Higher Federal Spending: Boon or Bane?

Art by James Yang

Take your pick. Pumping up federal borrowing even further will either:

A) Be an elixir to solve pressing unmet needs in our society, like replacing crumbling infrastructure, or …

Who is right? And how would expanding spending and borrowing affect the American economy?

As the 2020 US presidential race takes shape and partisan divisions sharpen, an odd new dynamic is animating the old debate over the level of government outlays. Until recently, a more or less centrist economic policy consensus held sway in Washington. Democrats set reasonable upper limits on their traditional push for enlarged government benefits, and Republicans warned that willy-nilly spending would harm the nation’s fiscal soundness. Those old positions are toast.

Now, the newly energized left wing of the Democratic Party is embracing what’s called Modern Monetary Theory, which holds that the US has a lot more room to borrow money to do such things as provide Medicare for all and a Green New Deal (an ambitious re-tooling of the economy to combat climate change).

MMT devotees argue that the US, as the creator of the world’s reserve currency, a much-prized commodity, benefits from a near-universal hunger for Treasury bonds. And central banks, like the Federal Reserve, that borrow from their own currency can’t go broke as they always can print more money.

While Republicans are deriding MMT and mega-spending goals as “socialist,” the Trump administration and GOP lawmakers have, in practice, cast off their party’s dedication to fiscal restraint. Thanks to larger military expenditures and an almost $1.5 trillion (over the coming decade) tax cut, the budget deficit ballooned to a six-year high of $779 billion last year and the national debt rose to $21.4 trillion, twice its level from 10 years before.

Meanwhile, backers of fiscal restraint are aghast at MMT. “A free lunch is a temptation, but this carries huge risks,” said Maya MacGuineas, president of the Committee for a Responsible Federal Budget. “This is about politics, not economics.”

Against this backdrop, here are the flashpoints as the debate escalates:

Deficit Bias

For fiscal hawks, the problem is that deficit spending is built into the government’s DNA. In Washington, deficits have been the norm for a long time. The government has only run surpluses 12 times out of the last 77 years (starting in the first year of World War II). The last time there was black ink was in the late 1990s and early 2000s, the bounty of the tech boom. In response to the Great Recession, President Barack Obama’s first four years featured deficits topping $1 trillion annually.

Once the economy appeared on the mend, the Obama administration and a GOP-controlled Congress whittled that gargantuan number down. From a $1.4 trillion high in 2009, the deficit shrank to a $438 billion low by 2015. The mechanism was a series of automatic cuts, called sequesters. Over the next few years, Congress allowed some tax breaks and lifted the sequesters, so the deficit began another ascent, hitting $779 billion in 2018 and is on track for a CBO-estimated $827 billion for fiscal 2019, ending this coming September 30.

Nowadays, despite rosy scenarios about how the economy will continue to roar, and thus spur tax revenue, the White House’s fiscal plans are unlikely to keep down the upward march of spending. The Trump administration, in its proposed fiscal 2020 budget, contends that the ratio of federal spending to gross domestic product will drop to 71% in 2029, from 78% today. The nonpartisan Congressional Budget Office, however, estimates that the number will rise to 93%.

If government borrowing gets out of hand, could a return of the bond vigilantes choke off the issuance of new debt? Probably not. The vigilantes were investors who dumped bonds for fear that their prices were set to plunge. They last were a factor in the 1990s, when in the space of a year, 10-year T-note yields soared to 8.0% from 5.1%, thanks to vigilante sales. Alarmed at the escalating yields, which made borrowing difficult, the Clinton administration and Congress pushed to hold down the budget deficit. Trouble is, the vigilantes haven’t been around much since then, likely due to low interest rates and burgeoning global demand for safe US government debt.

So the question becomes, not should the US keep debt-fueled running deficits, for it surely will. The question is how high the deficits will be.

Inflation

Time was that big federal spending led to big inflation. The object lesson here was the 1960s, when President Lyndon Johnson expanded federal spending to pay for both his Great Society social programs and the Vietnam War. That, coupled with galloping oil prices courtesy of the Organization of Petroleum Exporting Countries (OPEC) in the early 1970s, produced double-digit inflation—which threatened to destabilize the American economy.

That spending-inflation equation has been superseded, however. Today, despite robust economic growth and ever-higher federal spending, inflation has stayed below 2%, which is the Fed’s target rate.

Technological progress is one well-known reason for this. Fewer workers are needed to produce goods and services. Economic transactions happen more efficiently: Banks, for instance, don’t need armies of clerks to process paper checks. People don’t have to buy cameras anymore—they have cameras on their smartphones. The spread of Airbnb has pushed down the price of hotel rooms.

The other well-known inflation deflator is globalization. Offshoring industrial jobs to cheap-labor nations, which President Donald Trump decries, has thrown many Americans out of work. Add in the decline of unions, and there is not a lot of upward pressure on the wage front.

Nevertheless, trends change. At some point, perhaps, the price-reducing power of technology may plateau. And labor prices overseas will rise. This has been the case in China. What’s most important, if deficit-driven government spending keeps spiraling, it eventually will reach a point where it escalates inflation. Lyndon Johnson, were he still around, likely would concur.

Even MMT adherent Stephanie Kelton, a professor at Stony Brook University who advised Sen. Bernie Sanders during his 2016 presidential campaign, has admitted that super-sized federal spending could incite harmful inflation. Deficits, she has said, “can be too big—risking accelerating inflation.” She goes on to say that the greater threat is that deficits can be too small. MMT believers insist that Washington could always tax away any inflation-driven excesses, although Congress has seldom been in a mood to increase taxes

Interest Rates

A similar danger is that towering government spending could lead to too-high interest rates, which would be a drag on economic growth. But like rampant inflation, this remains hypothetical.

At the moment, high rates aren’t much in evidence. The Federal Reserve has all but called a halt to its short-term rate hike campaign, amid fears that the economy will flag under larger borrowing costs. The Fed also is eyeing an end to plans to reduce the balance sheet, which it bloated with a bond-buying binge aimed at keeping longer rates low. The balance sheet shrinkage was aimed at reversing that process, with higher long yields the goal. No longer.

Just the same, as Washington’s voracious appetite for more borrowing continues, we may find that private borrowers, like businesses wishing to grow, will be crowded out. There are a limited number of bond buyers. If Treasury paper offers good yields, bolstered by its risk-free promise, corporate bonds could end up as orphans—and be forced to pay much greater interest than they can afford.

Yes, right now no hint exists of crowding out. Corporate debt has been mounting along with federal debt, thanks to ready buyers and enticingly (for the issuers) low interest rates. The risk premium, i.e., the gap, between yields of investment-grade corporates and Treasuries lately is a low 0.7 percentage point.

But in historical terms, there have been times of crowding out. More precisely, it’s   been a partial crowding out. Higher government bond sales causes a decrease in investment-grade corporate bond issuance, according to a massive 2015 study of 100 years of data by three professors (Michael Roberts of Penn, John Graham of Duke, and John Leary of Washington University). Every percentage point increase in government debt compels institutional investors, who purchase the most bonds, to lower corporate debt buying by 0.12 point, they wrote.

Policy Flexibility

By MMT-ers reckoning, as long as rates stay beneath nominal (not inflation-adjusted) economic growth, the deficit is sustainable. That doesn’t include interest payments. At present, the situation is borderline. In 2018, GDP was 2.9%, which is slightly above the 10-year Treasury yield. GDP projections for this year are around 2.3%, which would be below short-term Treasury rates, and the yield now is 2.44% for a one-year T-bill.

Here’s the problem: “The federal debt cannot grow faster than the economy forever,” wrote David Wessel, a senior fellow at the Hutchins Center, part of the Brookings Institution. “At some point, something will give.”

The government raises money two ways, by taxing or borrowing. Taxes are limited by what the citizenry can afford to pay. Lift tax rates to 90% and people will do anything to stop paying, right before they bring out the torches and pitchforks. Borrowing is constrained by the ability to service the debt. If indeed, interest rates remain on the low side, paying the freight might not be so bad. But if rates climb or the principal owed skyrockets, then trouble arrives.

Federal obligations are mounting, owing to the aging population, with baby boomers retiring apace. While Social Security is set up to be funded by payroll levies, they will not be enough, and the system will run out of cash reserves by 2034. Next stop: Tapping the Treasury income. Beyond long-term liabilities, Washington will have to pay for economic downturns and wars, which have the unfortunate tendency to recur.

To Sonal Desai, chief investment officer of Franklin Templeton Fixed Income, “as politicians and voters become complacent and ready to embrace out-of-the-box policies, the risk that something goes badly wrong rises exponentially.” 

In economics. as in the rest of life, it’s too often what you don’t expect that gets you.

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