During a radio debate in 1933, the British economist John Maynard Keynes said, "You will never balance the budget through measures which reduce the national income." In an attempt to forget this lesson and repeat the mistakes of 1937, the United States is set to put the sequestration into motion in a few weeks. This package of quickly enacted cuts will try to balance the budget by destroying a million jobs in the next two years and taking a chunk of GDP off growth.
President Obama is likely to call for replacing this sequestration with a deficit reduction plan of $1.5 trillion over the next 10 years in his State of the Union tomorrow night. This is as the deficit is falling quickly, from 7% of GDP in 2012 to a projected 5.3% this year. Obama's target number would build off the $2.4 trillion in deficit reduction already in place through the Budget Control Act and fiscal cliff deal for a total of nearly $4 trillion.
But what if we needed significantly less than $1.5 trillion at this point? What number would be necessary, under what conditions? Richard Kogan of the Center on Budget and Policy Priority (CBPP) has called for $1.4 trillion. There's been an interesting pushback against this argument from Ethan Pollack of the Economic Policy Institute (EPI), who argues that CBPP's numbers are far too high and that the debt-to-GDP -- or debt ratio -- can be stabilized with less than half of that. Let's summarize this debate here.
If stabilizing the debt is the goal, everything depends on what we mean by stabilization. CBPP wants to stabilize the debt ratio with two conditions. The first is that it will be at the current rate of 73%, and the second is that it will occur by 2022, or within a 10-year window. Here is EPI's chart showing the current trajectory and the numbers proposed by CBPP and President Obama:
What Pollack notes is that if you relax either assumption, you can still have stabilization but at a significantly lower level of deficit reduction. If we relax the 73% requirement, and we target a debt-to-GDP level that is lower in 2022 than it was in 2018, we'd only need $670 billion dollars in deficit reduction with $580 coming from policy savings (and the rest from interest). That's a lot less in brutal cuts while the economy is still weak. This would still stabilize the debt, as the debt-to-GDP ratio starts to decline. It would just stabilize it at a higher level.
What if we want a debt ratio of 73%, but we relax the time constraint? What if we worry less about an arbitrary 10-year limit and look at the long run? If we want to stabilize the debt outside the 10-year window at the current rate, we'd need a long-run deficit of 3%. That would only require $500 billion in cuts, of which $430 billion is policy savings. This is still long-run stabilization, which is what we'd want, rather than stabilization while the economy is still weak.
So we can have stabilization with significantly less upfront costs. But why focus on a number like this at all? Pollack also argues that this magic number approach is dangerous in two additional ways. A single number losses all the stuff that is important about the actual cuts. Are they phased in only after unemployment is low? Are they from reductions in spending on the automatic stabilizers keeping the economy afloat, like food stamps? Do they include measures that are good for the long term, like a carbon tax? Like trying to figure out your health by only looking at your weight, using a single number to try and capture a large phenomenon confuses all the things that we know are important.
Also, having a single number presented this way gives the impression that additional stimulus deployed in the next few years would add to the number. If we need $1.4 trillion in cuts to stabilize the debt over 10 years, but want to do an additional $500 billion dollar stimulus in the next two, we don't need $1.9 trillion all of a sudden. Stabilization still takes place, just at a higher level.
Jared Bernstein of CBPP responds, arguing that "a) stabilizing at a lower level leaves us less exposed to higher interest payments when rates finally start to rise, and b) it will be a heavier political lift to argue for a cyclical deficits next time we hit a rough patch if we're starting at 85% vs. 73%."
I would note a few things. The first is, for all the theorizing, economists are deeply conflicted about whether or not a higher vs. a lower debt-to-GDP level matters. Right now, rather than just crowding out private investments, there will be a strong pull to crowd in actual economic activity. Or, to put it another way, when there's a fiscal multiplier, increases in debt can help offset themselves -- we could end up with a higher debt but a lower debt-to-GDP ratio.
Beyond that though, it isn't clear that the level of debt would impact interest rates or if they would make us richer or poorer, even at full employment. A larger pool of debt at full employment might just increase savings, through a mechanism economists call Ricardian equivalence, which will lower interest rates. There are many different ways of understanding how these relationships could happen. Economists are divided on this; it's not for nothing that Glenn Hubbard, in 2011, wrote that when it comes to the relationship between government debt and interest rates, "despite the volume of work, no universal consensus has emerged."
We could use more cost-benefit analysis on this matter. Assuming a worst-case scenario that we are currently at full employment, so additional deficits are crowding out private investment, how different would interest rates be if we have an 80% debt ratio vs. a 73% debt ratio? Again, this evidence is mixed, but Eric Engen and R. Glenn Hubbard found that a 1% increase in debt-to-GDP increases government interest rates two basis points. So we are talking about the bad case scenario having an 0.16% increase in government interest rates. That's not trivial, but it also isn't a doomsday scenario. And this bad case scenario is going to be avoided by prioritizing cuts that could put a serious hamper on both demand and long-term investments? Is this really an exercise worth taking?