasing real GDPorB) sharply reduced federal deficitsorC) reduction in the value of the outstanding bonds through inflation and most likely:D) some combination of these 3.If you suggest otherwise, it would be very interesting.

  4. HalI would suggest otherwise because the issue isn't the debt but the debt service, which is a policy variable as Stephanie explained (also, for your "c," the government need not sell bonds in the first place, and this wouldn't necessarily be more inflationary then selling them, and could be less so). If debt service is negligible, as it has been in Japan, then you have your "otherwise," though obviously rising real GDP would be the preferred result.Best,Scott

  5. "Increases in the federal deficit tend to decrease, rather than increase, interest rates. This is because deficit spending leads to a net injection of reserves into the banking system."Could you be a little more precise? Are you talking about a money or bond financed deficit. A bond financed deficit does not increase reserves from the banking system. It takes cash out, and therefore leads to higher rates.Also, you are missing the deeper public finance aspects of higher debt levels. The government has to pay interest on that debt which in turn means it can not pay for other public expenditure, say a national health service. Of course, the higher interest payments could be financed by higher debt issuance, but then the US economy starts to look like a Ponzi scheme, and didn't the US courts just send some old fool to prison for jus that crime only yesterday?This can't be a good thing.Alice

  6. Dear AliceEVERY TIME the government spends it raises reserves. Whether bonds are sold or not depends upon how the central bank achieves its interest rate target, and thus whether reserves need to be drained. There is no difference between "financing" deficits with bond sales or "monetization." The only issues are (1) the size of the deficit, since that affects aggregate demand, and (2) how the central bank sets the interest rate target, since that determines whether bonds must be sold by either the central bank or the Treasury.The distinction is only possible where a government is under a gold standard or currency board. Your analysis here and in other posts (unwittingly, it appears) assumes such a regime is in place, when in fact it obviously is not.Regarding debt service, this is mostly a policy variable under flexible exchange rate systems such as ours. So, we see, much as in Japan, long-term Treasury yields remaining at historical lows even with the largest deficits as % of GDP since WWII. Indeed, I'm still waiting for individuals who analyze deficits as you do to explain why interest rates have remained low in the US and in Japan . . . it simply doesn't fit your model.Best,Scott

  7. Dear AliceEVERY TIME the government spends it raises reserves. Whether bonds are sold or not depends upon how the central bank achieves its interest rate target, and thus whether reserves need to be drained. There is no difference between "financing" deficits with bond sales or "monetization." The only issues are (1) the size of the deficit, since that affects aggregate demand, and (2) how the central bank sets the interest rate target, since that determines whether bonds must be sold by either the central bank or the Treasury.The distinction is only possible where a government is under a gold standard or currency board. Your analysis here and in other posts (unwittingly, it appears) assumes such a regime is in place, when in fact it obviously is not.Regarding debt service, this is mostly a policy variable under flexible exchange rate systems such as ours. So, we see, much as in Japan, long-term Treasury yields remaining at historical lows even with the largest deficits as % of GDP since WWII. Indeed, I'm still waiting for individuals who analyze deficits as you do to explain why interest rates have remained low in the US and in Japan . . . it simply doesn't fit your model.Best,Scott

  8. I heard this "National debt does not matter" argument before but I never really understood it. The argument always goes like this: since US government can print as much money as she wants to pay down the debt, debt means nothing. This sounds like a perfect set up for US financially. I am just wondering why US even needs to produce anything? Why any citizen in US still needs to pay tax? Us can simply import everything from abroad, then pay those goods or services in dollar bills, either in paper form or in digital form. Am I in Alice's wonderland or not? Are those foreigners that stupid?

  9. Anonymous, you misunderstand the purposes of taxation. The primary reason the public accepts what we call "fiat currency" is because the public has tax liabilities to the government. If the tax system were removed, the government would eventually find that its fiat money would lose its ability to purchase goods and services on the market.The second point is that taxation does not exist to raise revenue or "fund" the government, but as a means of controlling aggregate demand. Taxation in broad terms can also be thought of as leaving room for the government to spend without creating inflation. The government has this unique ability to create new net financial assets. Left unconstrained (in a political sense) it could create inflation, but taxation serves to mitigate that threat.

  10. I recently came across your blog and have been reading along. I thought I would leave my first comment. I don't know what to say except that I have enjoyed reading. Nice blog. I will keep visiting this blog very often.Lucyhttp://forextradin-g.net

  11. what is the difference between gross debt anet debt in the above chart?

  12. Gross debt is simply the stock of outstanding government debt. Net debt is the difference between gross debt and the financial assets that government hold. In some cases the government (at large) holds some of its own debt in pension funds for public employees or the social security trust fund (this is why in the US the most common measure of government debt is “debt held by the public,” which is very similar to the concept of net debt), this debt is not a liability for the government.