Yes, Deficits Still Matter

By Kevin D. Williamson

Wednesday, November 22, 2017

There’s a lot not to like about the current Republican tax proposal, beginning with its effect on the debt, to which it will add about $1.3 trillion, according to current estimates.

It is becoming something of an unfortunate tradition in American politics that deficits matter only to the party out of power. Republicans wailed and moaned about the Obama-Pelosi-Reid deficits and, to their credit, reduced them when they came to power in Congress. But having whiffed on health-care reform and much else toward which they have turned their increasingly addled, muddled, and unample attention, they are desperate to pass some kind of tax-cut package, even though the government’s continued deficit spending means that there is effectively no such thing as a tax cut, only a tax deferral.

The numbers are always shocking and mind-numbing: so many trillions in debt, so many more in unfunded liabilities for Social Security and Medicare, etc. But while we should pay attention to the weighty question of what all that adds up to, we should spare a moment to consider the livelier question of risk. Deficits matter because, ultimately, debts have to be paid, but also because the reality is that sometimes debts go bad, and the fact and fear of that possibility can lead to chaos.

Why do deficits matter?

Let’s say you go into your bank to ask for a loan. (Comparisons between government finances and household finances are imperfect for reasons I’ll touch on in a bit, but it works for the current purpose.) The bank’s answer may be “No,” but it isn’t really a yes-and-no question. Often, the answer will be, “Yes, but at a high price.” Why do banks charge some borrowers higher interest rates than others? It isn’t because they don’t like them or because they think they’re bums, and it may not have much to do with them individually at all. They just know from experience that certain combinations of credit score, income, and wealth are associated with higher levels of loan default and some with lower levels. The bank charges more to take on a greater risk, because riskier loans are more expensive to the bank, even if the borrower doesn’t default — banks insure themselves against losses, and riskier loans make that more expensive.

So how does your bank think about your credit? There’s your credit history, which tells them whether you’ve had problems meeting your obligations on earlier occasions. And then there are your personal financials: your debt, assets, and income relative to one another. Each of those components matters on its own, but what really matters is the relationship between them. For example, imagine you have $25,000 in total personal debt. Is that a big number or a small number? If you make $20,000 a year, it’s a big number; if you make $400,000 a year, it’s a small number. What matters is your debt-to-income ratio.

Your debt-to-asset ratio is examined in much the same way: If you have $250,000 in debt, $50,000 in income, and pocket lint in the way of savings, that’s one thing; if you have $250,000 in debt, $50,000 in income, and $1 million in savings, that’s something else.

The third way of evaluating debt is the one most applicable to our current question, which is the ratio of your monthly debt-service payments to your income. Say you have a mortgage payment, a car payment, and some credit-card bills, and the minimum payment on all these adds up to $2,500 a month. If you make $20,000 a month, that’s no big deal. If you make $4,000 a month, that’s pretty tight. If you make $2,200 a month, you’re insolvent. That last situation is why we have bankruptcy law: You couldn’t satisfy your obligations even if you dedicated 100 percent of your income to trying to do so, so something somewhere is going to have to give. (This is why banks like it when you have lots of assets: If you fail to make your loan payments, they can force you to sell assets and make good on your debt.) Basically, the lower your monthly payments are as a share of your income, the better for your credit. Most people don’t want to default on their loans and will make their payments if they are able.

The problem is that both debt-service payments and income can change in unwelcome and unexpected ways. A lot of families in Greenwich, Conn., were living well within their means when they had seven-figure household incomes before the financial crisis, but they couldn’t make ends meet when those investment-banking jobs went kaplooey and they were reduced to mere six-figure incomes. At the opposite end of the spectrum, a great many mortgage borrowers with adjustable-rate loans were doing fine when their house payments were $1,200 a month but couldn’t swing it when they jumped up to $1,700.

As I wrote above, the U.S. government is not exactly like a guy applying for a mortgage or getting a new credit card. For one thing, the U.S. government can, if it decides to, increase its income — within limits. The government can raise taxes, but only so much. (Reality is not optional.) Second, the U.S. government can create money. If the government needs to make a $500 billion debt-service payment and it doesn’t have the cash on hand, it can simply create it. (That’s what’s meant by “fiat currency.”) That leads to inflation, which is a powerful negotiating tool for a debtor whose liabilities are denominated in a currency it controls.

But even given those extraordinary powers, the U.S. government, like any government, is judged in part by the size of its debt relative to the size of the economy and relative to the size of its income from taxes and the like. And lenders (in this case, people who invest in Treasury bonds and other U.S. government securities) are keenly interested in how big the government’s debt-service payments are relative to its income.

And that’s where the possibility of a vicious cycle has to be carefully considered.

The rate of interest the U.S. government pays on its debt is low by historical standards right now, and interest rates are low across the board. They aren’t the lowest they’ve ever been, but they’re pretty low. In 2016, the government paid an average of about 2.23 percent interest on its debt. Over the course of this year, that’s ticked up just a little bit, to just a little under 2.3 percent. Still not very high. But even at those modest rates, interest payments account for about 7 percent of federal spending, about $276 billion a year for 2017. That’s about 40 percent the size of the Department of Defense’s budget. Not chicken feed. Adding $1.3 trillion to that isn’t going to help things.

Historically, interest rates have been much higher. They were about 7 percent in 2000, and nearly 15 percent in 1982. So, what happens if interest rates go up? Suddenly — perhaps very suddenly — that $276 billion a year in interest payments gets a lot bigger, conceivably doubling or trebling. (And rates’ going even higher would not be without relatively recent historical precedent.) That’s bad enough on its own: We end up with a Pentagon-sized hole, or an even bigger one, in the federal budget, just for interest payments on money that’s already been spent.

But what’s talked about less often is how changes in our current borrowing costs are likely to affect our future borrowing costs in a self-perpetuating cycle. If our debt service goes from 7 percent of spending to 15 percent of spending, that makes our government debt a bigger risk for the same reason that a $1,000-a-month minimum credit-card payment is a very big deal for a man making $2,500 a month but not for one making $25,000 a month. How do lenders respond to greater risk? By demanding higher interest payments, usually. And those higher interest payments would raise our debt-service expenses as a share of federal income — and further erode our credit position, leading lenders to ask for even higher rates, etc. That’s the potential vicious cycle. That’s a recipe for a credit crisis that would make 2008–09 look like a picnic.

Hold on with the Chicken Little stuff. I’m not saying this inevitably will happen. I’m not even saying that it is very likely to happen over the short or medium term. Bond investors certainly don’t think it is likely, otherwise they’d already be asking for higher interest rates or moving their money to safer investments. What I am saying is that this is a risk, one that should be accounted for in our politics and understood in our debate about the debt and deficits, including in our debate about the current tax-cut proposal. Adding to the deficit adds an unnecessary risk — and avoiding unnecessary risks while working to minimize the risks we do have to take is what once was meant by the word “conservative.”

We have to understand the risk before we decide whether a certain proposal is worth the associated risk.

Ultimately, a long-term, bipartisan fiscal-reform project is going to be necessary, and it is going to involve taxes, spending, entitlements, the military, and much more. The current Republican tax plan just adds $1.3 trillion or so to the problem — and for what? Not much.