With an introduction by Markus Brunnermeier, Director of the Princeton Bendheim Center for Finance
On Thursday, October 15, Christopher Sims joined Markus’ Academy for a lecture on “how to worry about government debt.”
Christopher Sims is a Professor of Economics at Princeton University and a 2011 recipient of the Nobel Prize.
It’s not wise to quickly reduce debt primarily or solely through tax increases. The ratio of marketable debt to GDP dropped after WWII, but started to rise with the Reagan administration. It came down again with the Clinton surpluses, then shot back up to over 100% in recent years. The rise in the last year was particularly steep given the U.S. response to the pandemic. Still, Sims says, the optimal strategy is to keep debt steady and slowly reduce it over time. The cost of reducing debt by making taxes higher temporarily is not a good tradeoff.
We could be entering a period of significant inflationary pressures. Sims points out that many attribute inflation in the 70s to the Ford administration’s large deficits, and that those who do should be concerned today. When compared to today’s U.S. debt-to-GDP ratio, the amount of outstanding debt created by the Ford administration is relatively low. Today, the ratio of debt-to-GDP was high even before the pandemic, and the amount of the increase relative to size of the debt is even larger than the increase that occurred during the Ford administration.
In order for interest rate hikes to control inflation and have a contractionary effect, they must be accompanied by contractionary fiscal policy. For a long time up until the early 60s, interest expenses were 10% to 15%. They began to rise in the 70s, and then through a combination of increased debt and high nominal interest rates, the ratio of interest expense to total receipts shot up over 25% for several years. It was in this period that Congress put together budgeting rules requiring new expenditure proposals be matched by explanations of how to pay for them, resolving the fiscal situation for some time.
While we should be running high deficits in response to the pandemic, today’s debt does not have zero fiscal cost. When the real interest rate on debt is below the growth rate of the economy, the government can issue and roll over debt forever without backing it by new taxes and still see the debt-to-GDP ratio shrink over time. But this only applies when the government makes a one-time increase in debt unaccompanied by increased taxation. This is not the situation we’re in—even when it concerns pandemic relief spending. Given past, steady spending increases without tax increases, we unfortunately cannot view pandemic relief spending as a single, wartime increase in debt. Ultimately, these steady increases will affect the interest rate on debt and require dynamic solutions.
Today’s situation in Japan illustrates that for the price level to be stable and control inflation, policymakers must balance expectations of future fiscal policy against current debt. Spending on the pandemic, for example, has impacts not just on deficits today, but expectations for future fiscal policy. While Abenomics was meant to be a commitment to easy monetary policy combined with short-term fiscal expansion and medium-term fiscal adjustment, it’s unclear now whether the policy was ultimately expansionary or contractionary. Sims says many in Japan are aware they are approaching a situation where a major fiscal adjustment may be required.
Legislators may not take action until they see that the money they have to allocate is absorbed by interest costs. Sims says it wouldn’t take a very large increase in interest rates for this to happen and for debt service charges to reach 25% of total federal government receipts.