Fun With Money

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Written by Dean Baker   
Thursday, 03 June 2010 16:44

The deficit hawks have been working themselves into a frenzy in recent weeks over the prospect that the country will come out of the recession with a huge debt. They have convinced much of the policy elite (admittedly, a very gullible crew) that the United States is on the edge of becoming Greece, unable to pay its bills and forced to negotiate with the IMF, Moody’s, or other creditor creatures to avoid bankruptcy.

There is more than a little absurdity in this picture. The United States has about as much in common with Greece as it does with the robot in the old television show, “Lost in Space,” in other words, basically nothing. Greece is a relatively small economy that is very dependent on imports and does not print its own currency. The U.S. is a huge, still largely self-contained economy that does print its own current. If we’re looking for comparisons, Greece is much more like Arkansas than it is like the United States.

But, there is at least a grain of truth in the deficit hawks scare stories. If we follow the deficit path projected by the Congressional Budget Office, by 2020 we will have a debt to GDP ratio of close to 90 percent. This is far from a crisis – we have had higher ratios in the past and many countries currently have far higher ratios and have no problem whatsoever servicing their debt in international financial markets.

However, we will be paying out a much large share of our budget in interest payment on the debt in this scenario, with interest payments rising from less than 2 percent of GDP at present to close to 5 percent by 2020 – roughly the same share as at the beginning of the Clinton administration. Other things equal, it would be better not to have to pay so much interest to bondholders.

There is a simple way to prevent this rise in the interest burden. We can simply have the Federal Reserve Board buy and hold large amount of the debt issued to finance the recovery. The Fed is already buying much of the debt, but as a matter of policy Congress could dictate that it buy more and continue to hold the debt indefinitely.

This would mean that the interest on these bonds would be paid to the Fed, which would in turn refund the money back to the Treasury, thereby creating no net interest burden. If the Fed bought and held an amount equal to 20 percent of GDP (approximately $3 trillion), it could save the country $150 billion annually in interest payments.

In ordinary times this would be considered a dangerous practice since it could lead to inflation. However, few economists see inflation as a serious threat with the unemployment rate near 10 percent. In fact, we would almost certainly be better off with a somewhat higher inflation rate (3-4 percent) than the very low rate we are now seeing, since it would reduce the debt burden on homeowners and lower real interest rates.

Over the longer term, if inflation did appear to be a problem, the Fed could respond by gradually raising banks’ reserve requirements, thereby preventing the extra reserves in the system from leading to excess demand and higher prices.

In short, there is no reason that the county need bear an additional interest burden as a result of measures taken to pull the economy out of the downturn. This spending is creating demand for otherwise idle resources, not leading to excess demand in the economy.

This is a serious discussion that Congress and the country should be having right now rather than the absurd debate about plans for cutting Social Security and other important programs. But, we are not having this discussion because the deficit hawks are trying to convince us that we are like Greece and the financial markets have given us no alternative to these cuts. As the robot on Lost in Space used to say: “warning! Warning!”