So far, my foray into the world of the national debt has consisted of this:
- Don’t try to scare people with hyperinflation unless you have some basis for doing so.
- The recent deterioration in the projected debt situation is mainly due to the financial crisis and recession, not some kind of runaway spending under the Obama administration. (See Econbrowser for the deterioration over the last eight years.)
One of the curious things about the debt scare that is building in the media is that it is happening at a moment when long-term interest rates are very low. In other words, it’s based on a theory that the market is wrong in its collective assessment of the debt situation. I’ve heard this blamed on “non-economic actors” (that is, foreign governments that buy U.S. Treasuries not as a good investment, but for political reasons), or on a “carry trade” where investors are exploiting the steep yield curve (free short-term money, positive long-term interest rates), as Paul Krugman discusses here.
Menzie Chinn crunches some numbers. He takes a model that he and Jeff Frankel created several years ago to estimate the impact on interest rates of inflation, the future projected national debt, the output gap (economic output relative to potential), and foreign purchases of Treasuries. That last term is important, because the oft-heard fear is that foreign governments will suddenly stop buying our debt.
Using the future growth in the debt projected by the CBO, this model predicts that real interest rates will … go down by 7 basis points over the next year, assuming foreign purchases of debt are constant. The reason the impact of the debt is so small is that it’s already priced in; since the looming debt is no secret, it should already be showing up in the data.
The counterargument is that it hasn’t shown up in the data because of the “flight to safety” and foreign governments’ irrational purchases of Treasuries. So Chinn also looks at what would happen if foreign purchases of U.S. debt fell to zero, nada, zilch (which is an extreme scenario). In that case, interest rates go up by 1.3 percentage points. That’s not nothing, but it still keeps interest rates at reasonable levels by historical standards. In addition, the CBO is already incorporating higher interest rates into their forecasts; they expect the 10-year Treasury bond yield to go from 3.3% in 2009 to 4.1% in 2010, 4.4% in 2011, and 4.8% in 2012-13, and that’s built into their projections of future interest payments.
So I’ll say again: none of this is good. But if we’re going to make important policy decisions based on fear of the debt, we should have a rational way of thinking about the impact of that debt rather than just fear-mongering.
As for me, this is far from my area of expertise, but the first thing that comes to mind as far as a solution is some kind of binding commitment (or at least as binding as out government can make it) to raise taxes (or undo the Bush tax cuts) when the economy has fully recovered according to some objective metric like the output gap. That and, of course, fixing the health care system.
Updates: Whoops! Link fixed. Also, a reader says I should include the caveat from Chinn’s post:
“These estimates were obtained using data that spanned a period without extraordinary Federal Reserve credit easing, and in the face of an unprecedented financial collapse. And, the relationship is not precisely estimated.”
This implies that the model may not be accurate. On the broader issue, it’s not as if quantitative easing is a secret, nor is it a secret that it’s going to end sometime in the next few years. So this isn’t something that investors in 10-year bonds don’t know about.
By James Kwak