The Deficit Is Big, but Is It Bad?

Wednesday, April 30, 2003

The federal government is a large debtor. It currently owes its public creditors about $3.5 trillion and may add another trillion or more this decade. This is a large amount of money, but it must be compared to the total credit market that determines interest rates. The U.S. credit market is large, with many borrowers and lenders. Businesses owe about $7 trillion, and state and local governments owe another $1.5 trillion. Home mortgages total nearly $8 trillion. Moreover, mortgage borrowing grew by $4 trillion over the past decade without triggering interest rate increases. Other consumer debt totals $1.6 trillion. The federal debt is large but is only 12 percent of the total debt owed by U.S. debtors.

Furthermore, history tells us that the relevant market does not include just the United States but extends to the world market for debt. Government debt in the Euro area totals $5 trillion, and nonfinancial corporations and households owe another $7 trillion to financial institutions. Money flows freely among financial markets and institutions in Europe, the United Kingdom, Japan, Canada, and the United States, creating a roughly $50 trillion market for debt. This world credit market is growing rapidly as globalization of trade and finance brings in more participants. This world credit market has helped the United States deal with its fiscal problems. For example, foreign investors financed much of the new borrowing by Washington in the 1980s. This inflow of money helped avoid the interest rate explosion that some critics of Reaganomics predicted at that time. Although the federal government is probably the largest single player in the world’s credit markets, it is only a small part of the complete picture. A one or two trillion-dollar increase in federal debt will have small, if any, effects on long-term real interest rates.

Creditors will also demand higher interest rates if they believe that the Federal Reserve will use inflation to finance the new debt. These worries are often legitimate since many countries have resorted to inflation in times of fiscal distress. However, these are not problems today. First, the United States is not in fiscal distress. U.S. debt equals only a third of its $10 trillion annual national income, a small ratio by international standards. Even
fiscally conservative Germany has debt equal to 60 percent of its national income. The strong U.S. economy and fiscal system make it possible to finance a much larger national debt without resorting to inflation. Second, the Volcker and Greenspan regimes at the Federal Reserve have given the United States a credible, low-inflation monetary policy. Credit markets are less worried about future inflation because the Fed did not resort to inflation during the large-deficit years of the 1980s.

These arguments are supported by the facts. Historical patterns indicate at most a weak relation between national debt and interest rates. For example, after World War II, U.S. national debt was much higher than today relative to the economy, equaling 100 percent of GDP; foreign borrowing was limited, but long-term real interest rates were low. More generally, statistical studies of interest rates and deficits consistently find that nominal interest rates are related mostly to inflation and that any tendency of deficits to raise interest rates is small.

None of this argues for undisciplined use of debt to finance expenditures or tax cuts. Even Washington must pay its bills. More debt today will mean either higher taxes or less spending in the future. There are many important fiscal policy issues to debate. Fortunately, interest rate worries should not be a major concern.