Should We Worry About The Long-Term Federal Debt In An Era of Low Interest Rates?

For decades, conventional wisdom said that high levels of federal debt created a significant drag on the economy by diverting money that could more productively be used for business investment to purchasing government bonds.

Now, in an important new paper, two highly-influential Democratic economists argue that theory is badly outdated. Jason Furman, a former top economic adviser to President Obama, and former Treasury Secretary Larry Summers say that historically and persistently low interest rates require policymakers and economists to reconsider their thinking about the national debt.

Instead of focusing on the risks of government debt crowding out private investment, Furman and Summers argue, policymakers should worry about the risks of insufficient public investment in infrastructure, education, and low-income families.

Furman and Summers have been making this case for a while. But the timing of their new paper is striking. It comes just as the nation faces debt levels not seen since World War II and Congress is debating whether to spend another $1 trillion for COVID-19 related economic relief.

And it comes, of course, less than two months before the nation will swear in a Democratic president.  That, in turn, will set off a familiar debate in Washington: Even as President-elect Biden begins to turn trillions of dollars of campaign promises into new spending on infrastructure, health care, and aid to families, Republicans are expressing a renewed concern about rising federal debt.

In their new paper, Furman and Summers make four key points:

Interest rates have been falling for years. Rates have been dropping in the US and throughout the developed world for three decades and now are negative when inflation is taken into account. And markets expect they will remain low for at least another decade. While there is some risk that this forecast will be wrong, Furman and Summers say the greater risk is that government would slow economic growth by raising taxes or cutting spending to lower federal deficits.

Low interest rates carry their own risks. Low rates encourage excessive leverage that in turn can create financial instability (as it did in run-up to the Great Recession). And they limit the ability of central banks to respond to economic slowdowns. That puts more of a burden on fiscal policy.

Furman and Summers say this suggests the need to enhance policies that automatically boost government spending in the event of economic slowdowns, including more progressive fiscal policy and expansion of social insurance. The heathiest way to reduce deficits, they say, is to boost the economy.  

Change the measure of fiscal stability. The traditional tool, the ratio of federal debt to the Gross Domestic Product, is misleading and leads to poor policy choices. Instead, it would be more useful to compare interest payments to economic output. And because interest rates are so low, even a big increase in borrowing has relatively little effect on this measure. They say there is no need to worry unless the real cost of servicing the federal debt rises to more than 2 percent of GDP.

Aim for growth-oriented policy, not balanced budgets. Furman and Summers say they “reject traditional ideas of a cyclically balanced budget.” Instead, their primary fiscal policy goal is to “advance economic growth and financial stability.” They suggest three guidelines for success: Emergency spending in response to economic slowdowns need not be paid for, long-term commitments should be financed except for “ones that plausibly pay for themselves,” and fiscal policy should support demand.

Cynics might say that the timing of the Furman and Summers paper is convenient, given that it provides an economic justification for Biden’s big spending instincts. In fairness, both economists began making this case well before Biden was elected president.

And some will suggest that Furman and Summers are merely putting a new frame around the argument that conservatives have been making for years: The best way government can reduce deficits is to adopt fiscal policies that encourage economic growth. The only difference, of course, is that conservatives believe that growth-oriented policies should be built around tax cuts while Furman and Summers favor primarily new spending to support the economy.

Janet Yellen, Biden’s nominee for Treasury Secretary, seems sympathetic to the Furman/Summers argument. At the American Economics Assn. conference last January (pre-COVID-19, of course) she said the federal government’s interest burden was manageable even with high levels of debt, and she saw room for additional stimulus in the event of a future downturn.

It remains to be seen how the Furman and Summers reconsideration of fiscal policy will fare in the coming political wars over tax and spending priorities. But it certainly gives policymakers something to think about.