Monday, January 2, 2012

Why Government Debt Is Not Like Household Debt

Krugman explains how government debt differs from household debt. He felt compelled to explain the difference because some politicians believe that they benefit from a confused electorate. One of our major political parties has built its 2012 election campaign around the need to cut spending and reduce budget deficits, despite high levels of unemployment.

If investors were concerned about the ability of the US government to pay back the money that it borrows, they would demand higher interest rates that act as risk premium. Some countries in Europe have that problem today. The US government is able to borrow at the risk free interest rate because investors are not worried about the ability of the government to pay the interest on its debt, or on the ability of the government to refinance bonds as they mature. They expect that the US economy will continue to grow faster than interest rates. Government tax revenues increase as the economy grows, and the government can always raise taxes to increase its income if necessary.

The electorate also has an weak understand of what causes budget deficits. Budget deficits always increase during recessions because tax revenues fall in relation to the decline in national income. Spending on transfer payments also rise during periods of high unemployment. Much of that spending is automatic, and it is based upon current law. Only a small fraction our deficits over the last 3 years resulted from government stimulus spending. In fact, about 30% of the stimulus was from tax cuts which increased the ability of households and businesses to spend. The next largest share of spending went to states that saw their tax revenues fall, and were faced with cuts in essential services such as education, healthcare and public safety.

Everyone agrees that rising prices for healthcare, and the growing demand for healthcare services from an aging population, represents a longer term threat to government budgets. The US also spends as much on national defense as the rest of the world combined. Ironically, the bulk of defense spending by the rest of the world is done by our allies. Most of the national spending on defense is done by nations who have little to fear from each other. That is another area of spending that needs to be addressed. Our real longer term budget problems will require cost control in healthcare and national defense. We also need to find ways to increase government tax revenues in ways that do not interfere with the economy. The major risk to our fiscal problems is political. We have to make hard choices going forward and our politics have become so polarized that these choices will not be easy to make. Whatever we do to deal with our longer term fiscal problems, we should be focused today on increasing employment opportunities and investing our future today. This is not the time to be focused on short term budget deficits.

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