Not Soon Enough: A Response to Buchanan’s Post on Sept. 19th

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In a post on Professor Michael Dorf’s blog on Thursday, Neil Buchanan, a professor at George Washington Law, criticized the media—particularly the New York Times—for continuing to use the debt-doomsday narrative in covering the deficit generally and, in particular, the Congressional Budget Office’s recent 2013 Long-Term Budget Outlook. Buchanan is probably correct that there is little risk in the near future of a fiscal crisis. And he is right to point out that, given the very long time frame of the CBO’s projections, the actual budget results could be very different. However, he goes too far in his assertion that “[w]e have much bigger problems, if this is even a problem at all.” The deficit and the national debt are serious problems that have a real impact on the long-term well being of the U.S. economy.

To understand why the deficit and the debt, in their current states, are problematic, you can break the analysis up into two parts: (1) the risk of a fiscal-crisis; and (2) the ongoing impact of the debt and deficits on economic activity.

Regarding #1, Buchanan is right that the risk of a “fiscal crisis”—which I would define as either a default on U.S. debt or a sudden and dramatic rise in the cost of borrowing—is small in the near term based on the figures produced by the CBO (assuming a fiscal crisis is not caused by bipartisan political factors). However, looking only at the deficit-GDP and debt-GDP ratios doesn’t tell the whole story of the risk of a fiscal crisis in the medium and long term. Another important metric that investors use to determine the risk profiles of borrowers is the Debt Coverage Ratio, which is a measure of a debtor’s ability to service its outstanding debt. The Coverage Ratio is a function of a debtor’s revenue and the cost of servicing its debt, which includes the interest paid on bonds and notes.

If international interest rates, which have been low for some time, were to increase in the medium term (which I think is likely), the U.S. would be forced to offer a higher interest rate on its newly-issued debt securities in order to sell the necessary amount (i.e. the amount of the deficit) each year. This would mean that the total cost of servicing U.S. debt relative to its revenue stream—the coverage ratio—would increase, signaling to investors that the U.S. is a higher risk borrower than it otherwise would be and possibly causing a substantial risk premium to be built into newly issued debt securities. Further, the long-term uncertainty over the budget—which Buchanan uses to downplay the risk—would actually increase this risk premium as investors demand to be compensated for the uncertainty with a higher return.

The coverage ratio, combined with the relatively high—and increasing—level of U.S. debt, continuing deficits (especially if they’re at an “unsustainable” level), and the sheer magnitude of U.S. borrowing, means that the U.S. will have an increased risk of having to dramatically up the interest rates it offers for its securities in order to clear the market for newly issued debt. When combined with an external shock, a fiscal crisis could arise.

Regarding #2, even if there was no risk of a fiscal crisis, continually high deficits and debt are still serious problems because they can be a drag on long-term economic growth. As the CBO report points out, high deficits reduce private investment in productive capital because dollars that would have been directed to private—presumably more productive—investments go to government securities. While deficit spending can offset private investment in the short run, in the long run this “crowding out” has a negative impact on GDP growth. This is particularly true where a higher proportion of the debt is used to finance social spending as opposed to infrastructure—which is what the CBO report projects. Further, a high level of debt (as opposed to deficits) may also discourage investment. As private parties evaluate the viability of a particular investment, the future tax environment is incorporated into their analysis of the potential return. The prospect of a higher future tax bill—which a high debt-GDP level suggests—can discourage investment which, in turn, lowers long-term GDP growth.

Of course, the impact of the debt on GDP growth is dependent on its relative level. Some European studies have suggested that the GDP-debt ratio must hit at least 70% before there’s a drag on GDP growth, a level which the CBO report says we will fall below in the coming years. However, according to the CBO, the U.S.’s current GDP-debt ratio is north of 70% and will rise above that level again in ten years. Further, the debt level doesn’t speak to the impact that high deficits have on private investment and long-term GDP growth through crowding out.

Thus, while Buchanan is probably right that a fiscal crisis isn’t looming and that the media are being less-than-genuine in their coverage, the deficit and the total debt level are real problems that deserve the nation’s attention. Fiscal crises can and do occur, and the U.S.’s continued irresponsible spending increases the risk of a crisis in the medium-long term while possibly slowing economic growth.