Why deficits matter as much as ever
During normal times, most people grasp what economists call “opportunity cost.” If the government spends money, someone will eventually have to pay the price through higher taxes. During deep recessions, however, there is sometimes a mistaken perception that the old rules no longer apply, and that money can be freely spent without imposing a burden on future generations. Let’s not fall into that trap.
It is certainly true that in periods such as the Great Depression, the Great Recession and, yes, today, the cost of government borrowing is much lower than usual — even close to zero. But these debts will persist, and when interest rates eventually increase, the burden on future taxpayers will also begin to rise.
A substantial portion of the federal debt being issued this year has been purchased by the Federal Reserve. These “open market purchases” of Treasury bonds are the method by which the Fed injects new money into the economy. For various reasons, it probably should buy even more of our debt — perhaps more than 100 percent of the 2020 budget deficit. But the implications of these purchases are not what people who downplay deficits tend to assume. They do not constitute “monetization of the debt,” and certainly don’t relieve us of the burden of the debt.
Prior to 2008, Fed purchases of Treasury bonds did indeed represent a monetization of the debt — paying our bills by printing money. This is because the new money created by the Fed during the process, termed the “monetary base,” was essentially a form of cash which did not earn any interest — yet it was used to buy back interest-bearing Treasury debt. Imagine paying off your mortgage with phony dollar bills and you can get a sense of how profitable it is to monetize a public debt.
The profitability of debt monetization means that the Fed has to be very careful. Prior to 2008, it bought relatively little public debt each year in order to hold inflation down. Countries that aggressively monetized their debt, such as Zimbabwe and Venezuela, ended up with hyperinflation.
After the Great Recession struck in 2008, however, the Fed adjusted its approach to monetary policy by paying interest on the reserves banks have deposited at the Fed. This encourages banks to hold on to more reserves rather than lending the money out. It changed everything.
Because Fed “quantitative easing” programs now mostly involve exchanging interest-bearing bank reserves – not zero-interest currency – for interest-bearing Treasury debt, this form of money creation is no longer as profitable. And because most of the new money created by the Fed is interest-bearing reserves, it is no longer highly inflationary.
While currency issuance is still profitable for the government in 2020, by itself this covers only a tiny portion of our budget deficit. Most newly created money is now merely another form of federal government debt.
Right now, the interest rate paid on bank reserves is only slightly above zero. But as we saw in the latter part of the past decade, interest rates generally rise when the economy recovers. Thus, all the bank reserves currently being injected into the economy will eventually have to be neutralized in one of two ways: First, the Fed could withdraw the excess reserves from circulation as market rates rise by selling off Treasury bonds. Alternatively, it could increase the interest rate it pays on bank reserves to track market rates. If it chose neither option, then we’d have true “debt monetization,” but also risk ending up with hyperinflation.
Japan’s case seems to suggest a third way. After all, it’s had near-zero interest rates for decades, even as public debt has grown rapidly. On closer inspection, however, the Japanese case doesn’t provide much solace.
Japan’s near-zero interest rates reflect the fact that over the past quarter century, it’s had only trivial growth in aggregate demand (total spending), the worst performance of a major economy in modern history — far worse than even Italy. That’s not much of an argument for using deficit spending to boost an economy.
Successful stimulus policies lead to faster growth and higher interest rates over time. Japan’s done almost exactly what many Keynesian economists have recommended – run persistent and large budget deficits – and the policy has failed abysmally.
The Japanese government understands that it’s risky to increase the debt-to-GDP ratio forever on the assumption that interest rates will always be zero and has gradually increased taxes to control its debt. The national sales tax rate rose from 3 percent to 5 percent in 1997, then to 8 percent in 2014, and then 10 percent in 2019. Further increases are almost inevitable. Large deficits impose costly burdens on future taxpayers.
The lesson? Look for the current fiscal stimulus in the United States to lead to higher taxes in the future, perhaps as soon as 2021.
Scott Sumner is an emeritus professor of economics at Bentley University and director of the Program on Monetary Policy at the Mercatus Center at George Mason University.