The Truth About Deficits and the Debt

America needs to cut spending now.

Editor's Note: Reason columnist and Mercatus Center economist Veronique de Rugy appears weekly on Bloomberg TV to separate economic fact from economic myth.

Myth 1: Debt and deficits are a disease that can only be cured by raising taxes.

Fact 1: Debt and deficits are only a symptom. The disease is overspending. And tax increases are no cure. Besides, even if we could balance the budget by raising taxes it wouldn't stay balanced so long as programs like Social Security, Medicare, and Medicaid remain unreformed.

Polls reveal that debt and deficits have become defining issues in American politics. While these issues are indeed important and the American people are justifiably concerned about the level of debt our nation is racking up, they are only symptoms of the real problem: overspending. America is living beyond its means and is projected to continue doing so into the foreseeable future.

The above chart compares tax revenues and government spending as a percentage of GDP from 1930 to the year 2084, using Congressional Budget Office (CBO) projections for the years 2011 to 2084.  

As you can see, in the past, tax revenues have averaged 15.9 percent of GDP. During recent years, revenue collection has slightly increased, averaging 18.5 percent of GDP during the 1990s, and averaging 17.5 percent of GDP during the first decade of the new millennium. Notably, the federal government has never been able to collect 21 percent of GDP in tax revenues. It defies reality to think that it will be able to do so now. That's why the CBO estimates that revenues will remain fixed at 19.3 percent of GDP into the future.

Yet the CBO anticipates that from 2012 through 2021, the federal government will spend, on average, 23.3 percent of GDP—a higher level of spending as a percentage of GDP than the government has ever been able to collect.

Myth 2: There is no relationship between high interest rates and deficits. And even if there was, interest rates remain at all-time lows.

Fact 2: That may have been true once, but the data now shows that investors anticipate an increase in both interest rates and deficits.

For the last 20 years, economists have looked for evidence that deficits lead to higher interest rates. In 1993, for instance, North Carolina State University economist John Seater surveyed the literature on deficits and interest rates and concluded that the evidence is "inconsistent with the traditional view that government debt is positively related to interest rates." But George Mason University economist Arnold Kling argues that economists haven't seen a correlation between budget deficits and interest rates because foreign investment in U.S. assets has increased over the years, dulling the impact of fiscal policy. The real question is what happens if that investment slows or stops.

Moreover, deficits have reached a level that economists haven't really studied before. Current circumstances remind Kling of "a guy jumping out of a building from the 10th floor, passing the third floor, and saying, 'It's all fine so far.'" Deficits do not matter up to a certain level. But at what level do we hit the ground with a resounding splat?

Here is what we do know: To get deficits under control the federal government could cut spending, increase taxes, or do some combination of both. Neither of these policies is popular; hence the temptation to print money (or "monetize the debt") to pay the bills. The resulting inflation would reduce the value of each dollar, and it would introduce high levels of uncertainty into the economy. Imagine what it would be like to try to calculate the net present value of your investment in an environment where you can't predict what your dollars will be worth tomorrow. Such circumstances mean less innovation and less entrepreneurship, and therefore less economic growth and more hardship.

The Federal Reserve may be reluctant to take the inflationary route. But investors know that other central banks have done so in the past and that such a scenario could happen again. In exchange for extending more loans to a federal government that has become a riskier borrower, lenders will ask for an inflation premium.

As the chart below illustrates, a look at the yield curve signals that investors are indeed expecting inflation and an increases in rates.

The yield curve for U.S. Treasury securities, which reflects the functional knowledge of investors, provides a revealing look at investor expectations about the interest rates. In finance, the yield curve depicts the relationship between interest rates and the time to maturity of the debt. Normally, these curves slope slightly upward, reflecting investor tradeoffs between increased returns and time to maturity. However, when investors are concerned about inflation or economic uncertainty, the normally gently sloping curve can become much steeper, as investors turn away from holding securities long-term and thus drive yields higher.

Even now, the steepness of the yield curve for U.S. Treasury securities shows that investors expect interest rates and inflation to become higher in the future. Such expectations can lead investors to sell longer-term Treasury securities due to the predictable fact that when interest rates increase, bonds with longer maturities perform worse. In turn, that depresses the prices of those bonds and drives their yields higher.

Interestingly, in February China joined PIMCO (one of the world's largest bond companies) in selling long-term U.S. Treasury bonds.  

Understanding the relationship between maturity and interest rates sheds light on this behavior. Since 2007, China has been systematically transitioning its U.S. debt holdings to short-term debt. In June 2009, the most recent month for which data is available, China's holdings of U.S. debt were 12 percent of its total holdings, up from 3 percent in June of 2008.

In future years, after more research about the current period has been done, economists may conclude that deficits did lead to higher interest rates.

Myth 3: Debt and deficits may be a problem, but we don't have to fix it now.

Fact 3: Debt and deficits are having an immediate negative impact on the economy.

Even in the absence of a crisis, the effects of persistent deficits remain substantial. As the government borrows, some people delay spending and investment in anticipation of future tax increases. Others will not invest in the economy or start new businesses as government borrowing consumes a greater portion of the available capital. All of this hurts the economy. Economists use the term "crowding out" to refer to this contraction in economic activity that follows from deficit-financed spending.

The chart above uses data from two CBO papers forecasting the effect on GDP per capita that crowding out may have and contrasting that with commonly-used CBO projections. The red line, which uses data from a presentation to the Fiscal Commission in June 2010, shows per capita GDP growth simply shrinking around the year 2022 due to crowding out. The blue line shows another projection of the impact of crowding out that starts shrinking GDP per capita in 2034. The contrast with the black line, which uses data generally referenced by scholars and government officials, is striking.

In other words, regardless of whether CBO's original or updated predictions materialize, it is very likely that the people of the United States will feel the negative impacts of high debt and deficits driven by overspending. Our country risks getting caught in a downward, potentially unmanageable spiral.

The chart above shows the scale of the spending cuts that would be required to close the fiscal gap, or to stop the debt from growing as a percentage of GDP, through 2035. These estimates are conservative; they do not incorporate the feedback effects of increasing debt and deficits on the economy. Nonetheless, the longer we wait the more dramatic the required cuts will be.

If action is taken this year, lawmakers could close the fiscal gap through 2035 by reducing primary spending by 4.8 percent of GDP; if this action is delayed another 4 years, primary spending would have to be reduced  by 5.7 percent of GDP.  If lawmakers wait until 2020, the necessary cuts would grow to 7.9 percent of GDP. In other words, legislative inaction equals billions of dollars in additional spending cuts.

Contributing Editor Veronique de Rugy is a senior research fellow at the Mercatus Center at George Mason University.