The economic shock of the coronavirus has been as sudden and jarring as any in U.S. history. Even if policymakers did nothing to respond to it, the income losses generated by the shock and the automatic expansion of some safety net programs would have led to large increases in the federal budget deficit. But the correct policy response to a shock like the coronavirus is to push deficits even larger than they would go on their own by providing expansions to relief and recovery efforts.
As always, there are some who seem more concerned about the rise in federal budget deficits and public debt than by the rise in joblessness and losses of income generated by the shock. But prioritizing the restraint of debt in coming years over the restoration of pre-crisis unemployment rates is bad economics.
We must prioritize the restoration of pre-crisis unemployment rates over restraint of debt. Anything else is bad economics.
Joblessness and income losses in the wake of the coronavirus shock really are large enough to spark an economic depression that lasts for years. A rising ratio of debt to gross domestic product (GDP), on the other hand, will be mostly meaningless to living standards in the next few years. If baseless fears about the effects of adding to debt block this effective response, then it will cause catastrophic economic losses and human misery. It is often said that economics is about making optimal decisions in the face of scarcity. But we need to be clear what is and what is not scarce in the U.S. economy. The federal government’s fiscal resources—its ability to spend more and finance the spending with either taxes or debt—are not scarce at all. What is scarce is private demand for spending more on goods and services. We need to use policy to address what is scarce—private spending—with what is not.
In this blog post I attempt to answer a few of the many questions I hear about the deficit and debt in light of the current economic crisis. We have created an ongoing web feature here to answer these questions and new questions that come up. A common root to the answers of many questions about the effects of deficits and debt concerns whether the economy’s growth is demand-constrained or whether it is supply-constrained (i.e., at full employment). Because this distinction is so important to so many questions about deficits and debt, we provide this background first.
What is the one thing I need to understand first about debt before I can gauge whether it is a threat?
A distinction that you need to make in pretty much every single question about the economic effects of public debt is whether the economy’s growth is constrained by demand or by supply.1
When the economy has resources—particularly willing workers—that are unemployed simply because firms do not expect enough paying customers to justify putting more resources into producing goods and services, then the economy’s growth is constrained by demand. In such a demand-constrained economy, an increase in aggregate demand (i.e., spending by households, businesses, or governments) means more workers will be hired and more output will be produced. Anytime joblessness can be reduced and economic output can be increased simply by boosting aggregate demand, the economy is demand-constrained, and it is not at full employment.
When instead all the economy’s available resources—particularly willing workers—are already employed, a boost to aggregate demand does not cause output to increase or workers to be hired because all potential workers are already employed and hence no additional output can be created. In this case, aggregate demand is rising faster than the economy’s supply side (the labor force and capital stock) can deliver output to satisfy it, and this excess demand pushes up prices, leading to inflation.2
When an economy is at a point where faster aggregate demand growth spills over into inflationary pressures rather than output growth, then the economy is supply-constrained. In such an economy, growth can only accelerate if each worker becomes more productive.
Additions to debt affect the economy very differently depending on whether growth is demand- or supply-constrained. As we’ll see below, the U.S. economy in the midst of the coronavirus pandemic is severely demand-constrained and in urgent need of a boost to demand.
Why are we so sure that debt-financed relief and recovery is the answer to the economic shock of the coronavirus?
The economic shock of the coronavirus and the public health measures undertaken to combat it are unique in their specifics, but not actually all that different from the general cause of all other recessions: They constitute a mammoth negative shock to aggregate demand. Basically, all at once, tens of millions of Americans stopped spending money on a whole range of economic outputs (restaurants, hotels, air travel, brick-and-mortar retail, etc.). Because one person’s spending is another person’s income, this type of shock almost inevitably leads to another spending pullback as, say, restaurant workers lose their income and cut back on spending even in sectors still open during the lockdown period.3
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The proper response to this sudden and mammoth negative shock to demand is straightforward, if daunting. First, maintain spending power (income and wealth) during the lockdown period by providing relief (unemployment benefits, stimulus checks, etc.) to those who have lost jobs and incomes. Second, foster a rapid recovery by boosting aggregate demand as public health indicators allow a phased “reopening” of economic activity. We have already provided some relief during the lockdown, but we need to provide more. If we don’t expand and extend this relief—if we allow this relief to run out while the economy remains profoundly damaged—tens of millions of families will run down savings and take on debt, making them much less likely to spend robustly once the economy returns to closer-to-normal. This depressed spending will drag on overall recovery.
Because the goal is to maintain spending during the lockdown and boost it during the recovery, we want to finance these relief and recovery measures with debt instead of taxes. Taxes reduce disposable income and spending in the short run (although tax increases for high-income households drag on spending less than tax increases for other households). Given the crucial importance of ending the coronavirus-driven recession as quickly as possible with overwhelming force, it is best to finance relief and recovery efforts with debt instead of taxes.
Absent huge relief and recovery measures, the economic future looks grim, with unemployment potentially peaking at 25% or more, and remaining in double digits for years. Further, the experience of the Great Recession shows us beyond dispute that trying too hard to rein in deficits and public spending while the economy remains weak (i.e., inappropriately contractionary fiscal policy) makes recovery slower and more painful than it has to be.
Does fast-growing debt ever pose a danger to economic growth?
It is certainly possible in theory for larger deficits and debt to harm economic growth. But the chain of economic effects that leads from higher deficits to slower economic growth only comes into play when the economy is supply-constrained (i.e., is at full employment). And we know when fast-rising debt is harming economic growth because this situation has a clear “data signature”—a noticeable rise in either interest rates or inflation.
Here’s how the chain of effects works.
If federal spending rises faster than taxes (i.e., if the federal budget deficit grows), economywide aggregate demand gets a boost. Federal spending boosts aggregate demand either directly, say, by spending to build a road, or indirectly, by transferring resources to households that use the funds (from, say, Social Security checks) to purchase goods and services. Taxes reduce aggregate demand, all else equal, but as long as spending grows more rapidly than taxes (budget deficits are increased), then large deficits spur aggregate demand.
If the deficit rises when the economy is supply-constrained, then the boost to aggregate demand translates into upward pressure on interest rates and inflation. Take a hotel, for example. If the hotel is already fully booked and then a boost to aggregate demand from an increase in the federal budget deficit sends even more customers looking to book rooms, the hotel owner might want to expand the hotel’s capacity. Tangible business investment like this often requires borrowing, so the hotel owner will try to borrow money in capital markets to finance this investment.
In a supply-constrained economy, if the increased public spending were financed by borrowing rather than raising taxes, the hotel owner would find that they are competing with the federal government for available savings to borrow to finance their desired new investment. This competition for savings would push up interest rates (the “price” of savings) and these higher interest rates would “crowd out” some private-sector investment projects that might otherwise have happened. For example, maybe the hotel owner decides not to build a new wing. Or other businesses likewise take a pass on potentially productivity-enhancing investments.
Remember that in a supply-constrained economy, growth can only accelerate if each worker becomes more productive—i.e., if each worker has a greater store of capital (plants, equipment, and research and development spending) to use to increase the amount of income and production generated in the average hour of work. So rising debt in a supply-constrained economy can hurt economic growth in the long run if it pushes interest rates higher and this in turn reduces the pace of productivity-enhancing private-sector investment.
It is important to note that right now, and for the foreseeable future, we are in a demand-constrained economy, not a supply-constrained economy.
What this means is that for now and into the next year, there is next to no reason to think that higher debt used to finance relief and recovery will put enough upward pressure on interest rates or overall inflation to hamper economic growth. In summary, in a demand-constrained economy like the U.S. economy during the coronavirus pandemic, debt provides no countervailing drag on growth.