The coronavirus continues to exact an enormous human and economic toll. To prevent economic collapse, the federal government has pulled out all the stops, resorting to both monetary policy and fiscal policy. Monetary policy cannot go it alone, especially in our current crisis. Having all but zeroed out interest rates, the Federal Reserve currently has little room to maneuver in its traditional monetary policy space. By itself, monetary policy may not provide for as quick an economic recovery as compared to when it is used in tandem with fiscal intervention.[1] Research has shown that Congress’s aggressive fiscal policy helped businesses and households weather the initial onslaught by steadying incomes and consumer spending.[2] According to the International Monetary Fund, “The fiscal action taken by the authorities around the world is truly unprecedented and decisive, and extremely important in avoiding a financial and economic collapse.”[3] Many economists have cautioned against slackening the fiscal response while millions remain unemployed or underemployed.[4] While Congress has already passed aggressive stimulus measures, such as the $2.2 trillion CARES Act, the U.S. economy likely needs another boost to keep it afloat. Jerome Powell, chair of the Federal Reserve, has called for additional stimulus acknowledging that “fiscal policy is unequaled, by really anything else.”[5] As Congress ponders its next steps, the immense federal debt rears its head, exceeding $27 trillion as of this writing.[6] To what extent should deficit spending give us pause in this time of crisis?
Current Deficit
Let’s begin with the numbers. Federal deficit spending ballooned to respond to COVID-19. Recently, the Treasury Department announced that the U.S. deficit tripled in fiscal year 2020, reaching $3.1 trillion, or 16.1% of economic output.[7] This deficit almost doubles the largest deficit during the Great Recession.[8] Many consecutive years of federal deficits have piled up the national debt. The Committee for a Responsible Federal Budget expects the national debt to reach 102% of gross domestic product (GDP) this year.[9] The federal debt has not exceeded GDP since World War II.[10] Based on projections from the Congressional Budget Office, the Brookings Institution forecasts that the public debt will amount to 190% of GDP by 2050.[11]
Under conventional economic theory, these numbers are cause for concern for several reasons. First, economists have long warned of the dangers of “crowding out”—the notion that public debt competes with private debt, thereby increasing interest rates in the market for loanable funds. Second, the bill will eventually come due. As Thomas Jefferson wrote, “The principle of spending money to be paid by posterity, under the name of funding, is but swindling futurity on a large scale.”[12] Admittedly, lower interest rates create “breathing room” for public spending,[13] but, when the principal defies comprehension, interest payments can prove significant notwithstanding the low cost of debt. In the first eight months of fiscal year 2020, the U.S. government forked over $260 billion in interest payments, which roughly equals the combined budgets of the Departments of Commerce, Education, Energy, Homeland Security, Housing and Urban Development, Interior, Justice, and State.[14] Third, public debt leads to political stalemates, and partisan fights over the debt ceiling have repeatedly brought the federal government to a grinding halt. The most recent government shutdown, beginning in December 2018, lasted 34 days, making it the longest in U.S. history.[15] Finally, rampant public spending and tax cuts are widely thought to cause inflation; images of wheelbarrows of valueless cash in Weimar Germany are etched in our collective memory. However, fiscal policy, and deficit spending, still play an integral role in the economy.
From Keynes to MMT
From Keynesian orthodoxy to heterodox modern monetary theory (MMT), economic theory has established that the government must inject money into the economy during economic downturn, either by increasing government expenditures or lowering taxes. MMT differs from the more conventional theories in its cavalier acceptance of deficit spending, adopting the basic tenet that governments may spend more liberally by borrowing or printing money.[16] This more revolutionary view has its critics, with some deriding MMT as the “Cult of the Magic Money Tree.”[17] Whichever theory you prefer, the underlying principles help assuage public concerns about deficit spending during our current crisis.
Modern economic theory and our contemporary experiences suggest that public debt may not “crowd out” private investment. MMT rejects the basic notion that public and private sectors compete for loanable funds. According to this school of thought, public debt decreases rather than increases interest rates because, when the government spends, the private sector gets most of the money, which it injects into the banking system, increasing the money supply.[18] Stephanie Kelter, an MMT proponent and former economic advisor to Bernie Sanders, has written, “[The government’s] red ink is our black ink.”[19] Meanwhile, Paul Krugman has contested the idea that expansionary fiscal policy necessarily increases the money supply.[20] Regardless, many MMT adherents would have the Federal Reserve peg interest rates near zero to entirely evade “crowding out.” Perhaps growth prospects, more so than interest rates, drive private investment decisions. If so, smart deficit spending that secures the nation’s economic outlook might encourage private investment, even if deficit spending does increase interest rates. Additionally, the idea of crowding out largely came of age in the 1980s and 1990s, when interest rates far exceeded today’s near-zero rates.[21] We are currently living through a period of low interest rates and low inflation, minimizing the fiscal cost of public debt.
Many view public debt similarly to private debt—less is better than more. However, the federal government and households do not experience the same budget constraints. The federal government has a trump card in that it can issue currency, thereby printing money to pay its debts, and the Treasury can issue bonds. Both MMT proponents and more mainstream economists have distinguished the federal government from households in this regard. In 2005, former Fed Chairman, Alan Greenspan, testified before the House Committee on the Budget, “[T]here’s nothing to prevent the federal government creating as much money as it wants.”[22] During the Great Recession, Ben Bernanke, another former Fed Chairman, explained that the federal stimulus package more closely resembled printing money than borrowing it.[23] Putting things together, MMTers suggest that the government bankroll its spending directly from the Fed instead of issuing government bonds, in effect conjuring free money from thin air.[24] MMTers believe the default risk has been debunked because the federal government could hypothetically print its way to solvency.
Before the pandemic, MMT had inspired adherents and detractors. Progressives like Alexandria Ocasio-Cortez and Bernie Sanders would invoke MMT to justify running up the national debt to pay for their expensive policy programs like the Green New Deal.[25] Others have hinted at a line that the government ought not cross. According to former Treasury Secretary and Harvard President, Larry Summers, “Politicians and policymakers should focus on urgent social problems, not deficits. But they shouldn’t ignore fiscal constraints entirely.”[26] So, when do fiscal constraints counsel against deficit spending, and when should “urgent social problems” outweigh our qualms about spending beyond our means?
The Specter of Inflation
Even under MMT, deficit spending is subject to a limiting principle—inflation. As an empirical matter, deficits alone do not inherently cause inflation.[27] Advocates of expansionary fiscal policy point to Japan, which runs a much higher deficit than the United States while experiencing deflation.[28] However, inflation will run rampant if deficit spending outpaces the “real economy,” the goods and services that people can buy.[29] The extra dollars coursing through the economy’s veins must settle somewhere. If there are not enough goods and services on which these dollars can be spent at existing prices, the excess money supply will drive up prices.
How might inflation hamstring the U.S. government’s future ability to borrow? Historically, investors around the world have flocked to U.S. government bonds as a risk-free asset.[30] The attraction of U.S. Treasury bills is their backing by the full faith and credit of the U.S. government. Inflationary policies are a neat trick that undermine this guarantee. Inflation would cause the relative value of the dollar to plummet, perhaps driving away future investors.
Access to credit matters. During the pandemic, many developing nations have been unable to sustain high levels of deficit spending, limited by pre-pandemic debt.[31] Therefore, deficit spending might restrict access to credit markets, tying the government’s hands in the next crisis. Nonetheless, to the extent the government prints rather than borrows its money, access to credit theoretically would matter less, but this policy would still adversely affect outstanding U.S. Treasury bills and everyone holding them. Additionally, printing money risks hyperinflation. Those who subscribe to MMT turn to taxes to keep inflation down, suggesting that Congress intervene by siphoning the extra dollars that its deficit spending had initially injected into the economy.
However, MMT understates the risk of inflation and overstates the promise of taxation. First, taxation can only address half of the problem. Inflation occurs when demand outstrips supply.[32] Taxation can drive down consumer spending and aggregate demand, but it will not buttress supply. Second, MMT underestimates political pressures and blurs monetary and fiscal policy. Proponents of MMT advocate controlling inflation and unemployment through taxes and expenditures instead of interest rates.[33] Forcing the Federal Reserve to keep interest rates near zero would undermine its independence and raze both the institution and monetary policy. According to former chairman of the Council of Economic Advisers, Glenn Hubbard, such policy would evince “breathtaking naïveté.”[34]
The death of monetary policy would mean the ascendance of politics, as the Federal Reserve cedes its dual mandate to Congress. Unfortunately, history demonstrates that politicians cannot be relied upon to make the painful choices necessary to manage inflation, such as raising taxes or lowering spending.[35] Furthermore, expectations today lead to inflation tomorrow. Independent central banks help manage inflation expectations, but politicians blunt their anti-inflationary tools whenever they fail to make the tough shift towards contractionary fiscal policy once the economy has recovered.[36] People will not expect politicians to do anything other than spend and cut taxes once unleashed from the constraints of the national debt. Summers has warned that allowing the debt-to-GDP ratio to balloon without adjusting fiscal policy or raising interest rates, as recommended by some MMT advocates, would be “a recipe for hyperinflation.”[37]
Conclusion
With unemployment on the rise,[38] and with no end in sight to the pandemic, the U.S. economy is faltering. Extra unemployment benefits have expired, and the money is drying up.[39] For millions of unemployed Americans, the bills will soon come due, and without government relief, our economy will suffer permanent scarring. Any additional relief would add to the country’s already distended deficit. The long-term costs of deficit spending are not yet entirely clear, but, in the short-term, COVID-19 could hospitalize the U.S. economy. The choice is clear. It would be foolish to withhold life support.
When sagging aggregate demand contracts the economy, the federal government should spend—debt be damned. As both MMT proponents and critics agree, inflation provides the most meaningful limit on deficit spending. Given our current pairing of low interest rates with low inflation, the cost of deficit spending is low. With the economy on the brink, the benefit is high. However, institutional choice matters. Overtly political and partisan institutions are poorly suited to make the politically painful and nuanced decisions necessary to curb inflation. The current debacle over the next round of pandemic relief proves that Congress cannot take up the role of the Federal Reserve. Fiscal policy cannot completely swallow monetary policy because taxes alone are unlikely to keep hyperinflation at bay. We cannot completely disregard the specter of public debt because whether it is repaid through taxes or inflation, the bill eventually comes due. In our current crisis, we should proceed to spend in the red, but, because of inflation’s mercurial character, we should spend with care.
Jonathan Ellison is a J.D. candidate at Duke University School of Law
[1] See https://www.nytimes.com/2020/09/24/business/economy/us-economy-pandemic.html (“When the Fed is forced to try to rescue the economy on its own, the result is a painfully slow recovery that takes years to reach many of the most vulnerable households.”).
[2] https://www.wsj.com/articles/u-s-budget-gap-tripled-to-record-3-1-trillion-in-fiscal-year-2020-treasury-says-11602871210?mod=hp_lead_pos1.
[3] https://www.wsj.com/articles/pandemic-response-will-drive-up-global-public-debt-to-a-record-imf-says-11602676800?mod=hp_major_pos1#cxrecs_s.
[4] https://www.nytimes.com/2020/09/24/business/economy/us-economy-pandemic.html.
[5] https://www.nytimes.com/2020/09/24/business/economy/us-economy-pandemic.html.
[6] https://www.usdebtclock.org/.
[7] https://www.wsj.com/articles/u-s-budget-gap-tripled-to-record-3-1-trillion-in-fiscal-year-2020-treasury-says-11602871210?mod=hp_lead_pos1.
[8] https://www.brookings.edu/policy2020/votervital/how-worried-should-you-be-about-the-federal-deficit-and-debt/.
[9] https://www.wsj.com/articles/u-s-budget-gap-tripled-to-record-3-1-trillion-in-fiscal-year-2020-treasury-says-11602871210?mod=hp_lead_pos1.
[10] https://www.cbo.gov/publication/56542.
[11] Auerbach, Alan, William G. Gale, Byron Lutz, and Louise Sheiner. 2020. “Fiscal Effects of COVID-19.” BPEA Conference Draft, Fall.
[12] Letter from Thomas Jefferson to John Taylor, May 28, 1816.
[13] Auerbach, Alan, William G. Gale, Byron Lutz, and Louise Sheiner. 2020. “Fiscal Effects of COVID-19.” BPEA Conference Draft, Fall.
[14] https://www.brookings.edu/policy2020/votervital/how-worried-should-you-be-about-the-federal-deficit-and-debt/.
[15] https://www.nytimes.com/interactive/2019/01/09/us/politics/longest-government-shutdown.html.
[16] https://www.wsj.com/articles/what-modern-monetary-theory-gets-right-and-wrong-11554177661.
[17] https://www.cato.org/publications/cato-journal/modern-monetary-theory-critique; https://www.newyorker.com/news/news-desk/the-economist-who-believes-the-government-should-just-print-more-money.
[18] https://www.bloomberg.com/news/features/2019-03-21/modern-monetary-theory-beginner-s-guide.
[19] https://www.newyorker.com/news/news-desk/the-economist-who-believes-the-government-should-just-print-more-money.
[20] https://www.nytimes.com/2019/02/25/opinion/running-on-mmt-wonkish.html.
[21] http://larrysummers.com/2019/01/28/whos-afraid-of-budget-deficits/.
[22] https://www.businessinsider.com/modern-monetary-theory-mmt-explained-aoc-2019-3.
[23] https://www.businessinsider.com/modern-monetary-theory-mmt-explained-aoc-2019-3.
[24] https://www.wsj.com/articles/what-modern-monetary-theory-gets-right-and-wrong-11554177661; https://www.vox.com/future-perfect/2019/4/16/18251646/modern-monetary-theory-new-moment-explained.
[25] https://www.businessinsider.com/modern-monetary-theory-mmt-explained-aoc-2019-3.
[26] http://larrysummers.com/2019/01/28/whos-afraid-of-budget-deficits/.
[27] https://www.wsj.com/articles/what-modern-monetary-theory-gets-right-and-wrong-11554177661.
[28] https://www.businessinsider.com/modern-monetary-theory-mmt-explained-aoc-2019-3.
[29] https://www.vox.com/future-perfect/2019/4/16/18251646/modern-monetary-theory-new-moment-explained.
[30] https://www.vox.com/future-perfect/2019/4/16/18251646/modern-monetary-theory-new-moment-explained.
[31] https://www.wsj.com/articles/pandemic-response-will-drive-up-global-public-debt-to-a-record-imf-says-11602676800?mod=hp_major_pos1#cxrecs_s.
[32] See https://www.businessinsider.com/modern-monetary-theory-mmt-explained-aoc-2019-3 (“When a lack of productive supply met demand from excess cash, hyperinflation was the result.”).
[33] https://www.vox.com/future-perfect/2019/4/16/18251646/modern-monetary-theory-new-moment-explained.
[34] https://www.newyorker.com/news/news-desk/the-economist-who-believes-the-government-should-just-print-more-money.
[35] https://www.bloomberg.com/news/features/2019-03-21/modern-monetary-theory-beginner-s-guide.
[36] https://www.wsj.com/articles/what-modern-monetary-theory-gets-right-and-wrong-11554177661.
[37] http://larrysummers.com/2019/01/28/whos-afraid-of-budget-deficits/.
[38] https://www.nytimes.com/2020/09/24/business/economy/unemployment-claims.html.
[39] https://www.nytimes.com/2020/09/24/business/economy/us-economy-pandemic.html?action=click&module=RelatedLinks&pgtype=Article.
