Shrinking debt may stunt U.S. recovery

The U.S. federal government last ran a budget surplus in the fiscal year 2001. Since then, the government has borrowed roughly $20 trillion. That’s a large number, even for an economy as big as America’s: Federal debt held by the public has roughly tripled as a percentage of gross domestic product, from 32% to 94%.

I argued in my last column that we are not in a debt crisis. Historically, in fact, U.S. debt isn’t all that unusual. For example, over the past three centuries Britain emerged from each major war with debt as a percentage of GDP well above the current U.S. level.

Still, the political history of America’s 21st-century deficits isn’t edifying. George W. Bush squandered that 2001 surplus he inherited largely on tax cuts that favored the wealthy and the invasion of Iraq, both sold to the public on false pretenses. Donald Trump rammed through another big tax cut tilted toward the wealthy, again with false claims that it would do wonders for the economy.

It’s possible to imagine alternative histories that would have left us with less debt. But in many cases fiscal austerity would have created problems of its own, and the costs of not having a lot of debt would probably have been high.

It’s important to scale debt to the size of the economy. My preferred measure is debt as a percentage of potential GDP, an estimate of what the economy could produce at full employment.

Most of the debt was incurred during two episodes: the 2007-09 Great Recession and its aftermath, and the COVID-19 pandemic.

In the case of the recession, the deficit shot up largely because tax receipts plunged along with the economy, while social safety net spending, especially unemployment benefits, soared. Former President Barack Obama’s stimulus package was also a factor.

This deficit surge was actually a good thing at the time: It helped sustain spending, which in turn propped up the economy, and this was arguably a major reason we didn’t experience a full replay of the Great Depression.

But should there have been a bigger effort to balance the budget once the crisis was past? The problem is that recovery from the Great Recession was slow. And cutting spending or raising taxes to limit debt would have made that recovery even slower.

So the big rise in debt between 2007 and the late 2010s was actually justified by economic events, and any attempt to avoid that rise would have done more harm than good by slowing our recovery even further.

Then came COVID, and this time the government responded very strongly, with trillions in aid to families, businesses, the unemployed and state and local governments. Of course, there was also an upward jump in debt.

So should we start trying to pay this debt down now? Leave aside the fact that, politically, it just isn’t going to happen. Would it even be a good idea economically?

The answer depends in large part on whether the Fed would be able to offset the depressing effects of fiscal austerity on demand. Right now that wouldn’t be a problem, since the Fed is raising rates to fight inflation; all it would need to do is slow or reverse these rate hikes. But what will the economic environment look like in, say, two or three years?

Well, my view is that we’ll probably be headed back to an era of low interest rates. That would be a world in which trying to reduce the debt would cause economic problems.