Fixing the Debt: A Reality Check
The United States is now one of the most indebted countries in the world. The national debt is $23 trillion and is projected to grow to 150 percent of national income in coming years. Think tanks of different persuasions agree that this growth in debt is not sustainable, but there is little consensus on how to “fix the debt”; most proposals are unrealistic and misleading.
We can dismiss out of hand the new monetary theories proposing to print more money. Heavily indebted countries that finance spending by printing more money, such as Venezuela, end up with hyperinflation and a stagnating economy.
Some proposals would attempt to close the fiscal gap. Closing the fiscal gap means stabilizing the ratio of debt to national income at current levels. But experience with debt in other highly indebted countries suggests that simply closing the fiscal gap is not a sufficient condition for fixing the debt. With high levels of debt, a country is exposed to economic instability, as revealed in highly indebted European countries during the recent financial crisis.
The countries that have been successful in fixing their debt have done so by significantly reducing debt as a share of national income below the consensus target of 60 percent. Countries such as Sweden and Switzerland, for example, have reduced debt to sustainable levels by imposing a so-called “debt brake,” limiting the growth of spending and using surplus revenue to reduce their debt.
In our research, we use a dynamic simulation model to estimate the potential impact of a Swiss-style debt brake in the United States. (See vetfiscalrules.net.) Reducing the ratio of debt to national income below 60 percent would require fundamental reforms to America’s fiscal policies over the next three decades.
Our dynamic simulation model captures the positive impact of fiscal reforms on economic growth. A Swiss-style debt brake would significantly reduce government spending as a share of national income and restore long-term economic growth. Discretionary spending would have to be frozen at current levels. Mandatory spending for entitlement programs would have to be reduced significantly below the spending projected for these programs under current law. Reforming the tax code and reducing marginal tax rates would provide a further boost to economic growth.
The dynamic simulation analysis reveals that as a major debtor country the United States is now vulnerable to economic instability and insolvency in a financial crisis. Citizens need to understand the risks that high levels of debt pose for the federal government. Just as individuals and firms can become insolvent, governments become insolvent when they can’t meet their financial obligations in full and on time. Over time, a debt brake would help to stabilize our economy and limit exposure to insolvency.
The experience with a debt brake in Switzerland reveals how these fiscal reforms can stabilize an economy. The Swiss enacted their debt brake three decades ago at both the national and cantonal levels. With overwhelming support from their citizens in referendums, the Swiss enacted debt brakes to reduce debt significantly to sustainable levels; and during the recent financial crisis, they achieved economic stability without incurring more debt. As they reduced debt, Swiss citizens gained confidence in the ability of their government to pursue prudent fiscal policies, something that Swiss economists refer to as increasing dynamic credence capital.
Over the past half-century, fiscal rules in the United States have failed to constrain debt, allowing debt to grow at an unsustainable rate. Citizens have some confidence in the ability of their local governments to balance the budget and limit debt, but they have lost confidence in the ability of state and national governments to pursue prudent fiscal policies. In the United States, we have experienced declining dynamic credence capital.
Especially alarming is the virtual absence of serious discussions of debt in Congress and in the presidential elections. In the Democratic debates, some candidates have bought into the myth that pie-in-the-sky spending programs can be financed by printing money or taxing the wealthy.
Keynesian economists seem to have convinced politicians and citizens to stop worrying and learn to love the debt. Perhaps a reality check will help wake up citizens the risk that high levels of debt pose for our future. A pessimistic conclusion is that we must wait until we fall off a fiscal cliff in the next financial crisis before citizens will wake up the risks of high levels of debt. The instability experienced in other highly indebted countries during the recent financial crisis suggests that this is not a risk worth taking.
John Merrifield (firstname.lastname@example.org) is emeritus professor of economics at the University of Texas at San Antonio. Barry Poulson is emeritus professor of economics at the University of Colorado at Boulder