Grasping Reality on TypePad, by Brad DeLong

How does a government get into a situation in which it is printing bank notes like this? How does a government make sure that its successors will never get into a situation in which they are printing bank notes like this?

A government that finds itself printing hundred trillion-dollar bills is a government that is doing very badly indeed. It is destroying its system of monetary exchange. It is deranging its economic division of labor. It is severely crippling if not eliminating altogether the ability of people to make and trade things on markets for predictable prices—which is one of the things that makes us all so rich. It is returning the economy to barter and to the autarchy of unspecialized production for yourself. It is throwing away what we have learned through 6000 years of progressing civilization about how to organize economies.

The answer is that governments find themselves resorting to printing things like these Zimbabwean hundred trillion dollar bills when they have proven permanently unable to balance their budgets.

When government spending has outrun taxation, and when their spending has outrun taxation so long and so far that nobody is willing to lend the government money because nobody thinks that they are ever going to get whatever they lent back—that is when a government finds itself printing hundred trillion dollar bills. The questions of how governments get into such situations, and of whether the US government now is close or getting closer to such a situation—those are the key questions of government budget economics.

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The U.S. Debt-to-GDP Ratio Over Time: Look at this graph of the United States national debt truly held by the public divided by the annual GDP of the United States. Take the total amount of money the government has promised to pay its bondholders, divide that amount by annual GDP, and you have a measure of the potential burden of the debt on the U.S. economy. Here we have this measure back to the early 1790s.

Alexander Hamilton and the Origins of the National Debt: Back in the early 1790s, the national debt was close to 40% of annual GDP. It was close to 40% because the first Treasury Secretary, Alexander Hamilton, thought it was a good idea to make it close to 40%. He convinced congress to let him go to the states and say:

You know all that money you spent winning us our independence from Britain by raising armies during the Revolutionary War? The federal government is going to pay you back for all of that. We in the federal government are going to assume your Revolutionary War debts, and pay off all the bonds you issued at full face value.

Alexander Hamilton did this for three reasons:

Third and least important was he had a bunch of friends who were financiers in New York. Once they got wind of how he was thinking they had the opportunity to buy up pieces of the debt from the merchants, the soldiers, and the others to whom the government owed money—to say:

You don’t think New Jersey will ever pay off that piece of paper, do you? I’m willing to gamble that they will eventually pay something—how about you trade it to me for 40 cents? You get the cash, I take the risk, it is a good deal for both of us.

Then Alexander Hamilton announces his debt assumption plan. New York financiers who understand how Hamilton thinks make an awful lot of money. And they are grateful.

That, however, was only a minor reason.

Second and moderately important was that Alexander Hamilton saw that the United States was then a relatively small country in a world dominated by two super powers, Britain and France. Both Britain and France had ocean-spanning ambitions and blue-water navies. Hamilton thought it likely that we would at some time in the future get into a big war with either Britain or France. And he wanted to make sure that if we did get into a big war that the federal government would be able to borrow money in order to fight it effectively. Moreover, even if we did not get into a big war a U.S. federal government that could not borrow—that had no debt capacity—would be weak. Both France and Britain would both notice that we were weak, and they would steal our stuff, press our sailors and make them man their navies, etc... Thus Hamilton thought it was important for the federal government to start its existence by building up its debt capacity. And what better way to convince investors that the federal government would pay off its debts in the future than for it to pay off the debts of the United States incurred during the Revolutionary War—even, or perhaps especially, if those debts had not been incurred by the current federal government?

The first and most important reason, however, was that Alexander Hamilton was Secretary of the Treasury in a country where the rich were at best uneasy about the revolution and independence.

Of America’s upper class as it had stood in 1775, a full half of them were gone: had fled to Britain or Canada during the Revolutionary War. Those who remained remembered that back before 1775 the British monarch had protected property, that the British army and navy had protected them against deprivations of all kinds, that it was quite clear who the police worked for. Now you have a republic with a much broader electorate. Might politicians run on a platform of soaking the rich and redistributing wealth to the poor? Thus the rich people were nervous—and at least thinking about how maybe it would be good if the British came back and ruled again.

This was where Alexander Hamilton had his idea. Suppose, he thought, he could set things up so that the rich owned a lot of U.S. government bonds. Then if the British returned—well, the British were not going to pay off the Revolutionary War debt of the United States of America under any circumstances. Having a national debt was a way to bind the United States rich to the country—giving them a stake in the new republic’s survival. And by large it worked: the national debt was a national blessing.

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Standard U.S. Debt Dynamics: Take a look at the figure above. If we look at it from 1790 to 1980, we see what became the standard dynamics of the United States national debt:

During big wars—the Civil War, World War I, World War II, and to a lesser degree the War of 1812—the United States borrows big time to fight. And so the debt-to-GDP ratio rises. When the United States goes into a significant economic depression—either the Great Depression, or our current Lesser Depression—it also borrows frantically, sometimes enthusiastically and sometimes reluctantly, to avoid massive cuts to government spending programs and to try to keep the economy moving again.

In other non-war non-deep depression times between 1790 and 1980, the nominal budget was always more-or-less balanced. There might be a small deficit. But because the economy was growing through immigration, through capital accumulation, and through the progress of knowledge about technologies and organizations that increases productivity, GDP was growing much more rapidly than the debt, and so the debt-to-GDP ratio was falling. Raise the debt-to-GDP ratio in wars and depressions. Watch it fall at other times. Those were the standard dynamics of the U.S. national debt.

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The Reagan Revolution: That works until the 1980s. Then our debt dynamics changed.

What happens to change it? In 1980 we elect Ronald Reagan, the first of our non-depression peacetime deficit presidents.

When Reagan was governor of California from 1966 to 1974, he was very much a balanced budget governor: he thought it important that the government not overspend, that it not run big deficits. He believed in investment in the future, yes—funding the University of California and building infrastructure—but not in large-scale deficit spending.

As soon, however, as Reagan gets elected president he pushes for massive peacetime deficits, and the debt-to-GDP ratio rises quite rapidly during his terms and during his successor George H.W. Bush’s term. Then Bill Clinton gets elected in 1992. Clinton reverses course: he raises taxes and puts ceilings on spending growth. The debt-to-GDP ratio resumes its normal peacetime downward trajectory.

Then we elect--well, Justices Scalia, Rehnquist, Thomas, O’Conner, and Kennedy elect--George W. Bush. His vice president Richard Cheney believes that “Ronald Reagan showed that deficits don’t matter.” Lo and behold, the deficits starts up again and the debt-to-GDP ration rises. Then the financial crisis hits. We react as we usually do in a big downturn: spending money--albeit not enough money—to and keep the economy on an even keel.

Now the Obama administration and the Republican majority congress have cut the deficit substantially. They have done so even though, in my judgment, we are still far away from being out of our “depression economics” situation in which a bigger deficit is a positive good as a demand stimulus.

But suppose we eventually do get out of our current Lesser Depression, and reattain normal times in which it is sensible that the debt-to-GDP ratio be on a downward trajectory. When will that happen? And how are we then going to put the debt-to-GDP ratio on its normal peacetime non-depression downward trajectory?

As I look at the complexion of politics in Washington, putting the debt-to-GDP ratio on its normal downward trajectory appears a difficult task. Things have definitely changed. And that is scary.

There are two theories to why things appear to have changed around 1980—why our political system no longer generates the small government deficits and the downward debt-to-GDP trajectory that it used to.

The first theory is ideological: that something has gone very wrong with the minds of the Republican Party’s officeholders, apparatchiks, and their tame intellectuals.

From the end of the Civil War all the way up to 1980 the Republican Party tended to be a small-government balanced-budget party: its consensus was that the first priority was to balance the budget, and that if the budget was balanced the next priority was to cut spending. Since 1980 the Republican Party has been a large-government unbalanced-budget party: its first priority is to cut taxes, its second priority is to raise spending on national defense and spending and tax expenditures on programs of interest to lobbyists who fund Republican campaigns, and balancing the budget is a distant third priority—if it is there at all.

The second theory is structural: that we have changed the character of government spending.

It used to be that most of U.S. federal government spending was done through the appropriations process—spending that had to be decided upon and revoted year after year. The U.S. federal government spent on defense, on national parks, on building dams and ports, on building interstate highways, building canals. But that is not what the U.S. government spends on today: today the U.S. government spends on Medicare, Medicaid, and Social Security. Spending on those programs as a share of GDP goes up automatically as the population ages and as doctors and pharmacists become more inventive about how to treat people with diseases.

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Projected Spending and Revenues
as a Percent of GDP for CBO’s
Extended-Baseline Scenario

Health Care Spending: This particular chart here is by the Congressional Budget Office, an organization now directed by my friend Douglas Elmendorf. This is his take on the Long-Term Budget Outlook for the U.S. federal government’s spending and revenue—his guess of what will happen if Congress and the President more-or-less stick to current law, and to the extent that they do not keep additional spending and additional revenues in rough balance.

Now I think there is one big thing wrong with this graph and the calculations underlying it. Given current tax law, I see no way that payroll taxes as a share of GDP are going to flatline. The way I see it, as the excise tax levied on insurance companies that provide expensive employer-sponsored health insurance policies begins to bite in the 2020s and thereafter, employer-sponsored health benefits will become slimmer, money that employers would have paid to their insurance companies will be paid to workers instead, and that money will become part of the payroll tax base and so payroll taxes will rise. Unless I am missing something, the CBO is somewhat overstating what current law produces as far as the gap between federal spending and federal revenues are.

But it is only overstating it somewhat: the gap is there.

In this projection the U.S. government goes into and remains in increasingly-enormous deficit and the national debt as a share of annual GDP explodes. First, the government’s spending on health-care programs busts the budget as our doctors, hospitals, and pharmaceutical companies discover how to do more expensive things to keep us healthy and alive, and the government picks up the tab for many of them. Why? Because we think, at a deep level, that health care should go to all the sick and not just to the rich sick. Second, the interest on the debt piled up to finance past deficits further burdens the future.

The federal health spending programs: Medicare, Medicaid, the Children’s Health Insurance Program, the “exchange subsidies” part of our currently-being-implemented RomneyCare—oops, ObamaCare—system by which people are required to have or buy health insurance on but this requirement is eased by providing poor people with subsidies to make buying private insurance affordable.

The amount of money that these health care programs will cost is, if things continue as they have been, scheduled to grow from a total of 5.5% of GDP today to something like 8% of GDP in 2040 to 14% of GDP by 2090. These spending programs are on the books. The United States government has said that it will pay for them. For spending to grow less rapidly would require that congress vote, and the president sign, big changes in what categories of health spending the federal government will pay for. At the moment the federal government will pay for what your doctors and nurses say is medically appropriate. And Doug Elmendorf says that if he has learned anything from being a health economist over the past 30 years, it is that doctors are very good at figuring out new and expensive things to do that are “medically appropriate”.

And many of expensive things really are medically appropriate. Our revolutions in medicine and public health have doubled lifespan over the life of this country. And many of these things are expensive. Neither political party wants to make controlling the rate of growth of healthcare spending—changing the law so that Medicare will no longer pay for a kidney transplant for your grandma—its signature issue. The big Republican talking point year-after-year is that the Democratic Party’s promises to streamline Medicare to make it more efficient are really plans for huge Medicare cuts that mean that someday your grandma or you will have to go in front of a government “death panel” that will turn their thumbs down. We, the Republicans are saying, are going to repeal all of the Medicare cuts and the tax increases in the recently-passed ObamaCare—but we are going to keep all of the parts of ObamaCare that actually cost money. The big Democratic Party talking point is that the government will make health care affordable for everyone.

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Feckless Congress: That is what drives the increase in expected federal government spending as a share of GDP: that whenever it gets the chance congress will shy at the jump and push all steps it is considering to reduce the rate of growth of government health-care spending programs off, just for an extra year or two—as it has done with the Medicare Sustainable Growth Rate formula for a decade now. It will keep pushing them off.

Doug Elmendorf says: don’t bet on future Congresses restraining themselves. That is a problem. But it is not clear that we can do anything about it now. If the problem is that future Congresses will act badly, and would undo everything the current Congress has done or might do to control federal spending, what can the current Congress do to solve that problem? Absolutely nothing.

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Confident Investors: However, at the moment, it appears that investors all over the world do not agree with Doug.

At the moment, it appears that investors think that the United States government is a sound operation—that in the long run we will balance our budget and that we will raise taxes in order to pay for our spending and also pay off our national debt. That is the reason that U.S. Treasury bond prices right now are so high and U.S. Treasury interest rates right now are so low.

Nevertheless, when you read Doug Elmendorf’s Long-Term Fiscal Outlook document and when you look at this picture, it is hard to understand why investors are so confident. The world’s bondholding investors believe in us. They believe that we will in the end elect representatives and senators who understand that winding up as Zimbabwe is not what you want to do.

A problem is that even before you get anywhere near Zimbabwe—even when people just begin to fear that perhaps there is some chance the government might become one that resorts to hyperinflation—even the fear that there might someday be an unsound government with no plans to balance its budget can itself produce big financial crises and substantial episodes of depression economics. We saw this in Mexico 1995, in East Asia in 1997, in Argentina in 2001, and in Greece in 2010.

What happens when investors stop thinking that your government is certain to be a safe and sound place to put their money? Then the government has a choice between finding some other government to bail it out on the one hand, starting the money printing process on the other hand, and “austerity” on the… I guess on the prehensile tail.

If a government reduces government spending to match the limited amount of taxes that it is able to collect—well, this is where Greece is now. It makes people unhappy: they burn police cars in the streets of Athens.

Are we close to the edge in which investors appear to be losing confidence in the long term soundness of the U.S. government? Well, no we are not. Will we be there someday? Perhaps. When will we be there? We don’t know.

What happened to make things different after 1980?

This is a question to which the right answer differs depending on whether you are a Democrat or a Republican.

If you are a Republican, you say that the big problem was the Democratic Party had ruled from 1932 to 1980 by promising that the government would spend more money and pay for it by taxing the rich. Because the rich are a relatively small part of the voters, such promises lead people to elect you and you continue to rule even though your policies are bad for the country in the long run because too-high taxes on the rich do harm investment, enterprise and innovation, and do slow the rate of economic growth and in the end make everyone worse off.

If you are a Republican, you say that the Republican Party had to find a way to compete with the Democratic Party’s “spend money on programs you like and pay for them by taxing the rich” meme. How to compete? The only way was to adopt the “spend money on programs you like and pay for them by cutting everybody’s taxes” meme. “But that makes no sense!” the Democrats say. “But it is your fault that we are saying this,” the Republicans say: “If you Democrats had not been waging this class war since 1932, we Republicans would not have been forced to resort to unbalancing federal government finances in order to have a chance of winning congressional majorities.”

If you are a Democrat, you simply say that around 1980 the Republican Party candidates, legislators, apparatchiks, and tame intellectuals simply abandoned what remained of their scruples and ethics.

I am a Democrat.

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Conclusion: What is the most likely outcome for the U.S. government budget come 2060? We have our politics. We have a medical system in which we very much want to have medical care allocated to people who need it as opposed to allocated on your by basis of your wallet. We are unwilling to say: “a coronary bypass would do you good but if you’re not rich enough to pay for it yourself we are just going to let you have your heart attack.” So as doctors and pharmacists and nurses and technologists keep on inventing new things to do the list of medically appropriate procedures keeps on growing. Certainly by the time you are 80 there will be a doctor who will say that it is medically appropriate for you to have a cloned heart in the basement of Alta Bates Hospital just in case you suddenly need a hot heart-swap. That is the territory that allocating health care spending according to what is “medically appropriate” tends to push you toward.

We have health-care technologists who are very good at finding new things to spend money on. We have a political-ethical belief that healthcare should be allocated according to what you need rather than how rich you are. We have a government that has agreed to take on a huge load of healthcare spending. We have two political parties, one of which says that the middle class is taxed too high and should get tax cuts (but the rich could easily pay more) and the other of which says that everybody is taxed too much and should get tax cuts. And both parties say that we should not enact major cutbacks to the rate of growth of any forms of federal spending except those that are “waste, fraud, and abuse.” And those parts of federal spending that are actually waste, fraud, and abuse—ethanol anyone?—have very powerful political protectors, and are untouchable.

What do people think is the most likely outcome from this situation?

1. Come 2060 will we have raised taxes by a lot? We could double income taxes between now and 2060 and barely pay for extra government health spending.
2. Will we have cut doctors’ wages, and enslaved them by drafting them into a socialist national health service?
3. Will we have abandoned our egalitarian healthcare beliefs?
4. Will the healthcare efficiency cost-effectiveness fairy have come and rescued us?
5. Or will the federal government as we know it will have collapsed, and those of us who are still alive be involuntarily starring in a remake of Mad Max: Beyond Thunderdome?

What do people think?

1. is the answer given by people who are optimists—who believe that we will have raised taxes to pay for government spending, and that the United States will become more like a western European country with higher share of government spending in GDP than we have, a mixed economy with more of the government in the mix.

2. is what Ronald Reagan was worried about in 1961. He opposed Medicare. He cut vinyl records. They would then be distributed around the cities of California. People would come to grassroots meetings. They would play Reagan’s records. He would talk about how Medicare was the first stage on the road to full communism and slavery. Because after all, if the government was going to promise that it was going to pay for healthcare it had to raise the resources somehow. And what is the easiest way to raise resources? It is to draft doctors and send them where the government wants and pay them what the government wants. Nobody, Reagan thought, would speak up when the secret police came for the doctors. And he thought that once one group of people loses their freedom then eventually everyone is going to lose their freedom—that in order to keep liberty in America we had to stop Medicare now. I think that Ronald Reagan was substantially overwrought. We have now had Medicare for 50 years. In that time we have managed to avoid drafting and enslaving our doctors so far, let alone anybody else. But it is not impossible.

3. requires abandoning our commitment to providing state-of-the-art healthcare to the sick and not just the wealthy. That’s definitely a possibility—especially if health care becomes more and more expensive.

4. requires that the healthcare cost-effectiveness fairy will save us: we will figure out ways to treat people that do not become more expensive over time but instead less. The news on this front over the past five years on health-care cost-containment has been remarkably good.

5. is the real dystopian scenario. I don’t think we’re going there. All of the other solutions provide safety valves, and are much easier to envision coming to pass.