The United States is slated to come out of the coronavirus era with more federal debt than annual gross domestic product for the first time since World War Two. The debt has soared to that level from a mere 35 percent of annual gross domestic product in 2007, driven by spending hikes, tax cuts, and stimulus deals in the Great Recession and in the pandemic. The future is even more concerning because the Congressional Budget Office projects that, if no changes are made, the ratio of debt to gross domestic product will climb to 195 percent by 2050, as Social Security and health care and spending increase more rapidly than federal revenue.
As we note in a recent article, the debt threatens heavy burdens on future generations. To ease those burdens, policy makers should enact measures that will gradually reduce the debt while the pandemic subsides. The debt remains a major concern even though interest rates have been lower than the growth rate of the economy. It may seem that the lower interest rates allow government debt to be rolled over while decreasing relative to the economy, making debt a free lunch that imposes no future burdens. That optimistic view is flawed, however, because it overlooks the risk.
The free lunch theory goes as follows. Say the interest rate is 1 percent a year, while the economy grows at a swifter rate of 2 percent a year. The government borrows $10,000 and uses the money to increase spending or cut taxes. Next year, the government owes $100 interest on the debt that it borrows. The following year, the government has $10,100 of debt and owes $101 for interest that it also borrows. So if the government will keep up the rollover strategy, the debt rises 1 percent a year, slower than the economy, and drops as a share of gross domestic product.
The debt sets no burdens on future generations in this rosy scenario. The money that the government borrows comes from private saving, which would otherwise be fueled into business capital investment. But private saving rises with the economy, so it is more than sufficient to cover both government borrowing and business investment, while the capital stock continues to climb. If the return on capital is also lower, interest paid on the debt makes up for the lost output from the moved capital.
The free lunch idea would be valid if there was absolutely no uncertainty in the economy, with interest rates and returns on business capital both ensured to be lower than the growth rate of the economy. But there is no free lunch in the real world, in which the future interest rates, returns on capital, and growth are uncertain, and where the rates of returns on risky capital is usually higher than the interest rates on safe debt.
There is always a chance that the rollover strategy will fail and will do so precisely when the economy is performing badly and adjustment is most painful. As growth rate falls or the interest rate rises, leaving the interest rate higher than the growth rate, the rollover strategy causes the debt to rise faster than the economy. Government borrowing will outstrip private savings, and the capital stock steadily shrinks. To avert destruction of the capital stock, the government must stabilize the debt ratio, which forces either tax increases or spending cuts on future generations.
Moreover, even when the safe interest rate remains lower than the growth rate, the risky rate of return on business capital is likely to be higher than the growth rate. The lost output from displaced capital then rises relative to the economy, and future generations are harmed as the smaller capital stock reduces productivity and drives down market wages.
Even with low interest rates, government debt is not a free lunch. Instead, it poses a tradeoff of benefiting current generations at the cost of future generations. While there is no magical formula to determine the correct response to such a tradeoff, commentators across the political spectrum have voiced concern that the unrelenting debt level slated to occur under the current policies is both undesirable and unsustainable.
Addressing the fiscal imbalance will not be easy. It will take a bipartisan deal that cuts spending and increases taxes. A broad fiscal response to the pandemic was justified, and it would be unwise to enact large deficit reductions in the current crisis. To protect future generations, however, there should be a mandate that cuts spending and increases taxes that can be conducted over time while the economy recovers.
Sita Slavov is a professor at the George Mason University Schar School of Government and a visiting scholar with the American Enterprise Institute. Alan Viard is a resident policy scholar at the American Enterprise Institute.