Streetwise for Friday, March 1, 2019

One of the issues readers and students often raise is whether our nation’s rising deficit and national debt spell trouble. Will the end game result in economic harm to the country? Yes, over time and under certain circumstances, we could be headed for trouble.

However, recent commentary by Bill Dudley, a senior research scholar at Princeton University and former president of the Federal Reserve Bank of New York, put the issue in perspective.

Dudley pointed out that some mainstream economists, such as Olivier Blanchard, former chief economist at the International Monetary Fund, believe that sovereign debt is manageable in a world where economic growth exceeds low borrowing costs.

Proponents of Modern Monetary Theory (MMT) argue that because the government borrows in its own currency, it can always just print more dollars to cover its obligations.

I agree with Dudley and Blanchard that deficit spending is less problematic than in the past. The government’s debt burden, measured as a percentage of gross domestic product (GDP), will remain stable if debt and GDP grow at the same rate. 

This is easier to do now because the economy’s current long-run nominal growth rate (around 3.5 percent) is well above the government’s borrowing cost (around 2.5 percent). So, there is some leeway: 

The national debt can grow at nearly 4 percent per year, or 1.0 percent to 1.5 percent net of interest expense, without increasing the debt-to-GDP ratio. The low level of interest rates might help explain why markets are more tolerant of large, persistent budget deficits.

Yet, MMT goes one step further. It suggests that a government need not worry about debt at all. If it borrows in its own currency, there is no risk of default or bankruptcy. It can spend as much as it wants on projects, such as education and health care, using additional IOUs to cover the cost.

However, as Dudley carefully points out, there is no free lunch. For one, the economy might not have sufficient resources, in the form of workers and industrial capacity, to meet the combined demand from the government and the private sector. The result would be inflation, as too much money chased too few goods and services.

In addition, we consume considerably more than we produce and therefore depend heavily on foreign investors to lend us the money needed to keep us going in that manner. However, foreign investors do not have to make dollar-denominated loans or buy Treasury securities.

If our debt load were to keep increasing, at some point the Fed would face a dilemma. It could increase interest rates to maintain foreign (and domestic) demand for dollar assets, at the cost of damping economic growth. 

Or it could keep interest rates low and allow the dollar to weaken, which would push up inflation as imported goods and services became more expensive. Neither outcome would be pleasant.

We saw a moderate version of MMT in the 1960s and 1970s, when the government tried to simultaneously pay for the Vietnam War and Lyndon Johnson’s Great Society programs. The result was inflation, America’s withdrawal from the gold standard and the demise of the Bretton Woods system of fixed exchange rates. 

The result was that the Fed had to increase interest rates to double digits in the late 1970s and early 1980s, at great economic cost and pain to get inflation back under control.

If deficits are a concern, the choice is between increasing taxes or cutting spending. Desirable social goals, such as better roads and universal health care are considerably more attractive if you can argue that they do not need to be paid for. 

However, the constraints are real. The economy is operating close to capacity, especially in the labor market, and the government is already running a sizable deficit that is projected to increase substantially. 

Therefore, if we want to spend more infrastructure and health care, while keeping the economy healthy, we need to find sustainable sources of revenue to do so, not engage in wishful thinking.

Note to Readers: I will be teaching Portfolio Management, beginning March 11, for Ringling’s Osher Lifelong Learning Institute. Call 941-309-5111 for registration and information.

Lauren Rudd is a financial writer and columnist. You can write to him at LVERudd@aol.com. Phone calls accepted between 9 AM and 3 PM at (941) 706-3449. For back columns please go to www.RuddReport.com.