U.S. Fiscal Policy and Government Debt

James Poterba, President of the National Bureau of Economic Research and Mitsui Professor of Economics at MIT, discussed the “remarkable turnabout” in fiscal policy thinking in the U.S. in recent years at the recent Bradley Distinguished Lecture webinar.

He pointed to the evolving view that deficits and government debt aren’t nearly as much of a concern as they were in decades prior, and can be managed at a higher level than previous thought.

At present, the outstanding federal debt held by the public is over $22 trillion, or about $65,000 per person. Although that’s a large number, Poterba said that what we really should be concerned about more than the absolute size of the debt is the burden of that debt and how it affects households today and moving forward.

With the exception of the late 1990s and early 2000s, the U.S. has run annual budget deficits over the last 50 years, most notably during the Great Recession and more recently during the COVID pandemic.

The debt-to-GDP ratio for the same period fluctuated between 25-40% until the Great Recession, when it rose to 70%, followed by the pandemic, which has pushed it close to 100%. (For historical perspective, the ratio was around 110% immediately following World War II.)

The Congressional Budget Office projects the debt-to-GDP ratio to be around 200% by 2050 – without taking new spending proposals like the infrastructure plan into consideration.

Poterba said that it’s also important to consider how much interest we need to pay to cover the debt burden. The average interest rate has gone down significantly in the last 20 years, and interest payments by the federal government as a percent of GDP are actually lower today than they were in 2000.

In fact, the real interest rate (the nominal interest rate minus the inflation rate) is currently below zero, which he says makes it a great time to borrow.

“These negative real interest rates are now a feature of our economic landscape,” he said, noting that he didn’t even discuss the subject with his macroeconomic students 10 or 20 years ago.

But there are potential costs to higher debt ratios, including rising interest rates, the need for higher taxes in the future, and the raised risk of a fiscal crisis.

The real burden of the debt, Poterba said, is that it crowds out accumulation of productive provide capital.

“If there is $20 trillion of U.S. federal debt that has to be absorbed in the capital markets – $14 trillion of which is being held domestically – that is space in portfolios that could have been taken up by other assets, such as equity or corporate debt.”

Managing the debt-to-GDP ratio is a challenging prospect, he said. To stabilize the ratio at its current level in 2050, the Congressional Budget Office estimates that we would have to raise taxes or decrease spending by almost 3% beginning in 2025 (or 3.6% if we waited until 2030).

“It’s not inconceivable, but it would be a major change in fiscal policy,” he concluded. “And that’s not the way the winds are blowing right now.”

A recording of Dr. Poterba’s full presentation can be found here.

The Bradley Distinguished Lecture Series is sponsored by The Lynde and Harry Bradley Foundation and UWM’s Lubar School of Business.