Kill export subsidies. Kill the Ex-Im Bank.

Kill export subsidies. Kill the Ex-Im Bank.

Imagine the Chinese government decides to help the people of Kenya. To do this the Chinese government buys 5,000 wheeled loaders and excavators from Liugong Machinery and gives them for free to the Kenyan government, Kenyan construction firms, and groups of Kenyan citizens who want to build roads and stuff.

(Real world export subsidies are much smaller, of course, but the principle is the same. Foreign customers of a domestic exporter get taxpayer-subsidized discounts, not totally free stuff.)

Who wins? Kenyan customers and Liugong’s owners and employees, who now have a huge increase in demand for their product.

Who loses? Chinese taxpayers, who must foot the bill, and the owners and employees of Liugong’s Chinese and foreign competitors, who don’t have this generous taxpayer-subsidized benefit and can’t possibly compete with free.

Now let’s journey to America to meet an (imaginary) executive from Caterpillar, an American firm competing with Liugong to sell wheeled loaders and excavators to Kenyans. Caterpillar can’t give their product away, they need to sell it. This executive goes to a U.S. policymaker and asks for a similar export subsidy to what Liugong received from the Chinese government.

Imaginary Caterpillar executive: “Caterpillar is losing business in Kenya to our Chinese competitor Liugong. The Chinese government buys equipment from Liugong and gives it to Kenya. The U.S. government needs to do the same for us. If they don’t we’ll completely lose the Kenyan market to the Chinese. American taxpayers need to put up money to buy Caterpillar wheeled loaders and excavators and then give that machinery to Kenyans. If you don’t, we’ll lose that export business and American jobs.”

American policymaker: “Let me get this straight. We should take money from American taxpayers, use it to buy equipment from your company, and then give that equipment to the Kenyans, all because the Chinese are doing the same thing with your competitor?”

Cat exec: “I agree it sounds silly, but if you don’t do this we’ll lose American jobs. It would be better if neither China nor the U.S. did this, but as long as the Chinese do, you have to as well. Unless you want to put America at a competitive disadvantage and lose the Kenyan heavy equipment market…”

American policymaker: “There’s a difference between what’s good for America and what’s good for one firm in America. China’s policy puts one American company (yours) at a tremendous disadvantage in winning business in one foreign market. I feel bad about that, but I’m not sure the solution you propose makes things better for America as a whole. For instance, while I like Kenya, aren’t you asking me to have American taxpayers subsidize your Kenyan customers? That’s not my policy goal. If I wanted to help Caterpillar owners and employees, wouldn’t it be more efficient to just have the U.S. government write a check to Caterpillar? That way we wouldn’t dilute the help by giving most of it to foreigners.”

Cat exec: “Yes, that would be more efficient, but we both know there’s no way you could sell that to Congress or the American public.”

American policymaker: “So you want me to support a less efficient policy because the more efficient one would be unpopular. What about your American competitor John Deere? Wouldn’t I be giving you an unfair advantage over them?”

Cat exec: “Well, technically, yes, but…”

American policymaker: “Technically nothing. You’re asking me replace one tilted playing field with another. And what if China decides to do the same thing for the Rwandans? Do I have to match those subsidies as well?”

Cat exec: “Unless you want us to lose that business, sure…”

American policymaker: “What if Liugong got its subsidy from the Chinese government through less-than-noble means? What if a Liugong executive’s brother-in-law’s cousin is the guy who works for the key Chinese decision-maker? Are you saying that U.S. taxpayers should target American subsidies for American firms to match foreign subsidies determined by cronyism in a foreign government? Is that right? Where does it end?”

Cat exec: “Well, when you put it that way it doesn’t sound quite as attractive. But surely you don’t want America to unilaterally disarm.”

American policymaker: “Sorry, but I don’t buy your ‘disarmament’ analogy. China’s export subsidies of Liugong don’t only hurt Caterpillar, they also hurt Chinese taxpayers and Liugong’s Chinese competitors. They distort decisions and redistribute economic resources in China in ways that make their economy less efficient. While they undoubtedly help Liugong’s owners and employees, China’s export subsidies harm other parts of the Chinese economy. You’re asking me in turn to help your firm’s owners and employees at the expense of American taxpayers and the owners and employees of your American competitors. I don’t see why I should replicate their mistake here, even the alternative is that your firm loses the Kenyan market to Chinese subsidies. Seems to me the alternative you propose is better for Caterpillar but worse for America as a whole. A better analogy would be if you said I should not quit smoking until all my friends also quit. I should quit smoking if it’s healthier for me even if my friends continue to smoke. If China wants to harm itself, there’s no reason I should do the same just to match their mistake.”

Cat exec: “And therefore you’re going to force Caterpillar to compete on an unlevel playing field with Liugong. You’ll be responsible for the layoffs at Caterpillar that result because you refused to help us.”

American policymaker: “The alternative is that you want me to force American taxpayers to subsidize foreign consumers and the owners and employees of one American firm, and to create a new titled playing field at the expense of the owners and employees of your American competitors, based in part upon decisions made in foreign capitals that may have been determined by cronyism. You agree that this policy is less efficient than one that would be unpopular in the U.S., and you’re advocating this one because you think you can disguise that it’s a worse policy. No thank you.”

Cat exec: “How about if, rather than buying the equipment in total, you just give us a partial taxpayer subsidy? We can make it either a direct subsidy or a taxpayer-backed loan guarantee, and we can do it through the government run Export-Import Bank. That way nobody will understand it.”

My view

The U.S. government should not engage in industrial policy, choosing to help certain American firms and thereby indirectly punishing other American firms. Government should not be picking winners and losers.

American taxpayers should not be subsidizing any particular subset of American business owners and/or workers. American taxpayers should also not be subsidizing foreigners, even when they are foreign consumers of American exports.

Export subsidies are bad policy. Even when well-intentioned and designed to “level the playing field” to match other countries’ export subsidies, they create other tilted playing fields and do more harm to the economy as a whole than the problem they purport to solve for one firm. They also create opportunities for cronyism and other forms of influence-based rent-seeking.

Deep and liquid private credit markets exist today that did not exist when the Export-Import Bank was created in the 1930s. Ex-Im’s primary function now is to pass though implicit taxpayer subsidies to a select group of American firms.

Export subsidies should be eliminated and the Ex-Im Bank should be killed. Export credit finance should be done, without subsidies, by private markets.

 

Ryan v. Obama on short-term deficits

House Budget Committee Chairman Paul Ryan released his proposed budget resolution today. As I’ve done in the past I’m going to compare his proposal to the President’s budget. I’d like to include Senate Budget Committee Chairman Patty Murray’s proposal but she has chosen not to do a budget this year.

In this post I’m just going to compare the short-term deficit and debt effects of the two proposals. While I’d like to use comparable numbers, CBO has not yet rescored President Obama’s proposal because the President released his budget six weeks late. So for now I’ll compare Ryan’s numbers to Obama’s. That is suboptimal but the best we can do for now, and I am confident it doesn’t change the overall picture. Let’s start with deficits.

 

ryan v obama short-term deficits (apr 2014)

A few things jump out.

  • Chairman Ryan’s deficits are lower than President Obama’s throughout the budget window.
  • The difference is significant in the early years.
  • President Obama’s budget would reduce deficits below their historic average only after he leaves office.
  • The gap between the two stabilizes around 1.5 percentage points of GDP.
  • Chairman Ryan’s budget gets to balance, President Obama’s does not.

The most politically potent aspect is balance vs. no balance.

Now let’s compare the short-term debt effects of the Ryan and Obama budgets. Debt held by the public is (sort of) the accumulation of past deficits and a few surpluses.

ryan v obama short-term debt (apr 2014)

 

  • Both propose to reduce debt/GDP over the next decade.
  • Chairman Ryan’s debt is in all cases lower than the President’s.
  • Over time the difference is significant: Ryan’s 10th year level is 13 percentage points lower than Obama’s (caveat: This will change a bit when we get the CBO rescore of the President’s budget).

The notable points here are (1) the growing gap over time and (2) the President’s decision to reduce debt/GDP over time, albeit slowly. In past years he was content to stabilize debt/GDP in the short run.

Fiscal politics and strategy

At first glance the Obama and Ryan budgets appear quite similar to what each proposed last year. Because the downward slope is so gentle, President Obama’s declining debt/GDP path is more significant politically than as a policy matter. It allows him to say his budget would reduce debt over time, at least in the short run. He couldn’t say that last year.

In this midterm election year, Chairman Ryan has offered House Republicans a tremendous political advantage: BALANCE. This reminds me of 2011.

The two political parties have traditionally competed over which party was “the party of lower deficits and less debt.” Many elected officials and their campaign advisors have traditionally seen significant political advantage in labeling their opponents as being for higher deficits and more debt.

This debate is somewhat silly, as the principal fiscal policy difference between the two parties has usually been more about the size of government than about which party wants to borrow less from the future. Nevertheless, the political effects of deficit/debt comparisons are significant.

The same is true for a balanced budget. The economic difference between balance and a 1 percent deficit is not dramatically different from the difference between a 1 and a 2 percent deficit. But the politics of a balanced budget can be powerful.

In 2011 President Obama proposed his budget in February. Chairman Ryan then proposed a budget with a significantly more aggressive deficit and debt reduction path, thus seizing the political advantage in this partisan competition. The numbers clearly showed that (House) Republicans were for much lower deficits and debt than the President.

And then the President modified his budget in April, proposing significantly lower deficits than he did two months prior. He purported to match the deficit reduction in the Ryan budget–this was a lie, but he claimed it. (See Bob Woodward’s book for details on both the internal process and the lie.) What’s significant today is that in 2011 President Obama reacted to the political weakness he then faced by being for higher deficits and debt than House Republicans. He proposed more policy changes, some of which involved more political pain, just so the could claim to match House Republicans on deficits and debt.

Fast forward three years. It’s happening again.

Chairman Ryan has teed up a significant political tool for House Republicans: they can be for a balanced budget, in contrast both to President Obama’s higher deficits and debt and to the Senate Democrats’ lack of a budget.

This is a potent weapon for the mid-term election battle. Congressional Republicans can be not just opposed to something unpopular (Obamacare, of course), but for something popular. They can expand their topline economic message to have three legs rather than just one.

  1. The Obama economic recovery is terribly slow [and we can fix it over time through pro-growth policy changes].
  2. I voted for a balanced budget and long-term entitlement reforms. [The President's budget doesn't balance. Senate Democrats don't have a budget.]
  3. I want to repeal Obamacare [and replace it with (choose your favorite reform alternative)].

I’ll end with three important strategy questions:

  1. Are House Republicans a governing majority? Ryan’s balanced budget provides a political advantage only if House Republicans pass it. Can Chairman Ryan and Boehner/Cantor/McCarthy find 218 R votes for the Ryan budget?
  2. Will Republicans recognize the political and rhetorical advantage that a balanced budget gives them and integrate it into their core election message, putting it on a level playing field with both “weak Obama recovery” and Obamacare? Or will they bet all their mid-term election prospects on a single issue?
  3. Will President Obama react to House passage by modifying his budget proposal as he did in 2011? Or will he cede the rhetorical high ground on deficits, debt, and a balanced budget in favor of attacking the details within the Ryan budget?

 

Response to the President’s comparison to European growth rates

At that Manhattan fundraiser last night President Obama repeated one of his more frequent recent economic lines:

Over the last five years, our economy has recovered faster and stronger from the worst financial crisis and economic crisis since the Great Depression, better than any other developed country on Earth.

President Obama’s is drawing on the Economic Report of the President released by his Council of Economic Advisers on Monday. Here is the relevant chart, showing the U.S. at a higher relative GDP level than the major European economies, with 2007 as the starting point for the comparison.

Figure 1-4 -- GDP Per Working Age Population in Crisis Countries R2

Here is the CEA’s accompanying text:

[A]mong the 12 countries that experienced a systemic financial crisis in 2007 and 2008, the United States is one of just two in which output per working-age person has returned to pre-crisis levels. The fact that the United States has been one of the best performing economies in the wake of the crisis supports the view that the full set of policy responses in the United States made a major difference in averting a substantially worse outcome—although it in no way changes the fact that more work remains to be done.

(Technical note: “GDP per working-age population” is weird. I wonder what this same comparison with the more conventional “GDP per capita” looks like.)

This provokes three responses.

1. Apparently we’re supposed to feel good that the U.S. economy has grown more rapidly than the major European economies. But Europe had a second financial crisis during this time period, one which might still not be over! So the U.S. economy, recovering from one severe financial crisis in the past six years, is performing better than the European economies which have suffered two crises during that same time? Talk about setting a low bar.

2. While a relative comparison might in theory be interesting, it’s not very useful. We should care about how the American economy is doing in absolute terms, and relative to the potential of the U.S. economy. Is the U.S. economy growing as fast as it possibly can? How big of an output and employment gap do we have to close? (Answer: we’re about 6 million jobs short.) If Europe were to go into recession the relative U.S. position would be even stronger, but surely that wouldn’t be a good thing, right? We should want the U.S. and Europe both to grow faster, even if that were to mean a smaller relative advantage for the U.S., yes? Greater relative growth doesn’t teach us much that we can use.

3. The conclusion that “We’re growing faster than Europe so therefore our policies worked” makes no sense to me. And I write this as someone who helped enact and implement some of those U.S. policies (including TARP, the money market mutual fund guarantees, and the first tranche of auto loans). I think some of these policies worked as desired and helped end the financial crisis and make the ensuing recession shallower. I differ with Team Obama on how much the fiscal stimulus in particular contributed to those positive growth effects, and whether the additional growth from fiscal stimulus was worth the added debt costs. But whatever conclusion you reach about the growth benefits of any of those policies, you can’t get there from comparing the recent U.S. growth path to that of Europe. There are way too many other things going on, both in the U.S. and especially in Europe with its two crises, for anyone to be able to isolate the effects of just the U.S.-specific policies. If you want to argue that the U.S. policies worked as intended, you need to find another way to make the case.

I think the President’s statement, that the U.S. economy has recovered more rapidly than other major developing economies, is technically correct. But it’s a sad thing to boast about, it’s not a meaningful measure, it’s not the standard we should use, and it doesn’t support the argument that U.S. policies made a major difference in averting a substantially worse outcome.

Response to the President on economic anxiety

Response to the President on economic anxiety

At a Manhattan fundraiser this evening President Obama said the U.S. economy has “bounced back”:

Over the last five years, our economy has recovered faster and stronger from the worst financial crisis and economic crisis since the Great Depression, better than any other developed country on Earth.  And you can take a look at the charts and see that because of the actions we took — because of the Recovery Act, because of the Fed — because of swift, coordinated action, we have bounced back.

We’ve created 8.5 million new jobs over the last five years. We’ve had four years of consecutive job growth as well as economic growth.  We have seen an auto industry that was basically flat-lining rebound in ways that very few people would have anticipated.  The stock market is close to the highest that it’s ever been; close to $10 trillion of wealth has been recovered that was lost.

Presidents always want to be optimistic, but even so this is a very positive framing. He then offers his analysis of why, notwithstanding this good news, Americans are so “anxious and uncertain” about their economic future:

That’s not bad.  And yet, if you talk to folks around the country, there is still enormous anxiety and people feel uncertain about their futures, and more importantly, their children’s futures.  And why is that?  Because although we have rebounded and we are growing and there are all kinds of indicators that tell us that the 21st century can be the American Century just like the 20th was, that growth has been uneven and the beneficiaries of that growth have been uneven.

Set aside for the moment the irony of President Obama saying the problem is increasing income inequality when speaking at a $32,400/plate fundraiser in Manhattan. There’s a better explanation than the increasing income inequality explanation offered by the President. CBO gives it to us:

Employment at the end of 2013 was about 6 million jobs short of where it would be if the unemployment rate had returned to its prerecession level and if the participation rate had risen to the level it would have attained without the current cyclical weakness.

President Obama’s thesis is that the economy has “bounced back,” things are looking pretty good in the aggregate, and people are down because income inequality is increasing and the middle class isn’t benefiting sufficiently from economic growth.

The reality is that the economy is growing, but way too slowly, and only fast enough to roughly keep up with population growth. The economy is still about 6 million jobs short of where it should be if it were firing on all cylinders. Income inequality is increasing, but that trend goes back to the 1970s. It’s not a credible explanation for recent economic pessimism.

President Obama’s diagnosis is wrong in two respects. While the economy is growing slowly, it has not “bounced back.” And people are pessimistic about the economy because there aren’t enough jobs, period. Even worse, President Obama has no proposal to even try to fix that.

(photo credit: Family O’Abé)

Defense v. ObamaCare

DEFENSE SECRETARY HAGEL: To close these gaps, the President’s budget will include an Opportunity, Growth and Security Initiative.  This initiative is a detailed proposal that is part of the President’s budget submission.  It would provide an additional $26 billion for the Defense Department in Fiscal Year 2015.

defense v obamacare v2

Source for $88 B number: Congressional Budget Office, “Insurance Coverage Provisions of the Affordable Care Act–CBO’s February 2014 Baseline,” Table 1 (Net cost of coverage provisions for FY 2015).

Message to Governors: Biden v. Obama

Here is VP Biden, speaking this morning to all Governors:

THE VICE PRESIDENT:  It’s great to see you all.  And I don’t know about you all, I had a great time last night and got a chance to actually do what we should be doing more of — talking without thinking about politics and figuring how we can solve problems.

And here is President Obama, speaking at a dinner last Thursday night to just the Democratic Governors:

THE PRESIDENT: Now, unfortunately, state by state, Republican governors are implementing a different agenda.  They’re pursuing the same top-down, failed economic policies that don’t help Americans get ahead.  They’re paying for it by cutting investments in the middle class, oftentimes doing everything they can to squeeze folks who are bargaining on behalf of workers.  Some of them, their economies have improved in part because the overall economy has improved, and they take credit for it instead of saying that Obama had anything to do with it.  I get that.  There’s nothing wrong with that.  But they’re making it harder for working families to access health insurance.  In some states, they’re making it harder even for Americans to exercise their right to vote.

 

How CBO’s minimum wage analysis changes the debate

How CBO’s minimum wage analysis changes the debate

CBO’s intellectually solid new analysis concludes that the proposal, endorsed by President Obama, to raise the minimum wage to $10.10 an hour by 2016 would result in higher wages for some and destroy jobs for others. CBO’s most important conclusions are that this proposal would:

  • likely result in 500,000 fewer workers, with a range of roughly 0 to 1 million fewer;
  • increase wages for about 16.5 million workers who now have wages between $7.25/hour and $10.10, as well as for some others who now have wages a bit above $10.10.

I think CBO’s analysis is improving the minimum wage debate. President Obama and his allies have been selling this proposal as a free lunch, a policy that will raise pay for some with no costs for anyone: “Give America a raise.” Proponents of raising the minimum wage now must contend with a reputable nonpartisan analysis that the proposal has costs as well as benefits. Congress must decide whether higher wages for some are worth destroying jobs for others. Every responsible news story will now include a sentence like, “At the same time, the Congressional Budget Office projects the President’s proposal would result in lost jobs for half a million low-skill workers.”

I doubt the new numbers will change the minds of many proponents of a higher minimum wage. If you were previously inclined to support an increase, either for policy or political reasons, you can easily use CBO’s analysis to reinforce that conclusion: there are 16-31 times as many winners as losers.

The principal impact will come for a Member of Congress who thinks (knows?) that wage controls are bad policy and who opposes a higher minimum wage on policy grounds but was previously afraid to take the political risk to vote no. CBO has made it easier and more credible for this Member to explain to his or her constituents why he will vote no and why that’s good policy for those trying to enter the workforce. Here’s an example.

Q: Congressman, why do you oppose raising the minimum wage? Don’t you want to give Americans a raise?

A: You’ve heard the saying “There’s no such thing as a free lunch?” The President’s proposal to raise the minimum wage would put between half a million and a million low-skilled people out of work. Sure it would mean higher wages for some, but it would destroy jobs for others, and those others are the lowest wage, lowest skilled workers whom we should want in the workforce. It’s particularly important to have as many low-skill jobs available as employers want to offer so that people can grab the first rung of that ladder of opportunity and start to climb.

I appreciate that others may make a different judgment call, but when our biggest economic problem continues to be that not enough people are working, I want to make it easier for employers to hire people, not harder.

This Congressman or woman (probably a Republican) could have made this argument before CBO’s report, but now he has CBO to back up his numbers and his logic. That helps mostly with the press and also with some voters who are undecided on the merits. In the past Congressional Republicans who opposed a minimum wage increase would typically argue that it “hurts small businesses.” Now they can and should argue that it “will destroy jobs for low skill workers.”

In short, CBO’s analysis makes it easier for a free market member of Congress both to vote against expanding wage controls and to convincingly explain why doing so is motivated by a compassionate goal.

The Obama team had two options in choosing to react to the CBO report. They could have accepted CBO’s analysis, embraced the tradeoff between higher wages and fewer jobs, and used CBO’s numbers to support their judgment call on that tradeoff.

Instead they went the other way, sticking with their disingenuous “free lunch” logic and attacking CBO’s credibility. The path they chose was both intellectually and politically weaker. Now they’re fighting with CBO (rarely is there an upside to that), they’re indirectly highlighting CBO’s conclusions for the press, and they’re fighting what we all learned in first semester microeconomics, that when you raise the price of something people buy less of it. They are also making this not just a dispute about the measure of the costs and benefits, but whether there are any costs to their proposal. They will lose that fight, especially with CBO on the other side.

Team Obama could have argued “We agree with CBO that there are costs to raising the minimum wage, and we think those costs are worth it.” But if they had done this, they would be forced to acknowledge that opponents of raising the minimum wage have a point, that one can want to help poor, low-skilled people and just come to a different conclusion about whether this proposal does so. Had Team Obama granted this point they would have sacrificed their specious claim that opponents of a minimum wage increase hate the poor. This would then become a disagreement about judgment calls on a difficult policy tradeoff (which it is for many), not a battle between the forces of good and evil.

In a market economy prices play the central role in balancing supply and demand. Government should let market forces determine prices. In my view the only case where there’s even theoretical support for government intervention in the price mechanism is when there’s an externality, and even then I’d be cautious to make sure that a well-intentioned but poorly implemented government interference in a market price to address an externality doesn’t do more harm than good.

If you don’t like the results of how a free market allocates resources, then adjust the outcome through explicit after-the-fact transfers, not by interfering in the market mechanism that determines wages or prices. If you want to help the poor more now, expand the Earned Income Tax Credit and use taxpayer dollars to subsidize those lowest on the wage scale rather than forcing an employer to pay them more.

Policies that destroy jobs are bad. Let’s instead maximize the opportunities for people at all levels of education, skills and abilities to find work.

(photo credit: Maryland GovPics)

For every working American

I’ll let President Obama’s words and CBO’s analyses speak for themselves.

THE PRESIDENT: … that has jeopardized middle-class America’s basic bargain — that if you work hard, you have a chance to get ahead.

I believe this is the defining challenge of our time: Making sure our economy works for every working American. It’s why I ran for President. It was at the center of last year’s campaign. It drives everything I do in this office.

Source: President Barack Obama, Remarks by the President on Economic Mobility (The ARC, Washington, DC, December 4, 2013.)


CBO: Once fully implemented in the second half of 2015, the $10.10 option would reduce total employment by about 500,000 workers, or 0.3 percent, CBO projects.

Source: Congressional Budget Office, The Effects of a Minimum-Wage Increase on Employment and Family Income (February 18, 2014) Summary, page 1


CBO: The reduction in CBO’s projections of hours worked represents a decline in the number of full-time-equivalent workers for about 2.0 million in 2017, rising to about 2.5 million in 2024.

Source: Congressional Budget Office, The Budget and Economic Outlook: 2014 to 2024, Appendix C, “The Labor Market Effects of the Affordable Care Act: Updated Estimates” (February 2014) page 117.


CBO: About one-tenth of a percentage point is attributable to the incentives generated in 2013 by extensions of UI benefits (from the usual 26 weeks to as much as 99 weeks), primarily because the program’s rules led some people to remain in the labor force and to continue to search for work in order to remain eligible.

Source: Congressional Budget Office, The Slow Recovery of the Labor Market (February 2014) page 8.


THE PRESIDENT: So our job is to not only get the economy growing but also to reverse these trends and make sure that everybody can succeed. We’ve got to build an economy that works for everybody, not just the fortunate few.  Opportunity for all — that’s the essence of America.  No matter who you are, no matter where you come from, no matter how you start out, if you’re willing to work hard and take responsibility, you can succeed.

Source: President Barack Obama, Remarks by the President on Fuel Efficiency Standards of Medium and Heavy-Duty Vehicles (Safeway Distribution Center, Upper Marlboro, Maryland, February 18, 2014).

Why high government debt is a problem

The Obama Administration is trumpeting that the budget deficit has been cut by half, “the largest four-year reduction since the demobilization from World War II.” Indeed, CBO projects the deficit this year will be 3 percent, maybe dropping a few tenths over the next few years before beginning an inexorable climb driven by demographics, health cost growth, and unsustainable entitlement benefit promises to seniors. If you listen to the President, our only problem is that future one and that’s a few years off. Now that deficits have come down, he says we’re OK for the time being. Deficits around 3 percent will hold debt constant relative to the size of the U.S. economy, and he appears to think that’s fine.

I don’t. Look at this graph from CBO.

deficits-vs-debt

In their recently released annual Economic and Budget Outlook CBO lays out the four costs of higher debt (page 7).

  1. “Federal spending on interest payments will increase substantially as interest rates rise to more typical levels;”
  2. “Because federal borrowing generally reduces national saving, the capital stock and wages will be smaller than if debt was lower;”
  3. “Lawmakers would have less flexibility … to respond to unanticipated challenges;”
  4. “A large debt poses a greater risk of precipitating a fiscal crisis, during which investors would lose so much confidence in the government’s ability to manage its budget that the government would be unable to borrow at affordable rates.”

CBO attributes these damaging effects to “high and rising debt,” and doesn’t distinguish between high (where we are now, in the mid 70s as a share of GDP) and future entitlement spending-driven growth. The same logic applies both to today’s high debt and to future even higher debt. These are real and significant costs we are bearing today.

It’s obvious that we can’t allow debt to increase forever as it will begin to do a few years from now but there’s an additional important question that is being largely ignored. Momentarily setting aside future projected debt growth, is debt/GDP in the mid-70s acceptable? Should the goal be to not let the problem get worse, or both to solve the future debt growth and, over time, to reduce debt/GDP to be closer to the historic pre-crisis average?

CBO has done policymakers a great service by explaining these four costs of high and rising debt, and I wish more members of Congress understood them and talked about them. This is important enough that it’s worth the time to understand it well. You can find a slightly expanded version from CBO on pages 9 and 10 here.

I want to expand a bit on CBO’s points. I’ll take them in reverse order and start with the last one, the increased risk of a fiscal crisis. Those on the left who argue that high debt isn’t a problem like to (a) pretend that this increased risk is the only consequence of high debt, and then (b) dispute that the higher risk is significant enough to cause concern. I worry that when the U.S. has doubled its debt/GDP in five years, and when our future debt path looks like it does, that the risk of a fiscal crisis is significant. But this risk is unknowable, and even if we could somehow measure this risk, we can never know when that crisis would occur. My stronger arguments are (1) fiscal crisis risk is undoubtedly higher at a higher debt level; (2) the risk is only going to increase on our current path as debt increases; and (3) there are three other costs to higher debt, so even if you’re not worried about crisis risk, you need to address those other costs.

Moving up the list we get to CBO’s “less flexibility” point. CBO’s projected debt path assumes a (very) slow but basically steady return to macroeconomic health. If we have another recession, terrorist attack, or war, the numbers will be worse, and whatever increased government spending or fiscal stimulus we will then need will be initiated from a much weaker starting point (a much higher level of debt). Because our debt is so high we are poorly prepared to address future risks that require significant short-term deficit spending or tax relief.

Then we get to the cost with the greatest political impact: lower future wages. This is really a cost of the big recent deficits that resulted in today’s higher debt, and an additional cost of projected future deficit growth. The reduced national saving caused by big deficits leads to a smaller capital stock. This lowers productivity and therefore wages. To reduce our public debt government would have to save more (or even, perish the thought, balance the budget), leading to higher national saving, a bigger capital stock, higher productivity and higher future wages. To be politically crass: lower government debt means more shiny new factories with high wage American jobs. I’m willing to sacrifice quite a lot of government spending in exchange for higher future wages.

Finally, the item at the top of CBO’s list is the one most likely to drive Congressional action. Our government debt is now 37 percentage points above its pre-crisis average, but government interest payments are relatively low because interest rates are low because the short-term economy is still weak. When the economy eventually recovers and the government debt rolls over, that additional debt is going to increase government net interest payments by about 1.85 percent of GDP (37% X CBO’s 5% 10-year Treasury rate). Relative to the rest of the federal budget, 1.85% of GDP is enormous. That increased interest cost is as much as the federal government will spend this year on all military personnel (uniformed + civilian) plus all science, space, and technology research plus all spending on the environment, conservation, national parks, and natural resources plus all spending on highways, airports, bridges, and all other transportation infrastructure. Higher debt means higher interest costs which will squeeze out spending for other things that government does. It will also increase pressure to raise taxes even further.

Government debt is twice as large a share of the economy as it was before the financial crisis. In addition to increasing the risk of another catastrophic financial crisis, high government debt squeezes out other functions of government, creates pressure for higher taxes, leaves policymakers less able to respond to future recessions, wars, and terrorist attacks, and lowers future wage growth. This problem will only increase as entitlement spending growth kicks into high gear a few years from now, but simply stabilizing debt/GDP in the mid 70s is an insufficient goal. Don’t rest on your laurels because deficits are smaller than they used to be. High government debt is a big problem.

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