America’s debt ceiling is a disaster, though fiscal rules can help
IONCE again for this most bizarre economic spectacle, a debt ceiling showdown in America. In the name of fiscal responsibility, the world’s largest economy flirts with an act of shameless irresponsibility: a sovereign default. The government has almost exhausted its current statutory debt limit of $ 28.5 billion, after which it will struggle to meet its obligations. Janet Yellen, Treasury Secretary, warned the government would likely run out of cash next month.
Most economists and leaders assume America will come to its senses before that. After all, Congress simply needs to raise or suspend the debt limit, which it has done almost 80 times since 1960, even if it sometimes leaves it to the last minute. If that happens again – and it almost certainly will – the debt ceiling will disappear from view until the next clash, serving primarily as evidence of America’s polarized politics (as if it needed it).
America’s ritualistic threats of economic self-harm are unique. But the debt ceiling is an extreme version of what many other countries are doing: They limit government borrowing through fiscal rules. Germany applies a “debt brake”, capping its structural deficit at 0.35% of GDP (although he has ignored this cap since the outbreak of the covid-19 pandemic). In Britain, the Conservative government aims to match spending and income over a three-year horizon. Chancellor Rishi Sunak is expected to unveil even tougher rules in next month’s budget, including a pledge to lower the debt-to-debt ratio.GDP report.
The purpose of fiscal rules is to address what economists call a “common network” problem – that the recipients of public spending ignore the costs imposed on taxpayers and on future generations. The fear is that without a hard cap on spending, elected officials will burn money. Taken to extremes, bond and currency markets could sanction lavishness. Better not to test them. Hence the need, supposedly, for clear limits.
Yet the last decade has shown that the borders are a bit wider and blurry than previously thought. In America, federal debt was about a third of GDP In 2000; today it is roughly 100%. Far from precipitating a financial collapse, the growing debt burden has become more, not less, manageable thanks to ultra-low interest rates. In nominal terms, the cost of servicing all debt (the annual interest payments on it) is just over 1% of GDP, almost half of what it was two decades ago. Similar trends have occurred in the rich world. There might not be a free meal, but governments have learned that they can get much larger portions for half the price.
One answer is to soften the boundaries. Take the European Union rule that member states must cap their debt at 60% of GDP– which is widely observed in the breach, with an average EU debt levels now exceed 90% of GDP. Economists such as Zsolt Darvas de Bruegel, a think tank, suggest that this limit should be treated as a long-term anchor rather than a short-term goal.
Such softening would help. But that wouldn’t solve a more fundamental flaw in debt limits – that they are inherently arbitrary. There is little empirical basis for keeping debt at 60% of GDP, much less at exactly $ 28.5 billion in America. The very arbitrariness of these red lines risks creating a Crying Boy Debt Syndrome. As borrowing levels exceed them and the economy continues to perform well, some politicians may conclude that it is best to ignore all calls for fiscal restraint.
A more sophisticated answer is to focus fiscal rules on what really matters to the debt: the cost of servicing it. In a 2020 article, Larry Summers and Jason Furman suggested that governments should aim to prevent their actual interest payments from exceeding 2% of GDP. If they are successful, debt-to-GDP targets would become almost superfluous. More generally, economists recognize that as long as a country’s growth rate is higher than its interest rates, its path to fiscal sustainability should be easier, as the weight of its existing debt will gradually decrease.
However, these more elegant fiscal rules have their own problems. Why cap debt service charges at 2% of GDP and no, say 3%. In addition, the confidence that economic growth can exceed interest rates stems from the belief that rates will remain subdued in the future as the population ages. But the surge of inflation underway in the United States has shown how uncertain this is. If central banks were to raise interest rates to ease price pressures, debts would skyrocket quickly.
You only give me your funny piece of paper
The total elimination of the indefensible lines in the sand is a good alternative. In an article published this year, Peter Orszag, Robert Rubin and Joseph Stiglitz argue for a new tax architecture. An important part would be to index the long term expenses to the underlying drivers. For example, social security benefits could be automatically made less generous to take account of increased life expectancy. This can be seen as a fiscal rule that commits governments to making sound fiscal decisions, rather than specifying debt targets with spurious precision.
In another article published this year, Olivier Blanchard and others proposed general tax standards for the EUsuch as requiring governments to ensure that their debts are sustainable, while leaving them the choice of their policy mix. Independent fiscal councils could then use detailed debt sustainability criteria to assess their budgets. If this were done methodically, it would be more scientific than the fiscal rules currently observed in America and Europe.
Alas, all of these smart ideas may be nothing in America. The government is unlikely to drop its debt ceiling, because in one dimension it is the most efficient. Republicans have become good at using it as a club to block Democratic presidents’ agendas and portray them as spendthrift. No other fiscal rule can deliver this kind of return. ■
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This article first appeared in the Finance and Economics section of the print edition under the title “Rules of Engagement”