To Prepare for Emergencies, Maintain Fiscal Order – Press Enterprise

The tragic events of the past week underscore the wisdom of maintaining a financially healthy home, rather than a heavily indebted government, before emergencies strike. Russia’s barbaric invasion of Ukraine and the West’s response are likely to push inflation higher still. Expect calls at home for more government spending to help Ukrainians defend themselves and allow us Americans to better deal with supply chain disruptions.

Regardless of what the legislature decides, they will be hampered in one way or another by past tax mistakes.

The United States finds itself at a rate of inflation not seen since the early 1980s, thanks to overspending on COVID-19 aid and significant Federal Reserve adjustments piled on top of already outsized deficits. As a result, the national debt has now reached 100% of gross domestic product and our fiscal 2022 budget deficit will be $1.4 trillion. If Congress’ lack of interest in repayment isn’t worrying enough, our high debt levels will make controlling inflation even more difficult. Any hike in interest rates by the Fed will quickly translate into higher government interest payments and more deficit spending.

Even if we ignore the Fed’s failure to see inflation coming, we should at least ditch the trendy idea that debt can be increased without hurting the government’s fiscal sustainability. In fact, for years scientists have developed several scenarios in which increasing debt does not endanger our financial health. The most reasonable take two main forms.

The first is based on the notion that real interest rates are historically low and likely to remain so for a long time. Therefore, the government can carry large amounts of debt without worrying about debt sustainability, especially if the increased debt is used by the government for meaningful and productive investments.

Aside from the folly of setting interest rates low indefinitely, this first scenario requires tremendous confidence in legislators’ willingness to spend money to produce high and sustained economic growth. A review of the academic literature shows that such spending tends to crowd out healthy private sector spending.

The second, and more interesting, scenario argues that in countries where real interest rates are lower than the real rate of economic growth, a one-off increase in the deficit—even a large one—carries no cost over time. It’s a new twist on the old idea that under the right conditions, economic growth can outpace debt. Suppose the Treasury borrows $3 trillion to fund the next Build Back Better plan.

If Congress only allows the Treasury to borrow new money to pay the interest on the debt — and as long as interest rates remain below GDP — then debt will grow, but the debt-to-GDP ratio (a key metric our ability to borrow) will slowly decline.

As tempting as this scenario may sound, unfortunately it is not in sight for our country. My Mercatus Center colleague Jack Salmon and I explain why in a new study. This scenario only works with a one-off increase in the deficit, followed by decades of taxes high enough to pay our spending. What economists call the “primary deficit” (the difference between the current budget deficit and the interest payments on previous borrowings) takes years to make up.

This condition is a must if we want growth to outpace interest payments, and it is nowhere to be seen in US budgets today and in the future. A quick look at the Congressional Budget Office’s analysis reveals decades of large primary deficits and growing debt-to-GDP ratios, largely driven by the explosion in spending on programs like Social Security and Medicare. Those prospects would get a lot worse if the next round of emergency spending comes without a real payback plan.