The Hidden Risks of Stimulus Packages: Federal Debt Is Not a Problem – Until It Is

Most economists agree that some stimulus bill to mitigate the effect of the pandemic was a necessary evil (although they argue about how good the actual bill was). Unfortunately, we already were on an unsustainable course before the Covid-19 crisis, and we have now shifted into a higher gear.

Macroeconomics is a most difficult subject not only for managers but also for seasoned economists. I felt like an imposter for a long time, until the late Stephen Ross (of Yale and MIT fame) explained to me that even he did not really understand it. (And Steve, who started off as a macroeconomist, was perhaps the best economist I have known.)

However, in the wake of the Covid-19 pandemic and the looming election season and their proposals, I believe it would be malpractice if I did not write about the subject in our current context. Can the Fed rescue us? Can the stimulus? Is the stock market overreacting? Does the macroeconomy follow economic law? Will we all go back to “normal boom times” soon?

Macroeconomic Numbers in Meaningful Terms

One reason it is so difficult to wrap one’s head around macroeconomics is that politicians like to talk in terms of billions and trillions. These numbers are so gigantic that no one has an intuitive understanding of what they really mean—least of all the politicians. I want to try to give them more meaning and perspective.

Last year, our per-capita average income was about $56,000. Let’s ignore for a moment wealth inequality (not just income inequality) and uneven distributions of the tax burden.

Let’s just assume that you are the average, or that the average ratios also apply to you. The federal government and other governments taxed about $6,000 each, and payroll taxes were another $4,500, for total tax revenue of about $17,000. The federal government spent about $3,000 more than it took in. Looming in the medium future, say 10-20 years out, demographic changes have already been set to add the equivalent of another $5,000 per annum.

Taxes and deficits are not necessarily bad. Your government has been buying many useful (but also many not so useful) services for you. Roughly, your $20,000 in government spending today is buying about $4,000 in pensions for social-security recipients, $4,500 of health care ($2,500 for Medicare), $3,000 of education, $2,500 of defense, $1,200 of welfare, and about $5,000 of everything else (including about $1,000 for interest). About $13,000 of your $20,000 spending is mandated; about $7,000 is decidable by Congress.

You get to decide about your remaining $35,000. This becomes more interesting if we put together (1) how your decades of spending have added up; (2) what your looming obligations are; and (3) what your government is doing
and planning now.

Over many decades, the federal government has borrowed about $70,000 on your behalf (to be paid with your future tax payments), and state and local governments have borrowed another $10,000 or so (depending on the state). That is, your many governments have borrowed about $80,000.

They have also just borrowed about another $6,000 on your behalf in the first Covid-19 stimulus bill. 2020 will likely run a larger government deficit too, perhaps another $6,000. A reasonable estimate is that you will owe more than $90,000 by the end of the year. If a few more stimulus bills are coming, perhaps $100,000.

Roughly speaking, for each dollar you pay in taxes today, you already owe 5 times as many dollars. (If your earnings and taxes are higher or lower than average, use ratios to assess the future impact on you.)

Most economists agree that some stimulus bill was a necessary evil (although we argue about how good
the actual bill was). Unfortunately, we already were on an unsustainable course before the Covid-19 crisis, and
we have now shifted into a higher gear.

Election season means yet more government spending proposals so we may yet shift into even higher gears. The Green New Deal, free tuition, and Medicare for All would each cost about $5,000-$20,000 per person per year. They may not even be necessarily bad programs if they can reduce expenses that you are currently paying from your income’s remaining $35,000.

If $5,000 in government expenditures saves you $6,000 in private costs, you come out ahead! But my focus is not on analyzing the merits of these programs. I just want to discuss the basic math of government spending.

The Future

Debt is not a problem as long as your income grows faster than your debt. You can easily live with a $500,000 mortgage with an income of $100,000 per year if you expect your income to increase by 10 percent per year and your debt and obligations by only 5 percent per year. Your debt-to-tax ratio would decline over time. If you expect the reverse, you do have a problem. You are on an unsustainable course.

Let me recapitulate: You already owe about 5 times your annual tax payments. If the demographic shifts in 10 years hence were already here, you would spend about $25,000 per year. Thus, your payments would be about $8,000 short. Within 3 years, your debt-to-tax ratio will be 6 times. Within 15 years, it will be 10 times. At what point will your creditors ask themselves whether you will ever reduce your interest-to-tax-payment ratio?

These calculations suggest that you are already well into the region where you need to be aware of an important dilemma.

•  As long as your creditors believe that you are a safe bet, your $17,000 in tax payments will seem good enough to cover even $100,000 or $200,000 in debt. Indeed, your creditors right now seem content with nominal rates as low as 1 percent per annum and real rates of–1 percent! They believe in the magic powers of the Fed. This has kept most macroeconomists fairly sanguine: your creditors have shown no reduction in appetite. May it remain this way.

• However, if your creditors were to start worrying and/or if they find better and less expropriable opportunities elsewhere, they may no longer be willing to lend you money on such good terms. If they do start worrying and demand, say, a 3 percent in interest (as was the case in the not-so-distant past), how would you raise the money? On $150,000 in debt, a 3 percent interest rate will consume roughly the entire discretionary government budget. Can’t you just borrow more? Probably not. If your creditors learn that you have no stomach for raising funds the hard way, they may suddenly ask 5 percent or more.

Economists call such self-fulfilling prophecies “equilibria.” If your creditors become scared, then you (and they) should be scared indeed. Debt is not a problem—until it is. Worse, switching equilibria are not gradual problems. They are sudden-onset.

Hard Choices

So what can you, my American stand-in, do now?

1. Your first choice is to figure out how to increase your growth rate of income, so that it exceeds again the growth rate of your debt payments. Unfortunately, this requires the same kind of good luck, as Covid-19 was bad luck. Even in the best years of the current administration, the growth rate of debt was higher than the growth rate of income and taxes.

2. Your second choice is to start selling some of your assets. The government owns vast swaths of land (and many other) assets. Unfortunately, these are in (free) use by important voting groups in rural states that will be reluctant to give them up.

3. Your third choice is to elect a government willing to cut back on spending. The only categories that would make meaningful differences are Social Security, Medicare, and the military. Unfortunately, there are few of you (and certainly no politicians) willing to do so for now.

4. Your fourth choice is to confiscate your assets or to increase your taxes. As the average representative, if you wanted to cover your running expenses, you would have to increase your taxes by 50 percent. Instead of $38,000 to cover rent, food, medical expenses, etc., you would have only $30,000. Unfortunately, marginal taxes are already above. 50 percent for above-average earners. They would have to reach 75 percent or more.

5. Your fifth choice is to continue borrowing to cover deficits. Unfortunately, you are gambling that your creditors will never fear for your ability to pay up eventually.

6. Your sixth choice is to print more money. Unlike Argentina, your debt is denominated in your own currency. If you can double or triple inflation, you can erode the value of your outstanding debt. Unfortunately, this will also wipe out your financial savings in Treasuries. (If you think this is where this is heading, contemplate your investments!)

I see no appetite among the American public for any of the above today. Thus, I predict that we will muddle through until the train is so clearly about to hit the wall that we will switch equilibrium. Then, with lots of civil strife, we will probably have to adopt all of the above.

Paul Krugman would probably describe my views here as those of a zombie. I would love him to be proven right and for me to be proven wrong. Paul, where have I made a mistake?

Ivo Welch is the Distinguished Professor of Finance and holds the J. Fred Weston Chair in Finance at UCLA Anderson.

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