Has economic thought changed with the large amount of debt being taken on by the government?

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Question: 

When I attended ISU and graduated with an M.S. in economics in 1967, I was taught that government debt was largely a good thing, as it was (then) mostly money owed to ourselves. It also provided a useful tool for the Fed. to use for controlling the money supply by buying or selling bonds. Has general economic thought changed with the large amount of debt being taken on by government spending, quantitative easing, and a larger percentage of our debt being owned by foreign powers (China, etc.). Do we now believe that our national debt is not such a "good" thing?

Answer: 

Your understanding is correct that government debt is “good” in the sense that it serves as a useful tool for conducting both monetary and fiscal policy. By allowing federal, state, and municipal governments to borrow, it lets these entities build infrastructure and create human and knowledge capital that can serve future generations. As it may not be possible for the government to fund these projects from current tax revenues, it is justified to borrow from the current generation and then pay them back by taxing future generations who are most likely to benefit from these long run projects.

An added benefit is that debt allows governments to handle economic recessions better. When the private sector employment and therefore consumption demand is shrinking, the government can increase its public sector spending (by borrowing) which not only increases public sector employment but also provides for safety net to unemployed (benefits) and helps sustain aggregate demand in the economy.

However, for smoothing business cycles, the underlying policy principle is that ‘spend in bad times and save in good times’, which would require that the government run surpluses when the economy is doing well. Unfortunately, in the last forty years, the US government has run (relatively small) surpluses only during 1998 – 2001. In the rest, it has run deficits.

As a result, the current US debt to GDP stands slightly above 100%, which in the developing world is considered high – only few countries, e.g., Japan and Italy have a higher government debt to GDP ratio.

The key issue and the current debate is on whether the present level of debt and ongoing deficits are sustainable. There is a general agreement that current benefits under Medicare and Social security programs cannot be funded from current revenue streams and as more and more baby boomers retire, these programs will eventually be bankrupt. Either benefits under these programs need to be reduced (which people on the right argue), or tax revenues need to be increased (which people on the left suggest) in order to meet future benefit obligations. Otherwise, the government will continue running deficits, and its debt will continue to grow, and in the end servicing and repaying this debt will itself become impossible – that is, the debt will become unsustainable.

About a third of US debt is held by foreigners (and largest chunks by China and Japan). US treasuries are the safest assets (despite S&P downgrading it to AA+ last years), and all foreign central banks want to hold it as reserves that provides with them with a critical cushion in times of their financial and currency crisis. The dollar happens to be the most desirable currency because of its stability. This can be a boon but also a curse: due to worldwide demand for US treasuries, the interest rate is low. As treasury interest rates work as benchmark interest rates for most of the other US financial products (including mortgages), a low interest rate (relative to fundamental) may encourage over borrowing – this is one of the reasons for extremely low US savings rates before the subprime crisis.

In general, foreigners owning a large amount of US debt is not really a problem, unless one of the owners (say, China) plays strategically and decides to begin dumping US treasuries, which can destabilize the US bond market. This is what some people fear.

As for the Fed’s quantitative easing program, it is not directly related to increases in government deficits or debt. But, yes, Fed’s aggressive buying of US treasuries increases its demand and lowers interest rates (that is what the FED aims for). This has been a cause of concern domestically: some people fear that excessive money supply will eventually lead to inflation. Foreigners (for example, Brazil) complain that excess money in the US is chasing their assets and demand for their currencies, which in turn hurts their exports. But, this is an international dimension, and I am not sure whether we should get into this to answer your concerns.