How much should we borrow?

A commenter directed me to a Noah Smith post that begins as follows:

One of the most important questions in macroeconomics is one that economists have curiously chosen not to study. That question is: “How much can the government safely borrow?”

In my view, this is the wrong question.  The right question is: How much should the government borrow?

The term “safely” is quite vague.  Safe from what?  From default?  From hyperinflation?  From future tax rates that are punishingly high?

In contrast, we have a great deal of research on the optimal level of public borrowing.  In a 1979 JPE paper, Robert Barro argues that the budget deficit should fluctuate in such a way as the minimize the long run deadweight cost of taxation.  Here is the abstract:

A public debt theory is constructed in which the Ricardian invariance theorem is valid as a first-order proposition but where the dependence of excess burden on the timing of taxation implies an optimal time path of debt issue. A central proposition is that deficits are varied in order to maintain expected constancy in tax rates. This behavior implies a positive effect on debt issue of temporary increases in government spending (as in wartime) a countercyclical response of debt to temporary income movements, and a one-to-one effect of expected inflation on nominal debt growth. Debt issue would be invariant with the outstanding debt-income ratio and, except for a minor effect, with the level of government spending. Hypotheses are tested on U.S. data since World War 1. Results are basically in accord with the theory. It also turns out that a small set of explanatory variables can account for the principal movements in interest-bearing federal debt since the 1920s.

Can we safely borrow as much as we are currently borrowing?  I’d say yes.  Should we be borrowing as much as we are currently borrowing?  I’d say no.  After all, I don’t think anyone in their right mind expects a “constancy in tax rates” in the coming decades.  Tax rates are going to increase.

PS.  If you don’t believe that tax rates are set to increase, consider today’s news:

House Republicans voted to allow their members to request dedicated-spending projects, known as earmarks, following that same move by Democrats, in a positive sign for President Joe Biden’s hopes for a bipartisan infrastructure bill.

So remind me, which one is the party that favors small government?


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What does it mean to say a debt is “unsustainable”?

I often warn against countries running up excessively large public debts. Some people interpret my worry as a prediction of a future financial crisis, perhaps including default and/or very high inflation. They point out that countries such as Japan have run large deficits for many decades, with interest rates on long-term bonds remaining near zero. So are these worries overblown?

For developed countries with their own currency my actual fear is not outright default, or even hyperinflation. Rather I fear that an excessively large public debt will eventually force painful changes in fiscal policy, such as benefit cuts or more likely large tax increases. The most efficient fiscal policy is one that smooths tax rates over time, as high taxes are a drag on the economy.  Furthermore, the effect of tax increases is not linear. A doubling of the tax rate will lead to a roughly fourfold increase in the deadweight loss, without even doubling tax revenue.

By the mid-1990s, Japan’s budget deficits were on an unsustainable path while the US budget deficits were still on a more sustainable path.  At this time, Japan had a 3% national sales tax whereas the US had no national sales tax.  Both countries had overall tax burdens that were below average for developed countries.

In 1997, Japan raised its national sales tax to 5%.  In 2014 they raised the tax to 8%.  In 2019 they raised the tax to 10%.  These increases were intended to address the debt problem.  Meanwhile the US continued to have no national sales tax.  Thus the very thing I was worried about did actually occur in Japan.  Furthermore, more tax increases are almost certainly on the way.  Unfortunately, the US budget deficit situation also became unsustainable during the late 2010s, due to a highly expansionary fiscal policy.  Thus the US is likely to be forced to raise taxes (or cut benefits) in future years.

To summarize, it is true that Japan is likely to be able to avoid default on their public debt.  But this does not mean that those who warned the deficits were unsustainable were wrong.  Indeed, Japan was forced to repeatedly raise taxes precisely because the path of the public debt was unsustainable without future tax increases.

PS. The FRED data site shows net debt for Japan (blue line) and gross debt for the US (both as shares of GDP.)  So the actual gap is even larger than it appears:



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