Debt Keeps Rising and Nothing Bad Happens

(Bloomberg View) -- As the Republicans prepare for their big tax reform push, the issue of deficits and debt is once more coming to the fore. Many economists realize that tax cuts, especially income tax cuts, tend to increase deficits, which over time lead to increases in the national debt. The GOP plan, if adopted, probably would pump up both deficits and debt. This isn't the first time that's happened, of course -- Presidents Ronald Reagan and George W. Bush also cut taxes and deficits swelled:

So the question is: Is more debt good, bad or does it even matter? But if it's bad, how serious a problem is it?

The answer is that no one really knows. Like so many things in macroeconomics, there is no reliable, well-confirmed theory that tells us the effect of government deficits or debt.

In the short term, the big question is whether deficits raise aggregate demand. Aggregate demand isn't a particularly well-defined concept, but it essentially means how much people want to spend money on all the goods and services in the economy. Government spending puts money in people's pockets, while taxes take money out, so if people spend some of the net amount that government puts in their pockets, deficits should give consumption -- and therefore the economy -- a boost. This is the basic Keynesian theory that gets taught in most introductory economics courses. Many have dryly noted that Reagan's tax cuts in the 1980s looked an awful lot like Keynesian stimulus.

On the other hand, if people save most of what they get from the government, aggregate demand won't rise much at all. If people think that a deficit today has to be paid back tomorrow, they will expect their taxes to go up in the future, and this will make them spend less -- a theoretical possibility known as Ricardian Equivalence.

So how much do deficits prompt people to actually go out and spend? It might depend on the type of deficit. There's evidence that the tax rebates in the 2009 American Recovery and Reinvestment Act -- the stimulus package under President Barack Obama -- didn't boost spending a lot (direct spending on things like roads had a bigger effect, but was a small part of the stimulus overall). Perhaps that's because people anticipated that Obama's deficits were temporary, and that taxes were going to go back up:

That doesn't mean the debt incurred by the stimulus was paid back, but any consumer who correctly predicted Obama's fairly rapid turn back toward fiscal austerity would have realized that their increased income was transitory.

That doesn't mean stimulus is useless. Direct government spending on things like roads, and transfers to cash-strapped states, seem to have had a sizable effect. That's consistent with basic Keynesian theory, and with other more general evidence. But the dubious value of tax rebates shows that deficits created by temporary tax cuts don't do much good.

But will the deficits from the Republican tax plan be temporary, or permanent? If recent past experience is any guide, the debt incurred won't be paid back anytime soon. The last time the federal debt shrank was during President Bill Clinton's administration, and that period of austerity was short-lived -- as soon as Bush came to power, the surpluses were eliminated in favor of a big tax cut.

Lots of economists think that debt can't keep increasing forever, as a percent of gross domestic product. Most mainstream econ models include a long-term budget constraint, meaning that the ratio of debt to output has to shrink to zero in the long run. But outside the world of academia, people are starting to wonder whether this is actually true. After all, advanced nations around the world have been running big debts for decades, and for most of these countries there have been no obvious negative consequences that can be blamed on that debt:

Is there any limit to how high these debt levels can go? If central banks keep interest rates at or near zero forever, governments will never run out of cash, since debt service costs will be minimal. Of course, interest rates could rise if bond buyers stop buying government bonds, causing a solvency crisis and forcing a government default.

But that would only happen if the central bank refuses to step in. If the central bank prints money to buy newly issued government debt at a zero interest rate, the government can borrow infinite amounts while paying nothing.

Many think this would result in hyperinflation -- if you print enough money, basic intuition says that its value would drop. Yet countries around the world never experienced even moderate inflation, despite central banks' huge asset-purchasing programs, causing some economists and policy makers to question this conventional wisdom. If inflation never materializes, central banks can keep printing money and using it to finance government deficits forever. This idea is the centerpiece of a theory called modern monetary theory, once relegated to the intellectual fringes but now gaining currency outside academia.

If Republican administrations continue to believe that deficits don't matter, and if Democrats prove politically incapable of stopping their insistence on tax cuts, there will eventually be no alternative but to test this theory. At some point, if debt increases enough, the Federal Reserve will have to start financing the government with printed money. That would be a fascinating macroeconomic experiment, though maybe not one we should eagerly anticipate.

This column does not necessarily reflect the opinion of the editorial board or Bloomberg LP and its owners.

Noah Smith is a Bloomberg View columnist. He was an assistant professor of finance at Stony Brook University, and he blogs at Noahpinion.

To contact the author of this story: Noah Smith at nsmith150@bloomberg.net.

To contact the editor responsible for this story: James Greiff at jgreiff@bloomberg.net.

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