The Default Question
GLENN HUBBARD: Before jumping into some economic concerns that I expect we both share, I would like to start with what’s on everybody’s mind, which is the debt ceiling. We have another deadline coming up on December 3. It’s a periodic pain in the fiscal behind. How big of a deal is this deadline? Is the Treasury going to default?
PIERRE YARED: I don’t think that the Treasury will default. The truth is that there are other things they can do, such as cut payments, to avoid a more calamitous eventuality.
In general, these debt ceiling standoffs are suboptimal and probably not something that we should celebrate. That being said, it does introduce some discipline into the budget-making process that is useful. But it would be ideal to improve fiscal discipline without a costly and dangerous event hanging over our heads.
HUBBARD: On the one hand, I agree with you that it does focus the mind, which has some advantages in Washington that may dither otherwise. On the other hand, it does so in a very brinksmanship kind of way that worries markets. At least I got you on some good news first. We’re not going to default. I shouldn’t panic on Treasuries.
Dispelling Myths About Debt: How We Got Here
HUBBARD: I want to ask you about an area in which I don’t think the media and the public spend a lot of time. Why is the debt so high in the first place? What happened?
YARED: That’s a really good question, and it’s one that I’ve studied for years. National debt has been increasing relatively steadily since the mid-1970s with some particular points of rapid growth, such as the global financial crisis and the COVID-19 pandemic. Since that time, the United States has been running up deficits of around three percent of GDP in good times, and more than 10% in bad times. But the US is not alone.
If you look across advanced economies, with a couple of exceptions like Norway, you’ll see there’s this long-term trend and increase in debt-to-GDP. That increase is not set to reverse. According to the latest Congressional Budget Office (CBO) data, US debt, which is around 100% of GDP today, is expected to climb to over about 200% of GDP by 2050.
You asked about why we’re here and I think there’s a lot of misinformation about the reasons. There are three myths we often hear.
The first is that we just got unlucky – and that’s partially true. We were unlucky with the global financial crisis. We were unlucky with COVID-19. Those two events have increased the debt dramatically. But there have been other periods of time where catastrophes have happened and the debt has increased and then decreased. So, there’s something else going on. It’s not just bad luck.
The second myth is that mounting debt is the result of too much spending on defense. In fact, military spending as a proportion of GDP has been on a steady decline since 1960. Even with the War on Terror, defense spending relative to GDP is nowhere near where we were in the past. So, we can’t blame it on the military.
The last myth is that excessive tax cuts have caused the debt increase. What’s true is that tax revenue, as a proportion of GDP, increases or decreases partly because of tax policy but also due to the economic cycle. Tax revenue as proportion of GDP was quite high during the boom of the 1990s. But if you look historically, tax revenue as a proportion of GDP has been relatively stable. So, tax cuts aren’t the culprit either.
The fact is that something is happening on the spending side. In particular, it’s spending on an aging population in the form of Social Security and Medicare entitlements. Spending on those components has increased from below three percent of GDP to over eight percent of GDP since the mid-1960s.
And if you look across the globe, countries with the fastest-growing aging populations experience the greatest increases in debt. The prime example is Japan, which has seen old-age obligations drive up debt so much over the past several decades. This trend will continue to grow in the decades ahead.
HUBBARD: That’s a great way to think about it. It’s not the usual things people point to. It’s not the military. It’s not taxes. It’s not public goods, generally. It’s entitlements.
What’s the Problem?
HUBBARD: So, we’ve got this growing debt, and you’ve identified the source of it. But what do economists worry about? Is it that we’ll see interest rates go up? Is it that future tax burdens have to go up? Is it that we’ll force unpleasant choices fiscally? Maybe we have to continue to gut defense, education, or anything other than interest in social spending. What’s the problem?
YARED: It’s a combination of those things and the different ways it could play out. While the US doesn’t appear likely to default, as we discussed earlier, we could be forced into some kind of reckoning.
Such a reckoning could take the form of inflationary pressures, which often occur when there’s a lot of liquidity and a lot of debt in the system. With those inflationary pressures, we’d face the choice to allow the debt to be inflated away (I’m a little bit skeptical that inflation would significantly reduce our debt burden, but that’s sort of what happened after World War II) or the prospect of the Fed being forced to raise interest rates. And as the Fed raises interest rates, the interest expense grows and we’d have to make some hard choices, either increase taxes or cut spending, which in today’s political environment would be challenging to pursue and also costly for the economy.
There is another possibility, which is a sort of Japanification of the economy. I often hear the argument that we shouldn’t worry about the debt, look at Japan. But I respond to that, “Well, yes, look at Japan.” It’s been a relatively stagnant economy since its financial crisis in 1991. The debt-to-GDP has exploded and economic activity remains low. While everyone understands that, at some point, austerity will be required, there’s a sense of kicking the can down the road. We saw some version of this in the US and Europe in the aftermath of the global financial crisis. It’s possible we’ll return to that.
The bottom line is, whatever path we choose, it will involve either hard choices or stagnation.
The Path Towards Fiscal Consolidation
HUBBARD: Reinhart and Rogoff famously got into trouble defining a line in the sand: “Thou shalt not cross this debt-to-GDP ratio.” How do we focus policymakers’ minds when they could easily say interest rates are low? Reinhart and Rogoff weren’t right. What do you say?
YARED: I tend to think it’s possible that even though policymakers don’t necessarily want to make hard choices now they’d be willing to put constraints on the future government or to create some sort of institutional commitment for balancing things out.
The Budget Control Act of 2011 had a guiding framework for not exceeding certain levels of spending. While I have a lot of criticism of that structure, I think it did serve to stop the growth of debt.
Globally, we’ve seen Sweden and Switzerland institute similar frameworks to improve the fiscal health of their countries. So, that’s where I’d focus the mind.
HUBBARD: Sweden and Canada both have been examples in the modern period of that kind of change. Of course, they’re not the reserve currency countries. They did hit a fiscal wall.
I think for the US, the old quip from Saint Augustine, “Lord make me chaste – but not yet,” is how policymakers approach fiscal policy. How do we change that? Do you see a path towards fiscal consolidation?
YARED: I’d start by focusing on specific elements of spending, such as Social Security and Medicare, and tackle the trust funds that are set to go in the red within the next decade or so. One idea is to create frameworks in which those entitlements are self-funded with current revenues, as opposed to taking away from the rest of the budget.
This approach would be similar to the pension system in Sweden, which is self-funded and automatically balances. For example, if more people retire, the participation rate declines and the benefits received by retirees automatically decline. Alternatively, if wages in the economy go up, then benefits go up. There’s risk-sharing by the elderly against both changes in the economic cycle and changes in long-term trends. The other interesting aspect of the Swedish system is that it is highly redistributive at the very bottom of the income ladder, so it takes care of the very poor.
More broadly, it would be useful to consider establishing rules in the budget process that function as a guard rail against the types of deficits we have been seeing. In Switzerland, there’s a constitutional amendment that says they cannot have a structural deficit unless a super majority votes for it in an emergency.
HUBBARD: It’s hard because it would require a constitutional amendment, a version of which that Tim Kane and I proposed in our book Balance. But it’s politically very, very difficult. When I talk to non-economist audiences, I always talk about a “We the People” budget in which we should pay for normal, current consumption in the here and now. “Extraordinary” should be a crisis, a war, some long-lived capital asset. But that’s not what we’re spending money on in entitlements.
I would like to end by touching on the trust funds and the entitlement programs you mentioned. I’ve always wondered if there’s not really an opportunity here. Think about some of the successes we’ve had in budget control: the Greenspan Commission, for example, exploited a “crisis” in Washington by pointing out a cash flow issue in Social Security in the early 1980s.
Does the arrival of the Medicare trust fund crisis and next the Social Security trust fund crisis actually present an opportunity to really impose some discipline?
YARED: I think that sounds like a very interesting idea to think about.
Glenn Hubbard is Dean Emeritus and the Russell L. Carson Professor of Finance and Economics at Columbia Business School. He currently serves as Director of the Jerome A. Chazen Institute for Global Business.
Pierre Yared is the MUTB Professor of International Business, Vice Dean for Executive Education, and a Chazen Senior Scholar at Columbia Business School.