Nobody Understands Debt

[Tom Wetmore]

Nobody Understands Debt

By Paul Krugman

January 1, 2012

In 2011, as in 2010, America was in a technical recovery but continued to suffer from disastrously high unemployment. And through most of 2011, as in 2010, almost all the conversation in Washington was about something else: the allegedly urgent issue of reducing the budget deficit.

This misplaced focus said a lot about our political culture, in particular about how disconnected Congress is from the suffering of ordinary Americans. But it also revealed something else: when people in D.C. talk about deficits and debt, by and large they have no idea what they’re talking about — and the people who talk the most understand the least.

Perhaps most obviously, the economic “experts” on whom much of Congress relies have been repeatedly, utterly wrong about the short-run effects of budget deficits. People who get their economic analysis from the likes of the Heritage Foundation have been waiting ever since President Obama took office for budget deficits to send interest rates soaring. Any day now!

And while they’ve been waiting, those rates have dropped to historical lows. You might think that this would make politicians question their choice of experts — that is, you might think that if you didn’t know anything about our postmodern, fact-free politics.

But Washington isn’t just confused about the short run; it’s also confused about the long run. For while debt can be a problem, the way our politicians and pundits think about debt is all wrong, and exaggerates the problem’s size.

Deficit-worriers portray a future in which we’re impoverished by the need to pay back money we’ve been borrowing. They see America as being like a family that took out too large a mortgage, and will have a hard time making the monthly payments.

This is, however, a really bad analogy in at least two ways.

First, families have to pay back their debt. Governments don’t — all they need to do is ensure that debt grows more slowly than their tax base. The debt from World War II was never repaid; it just became increasingly irrelevant as the U.S. economy grew, and with it the income subject to taxation.

Second — and this is the point almost nobody seems to get — an over-borrowed family owes money to someone else; U.S. debt is, to a large extent, money we owe to ourselves.

This was clearly true of the debt incurred to win World War II. Taxpayers were on the hook for a debt that was significantly bigger, as a percentage of G.D.P., than debt today; but that debt was also owned by taxpayers, such as all the people who bought savings bonds. So the debt didn’t make postwar America poorer. In particular, the debt didn’t prevent the postwar generation from experiencing the biggest rise in incomes and living standards in our nation’s history.

But isn’t this time different? Not as much as you think.

It’s true that foreigners now hold large claims on the United States, including a fair amount of government debt. But every dollar’s worth of foreign claims on America is matched by 89 cents’ worth of U.S. claims on foreigners. And because foreigners tend to put their U.S. investments into safe, low-yield assets, America actually earns more from its assets abroad than it pays to foreign investors. If your image is of a nation that’s already deep in hock to the Chinese, you’ve been misinformed. Nor are we heading rapidly in that direction.

Now, the fact that federal debt isn’t at all like a mortgage on America’s future doesn’t mean that the debt is harmless. Taxes must be levied to pay the interest, and you don’t have to be a right-wing ideologue to concede that taxes impose some cost on the economy, if nothing else by causing a diversion of resources away from productive activities into tax avoidance and evasion. But these costs are a lot less dramatic than the analogy with an overindebted family might suggest.

And that’s why nations with stable, responsible governments — that is, governments that are willing to impose modestly higher taxes when the situation warrants it — have historically been able to live with much higher levels of debt than today’s conventional wisdom would lead you to believe. Britain, in particular, has had debt exceeding 100 percent of G.D.P. for 81 of the last 170 years. When Keynes was writing about the need to spend your way out of a depression, Britain was deeper in debt than any advanced nation today, with the exception of Japan.

Of course, America, with its rabidly antitax conservative movement, may not have a government that is responsible in this sense. But in that case the fault lies not in our debt, but in ourselves.

So yes, debt matters. But right now, other things matter more. We need more, not less, government spending to get us out of our unemployment trap. And the wrongheaded, ill-informed obsession with debt is standing in the way.

[Jeannieb43]

Wow! That's an eye-opener.

[phkrause]

Great article Tom. I do recall posting a number of links and articles that relate to this. And almost each one says the same, that we need to spent more and not less. Does seem odd though.

[bonnie]

Great article Tom. I do recall posting a number of links and articles that relate to this. And almost each one says the same, that we need to spent more and not less. Does seem odd though.

Once you max out one credit card,get another with a higher limit.

Checking account overdrawn,keep writing and spending

[Bravus]

The analogy between household finance and government finance is fundamentally flawed. That was the *point* of the article.

[bonnie]

The analogy between household finance and government finance is fundamentally flawed. That was the *point* of the article.

Of course it is.It is still difficult to see the logic of spendng more than you are taking in.Spending more than is coming in can only be done for so long in any budget

We have tried this....We need more, not less, government spending to get us out of our unemployment trap

Government cannot sustain employment by spending in the long term.It can quit placing obstacles in the way and the private sector will create jobs

[bonnie]

How did the US pay down WW2 debt?

Brett Williams, BA, History

1. The US paid it off over a very long period of time. Reagan was the first president who didn't have to pay off the WWII debts. Britain finally paid off their debts in 2007.

2. Inflation. Because the debt was paid off over a long period of time, which included several inflationary periods like the 60's and the 70's.

3. Taxes: Taxes were FAR higher, in the range of 93 percent for top tax brackets.

4. Expanding Economy: The US economy in the 40's, 50's, 60's, 80's and 90's was huge, growing and incredibly productive. A growing economy, plus Taxes and Inflation made the debt far less of an issue than it is now.

5. Lack of Competition: The war had been fought over top of the main industrial competitors to the US. The US essentially had a war-induced industrial monopoly for 10 years.

[bonnie]

Krugman versus Krugman on deficits and debt -- who can you believe?

Government deficits totaling $9 trillion over the next ten years are coming, the Obama administration now projects. (Up from its prior projection of $7 trillion. For perspective, $9 trillion is over 20% more than the entire national debt accumulated from George Washington's inauguration until today: $7.4 trillion).

Many commentators are alarmed. Prof Hamilton at Econbrowser illustrates alarm with a nifty chart showing the difference for the worse between now and the last time such debt levels were reached, during World War II, and draws Paul Krugman's attention.

Krugman's response: Good God! He's "terrified"! This is a "looming threat to the federal government's solvency"!! No less than that. Brace yourself for the horrors he predicts, quoting here ...

...last week I switched to a fixed-rate mortgage. It means higher monthly payments, but I'm terrified about what will happen to interest rates once financial markets wake up to the implications of skyrocketing budget deficits... we're looking at a fiscal crisis that will drive interest rates sky-high.

A leading economist recently summed up one reason why: "When the government reduces saving by running a budget deficit, the interest rate rises." Yes, that's from a textbook by the chief administration economist, Gregory Mankiw.

But what's really scary, what makes a fixed-rate mortgage seem like such a good idea, is the looming threat to the federal government's solvency.

That may sound alarmist: right now the deficit, while huge in absolute terms, is only 2 , make that 3, O.K., maybe 4 percent of G.D.P.

But that misses the point ... because of the future liabilities of Social Security and Medicare, the true budget picture is much worse than the conventional deficit numbers suggest.

... the conclusion is inescapable. Without the Bush tax cuts, it would have been difficult to cope with the fiscal implications of an aging population. With those tax cuts, the task is simply impossible. The accident, the fiscal train wreck, is already under way.

How will the train wreck play itself out? ... my prediction is that politicians will eventually be tempted to resolve the crisis the way irresponsible governments usually do: by printing money, both to pay current bills and to inflate away debt. And as that temptation becomes obvious, interest rates will soar.

... investors still can't believe that the leaders of the United States are acting like the rulers of a banana republic. But I've done the math, and reached my own conclusions -- and I've locked in my rate.

No. Wait ... wait. Sorry. Wrong column, my bad.

That was Krugman back when Bush was president, when CBO had projected 10-year deficits of $1.8 trillion, rather less than $9 trillion.

Krugman's response yesterday to Professor Hamilton was entirely different: Why worry? Be happy!

I respect Jim Hamilton a lot, [but] I think that he and others are quite wrong, on several counts.

... let’s take a slightly later start date: in 1950, federal debt in the hands of the public was 80 percent of GDP, which is in the ballpark of what we’re looking at for 2019. By 1960 it was down to 46 percent — and I haven’t heard that anyone considered America a debt-crippled nation when JFK took office.

So how was that possible? ... How, then, did America pay down its debt? Actually, it didn’t: federal debt rose from $219 billion in 1950 to $237 billion in 1960. But the economy grew, so the ratio of debt to GDP fell, and everything worked out fiscally.

... the lesson of the 1950s — or, if you like, the lesson of Belgium and Italy, which brought their debt-GDP ratios down from early 90s levels — is that you need to stabilize debt, not pay it off; economic growth will do the rest....

So, to review: to make the debt look scary, you have to dismiss the post-World -War II experience, even though it turns out that the 50s offer a quite good lesson...

So which Krugman are we supposed to believe?

[] Krugman 2003 [deficit at 3% of GDP, 10-year deficit projection $1.8 trillion]: "I'm terrified ... we're looking at a fiscal crisis that will drive interest rates sky-high ... the conclusion is inescapable ... the task is simply impossible ... the fiscal train wreck, is already under way." Or,

[] Krugman 2009 [deficit at 11% of GDP, 10-year deficit projection $9 trillion]: What's to worry? The Ozzie & Harriet era of government finance will be easy enough to bring back. Just stabilize the debt in terms of GDP and be happy!

Well, to decide, let's look at the data. Krugman today is saying the years 2019 to 2029, after the projected run-up, can easily be just like the years 1950 to 1960 -- with the debt stabilized in terms of GDP from an earlier big run-up.

Here are the actual percentage changes in real-dollar debt and GDP for 1950-1960, and the projected changes on current policy for 2019-2029*

_____1950-1960 ___ 2019-2029

debt .. -13.5% .... +103.4%

GDP ... +41.1% .... + 23.9%

Hello? That's a rather big difference in the direction "debt" moves between the two decades. What's the source of the difference?

The minor source is that Krugman was being a bit disingenuous when he said the US "didn't" pay down its debt in the 1950s. The gov't ran multiple surpluses during the decade and did reduce the debt in real-dollar terms. (No such surpluses are planned in our future.)

But the huge reason is the approximately $62 trillion at present value in unfunded obligations that the government owes for Medicare, Social Security, Medicaid and federal-military pensions. This $62 trillion did not exist in 1950. As the baby boomers sail into retirement, to pay for them this $62 trillion of "implicit debt" rolls into cash-interest-paying Treasury debt annually at an ever-accelerating rate. This cost over time piles up to a staggering, unsustainable amount, detailed previously. (As Krugman 2003 knew!)

Krugman now says we "merely" have to stabilize the debt. Let's look at what that will take.

CBO says spending on Medicare, Social Security and Medicaid alone, will increase by 6 points of GDP by 2030. Being that government expenditures have been around 20% of GDP in recent decades, just this alone requires a 30% real increase in revenue by 2030 to "stabilize" deficits.

That requires tax increases. (You know Krugman doesn't want to slash social insurance spending.) How much in tax increases?

CBO has provided numbers: A 50% across-the-board income tax increase on everyone, both individuals and businesses (or an equivalent revenue raiser) by 2030 -- just for starters, as spending rises on ever after. (Here are details, with comparisons to past fiscal events, such as World War II.) In the alternative, both Moody's and Standard and Poor's have projected the credit rating of the US will start falling in 2017, with S&P projecting Treasury bonds will be "junk" by 2027. (And those projections were made before the effects of the current recession and Obama's policies)

Does Krugman have any proposal for tax increases on such a scale? Nope. He ignores the issue.

Hey, but does Krugman somehow not know about the $62 trillion of "implicit" debt that will be turning into real, explicit debt in coming years? Of course he knows all about it -- when it's politically convenient.

Remember Krugman 2003 knew all about it when writing: "because of the future liabilities of Social Security and Medicare, the true budget picture is much worse than the conventional deficit numbers suggest. ... the conclusion is inescapable. Without the Bush tax cuts, it would have been difficult to cope with the fiscal implications of an aging population. With those tax cuts, the task is simply impossible ... the fiscal train wreck, is already under way".

But now Krugman 2009 has forgotten all about it.

The Bush tax cuts haven't been repealed, right? And Obama says he's not going to repeal the bulk of them -- $2 trillion worth (over 10 years) on persons with incomes under $250,000. In fact, he's explicitly promised further net tax cuts.

So how has the "simply impossible" of 2003 become so trivially easy in 2009, even as the fiscal situation has gotten much worse? The answer is trivially obvious:

Krugman, like every other strident political hack advocate, follows this rule in evaluating deficits:

[] When out of power, so I'm not getting the political benefit of deficit spending, my opponents are getting the benefit, deficits are so wantonly irresponsible as to threaten the solvency of the government itself!

[] When in power, so I am getting the political benefit of deficit spending, and my enlightened spending is beneficial to all, all those modest deficits of history never hurt Ozzie and Harriet, so what's to worry?

Thus it has been in politics, and so it shall always be -- until the cash bill for $69 trillion-plus in total explicit-and-implicit debt starts seriously arriving around 10 years from now ... and 10 years after that either we are up to our eyeballs in tax increases or the government is broke. Or both.

~~~

[Dr. Shane]

Quote:

Nobody Understands Debt

By Paul Krugman

January 1, 2012

The debt from World War II was never repaid... that debt was also owned by taxpayers, such as all the people who bought savings bonds. So the debt didn’t make postwar America poorer.

Well, someone certainly doesn't understand.

[Dr. Shane]

The analogy between household finance and government finance is fundamentally flawed.

That is true but it is no big deal. The analogy doesn't have to be spot on to make the point. Government debt will eat our lunch. It has in other countries and is in Europe now. To say we don't have to pay it back simply isn't true. If you by a US T-bill, you are loaning money to the US government and you will be paid back.