A Balanced View of the Debt Jude Wanniski October 20, 2000

I watched Evans&Novak this past weekend and was sorry to see you have decided to quit politics at the end of this Congress. Just when you were getting the hang of things!! While you still have some work ahead of you in the budget fights ahead, I send along an essay on the subject that I wrote for the Institute for Policy Innovation -- which I think is the best of all the conservative think tanks. It ran in its February magazine, Insights, and is called "A Balanced View of the Debt." Perhaps it may help you simplify the complex problems you face in a most difficult assignment. You can link to the IPI website, if your computer has an Acrobat program, or you can read it here. I hope it helps. And remember, we still owe each other a round of golf, where you can give me the tips on how to better my game.

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While it’s always nice to have some extra money (surplus income) left over at the end of the month, it does present some problems -- although they are nice problems. What should be done with the money? When determining the best use of surplus income, most people do not have to be taught that credit-card debt at 18% interest rates should be paid down before surplus income is used to pay down a 7% mortgage rate. Nor would it make sense to pay off the car loan early with surplus income if their home needs a new roof or the kids are about to enter college. If there are better uses to which surplus income can be applied, it makes no sense to pay down debt. The bank that holds the debt will be perfectly happy to get payments of interest and principal on time. It would even be pleased to see a new roof go on the house it has collateralized. It is almost axiomatic that creditors will never object if they see a family managing its finances in a way that makes it more likely that it will be able to meet its future debt obligations. It is often those families who are the deepest in debt who find it easiest to borrow more, because their future earning power seems so secure. The same is true of businesses -- so long as the business is servicing its debt and managing its finances well, its creditors are happy to grant even greater levels of credit. How can this be? It’s really quite simple. When a borrower (debtor) can persuade lenders (creditors) that it will absolutely, positively pay back dollars that will buy as much at some future date as they can at present, the creditors will bid interest rates down to the lowest possible levels. If you have a good credit rating -- based on your income, wealth and history of debt repayment -- you will be able to get credit at low rates whether you are a government or a household. When do creditors get nervous? When they see governments who owe them money are losing battles in war or when businesses whose paper they hold appear headed toward failure, or when breadwinners become unemployed and the family begins missing payments. Why then is there no more persistent snakeoil involving public finance than that which recommends a balanced budget? With the federal government now contemplating official estimates of a $2 trillion revenue surplus in the next decade, why are both major political parties seemingly so transfixed with paying down debt? Surely there are better uses of our surplus national income than paying down low-interest debt?

The Golden Rule for Debt Servicing In 1902, a young American college student who was to become one of the most influential economists of the century wrote his doctoral dissertation on the Union government’s financing of the Civil War. Wesley Clair Mitchell propounded the view that the Lincoln Administration should not have left the gold standard in 1862 in order to pay for the war with "greenbacks," i.e., dollars whose value was no longer guaranteed in gold by the government. Mitchell demonstrated that in the inflation that followed, it quickly took twice as many greenbacks to buy an ounce of gold -- and twice as much to buy the materials of war. In addition, interest rates doubled on the greenback bonds the government floated, which meant the taxpayers were burdened by much higher post-war costs of debt service. Mitchell became a well-regarded professor of economics at Columbia and a founder of the National Bureau of Economic Research. His ideas about the financing of war debt became a fixture in the decades that followed. They were in many ways responsible for the United States keeping the dollar as good as gold, at $35 an ounce, as it financed WWII, the most expensive war in its history, at 2% interest rates. The public debt in 1945 was the equivalent of $2,400 or 68.5 ounces of gold per capita. By contrast, today’s public debt is $11,500 per capita, but after a half century of inflation, the amount is equivalent to only 40 ounces of gold. In other words, a much heavier debt in 1945 was being financed by the government’s creditors at a third of today’s 6% rate. ###

The answer is in the political realm. In every family -- the nation’s basic political unit -- there are always discussions, at times arguments, over how to spend current and future income. Father or mother may manage the checkbook of household finance, but even the children participate in the process of allocating the family’s resources. The national government -- the executive and legislative branches in this case -- represent the opinions of a hundred million families. If there is a reliable estimate of resources becoming available to the nation over the next decade, the President and the members of Congress must decide on how to optimize the return on the public investment of those resources.

Should the monies be directed at increased public spending -- for social programs, federal infrastructure or national defense? Or should tax rates be reduced -- to promote targeted social objectives or expand the economy through supply-side effects? Or should the $3.5 trillion national debt be paid down by running budget surpluses -- to clear the decks in order to more easily finance public pensions and health-care programs a generation from now?

Each of these questions forces upon the elected officials the question of return on investment. At the end of the budget process each year, the amount of money authorized and appropriated for a specific line item represents the best guess of the government on its ROI -- whether the investment is in the National Endowment for the Arts or another aircraft carrier. The process is a messy one, but it is ultimately much more efficient than the methods employed by fascist or communist dictatorships, which on the surface seem so much neater.

In our system, when there is no clear mandate from the people to the government on which of the paths to take, the safest one is to pay down debt -- at least until a new national election clears up the favored public choices. The Republican tax legislation of 1999 was so poorly designed, for example, that the President’s veto seemed reasonable and the electorate sided with him.

Classical (supply-side) economics has no opinion on spending priorities, for example, except to note that on certain capital projects -- fixing roads and bridges, for example -- there may be a higher ROI than in lowering certain tax rates. In other words, higher federal spending and a bigger government can be compatible with a supply-side economic system. That is, there is no reason why Democrats cannot embrace supply-side tax and monetary principles to promote economic growth in order to finance their favored social programs. Indeed, President John F Kennedy in 1963 proposed supply-side cuts in high marginal income tax rates in the face of a federal budget deficit.

The GOP administrations of Harding and Coolidge in the 1920s explicitly based their tax-cutting plans on the idea that lower tax rates in certain cases would produce higher revenues and thereby reduce the burden of the national debt. It was not until 1960 that this issue was addressed in a formal academic setting. In the December 1960 issue of the Journal of Political Economy, the Canadian supply-sider, Robert Mundell, demonstrated in a Keynesian framework that a lower tax on corporate profits could lower interest rates on government debt even as the budget deficit increased.

Mundell, the 1999 Nobel Laureate in economics, used similar proofs to provide the intellectual underpinnings for the Reagan personal income-tax cuts of 1981. The tax cut need only produce sufficient economic growth so added revenues would be able to pay the interest on the bonds floated to finance the tax cut. In the 1980 campaign, George Bush called this "voodoo economics," but it is the same rationale used in private enterprise. If a business can issue debt to finance an expansion of a product line, it need only sell enough at a profit to service the debt. Anything else is gravy, but the market for its equity will not punish it as long as it does well enough to cover interest.

Opponents of the Reagan policies to this day blame the ensuing budget deficits on his tax cuts, but one need only observe that the deficits were accompanied by declining interest rates on government bonds to see the wisdom of Mundell’s hypothesis. The investment made in lower tax rates in the Reagan years -- and the bipartisan tax cuts of 1997 -- produced the economic growth responsible for the "profits," or budget surpluses, that have emerged today.

To solve the longer-term problem of actuarial deficits in Social Security and Medicare, at least a portion of the projected near-term surpluses should be devoted to lowering those tax rates on capital and labor that are higher than they need to be. Only if the amount of capital available to labor is increased by 50% over the next 20 years will it be possible for two workers instead of three to provide for a pensioner. Merely paying down the debt will not accomplish that goal.

And if Wesley Clair Mitchell were alive today, he would make the same kind of observation about current debt management as he did about the Civil War. If the U.S. dollar were fixed to gold instead of a floating greenback, interest rates on government bonds would be closer to 4% than 7%. The cost of debt service would decline by more than $80 billion a year over the average five-year maturity of the debt. This is a policy that deserves far more consideration than it is getting.

These principles are not peculiar to the United States. They apply to every national or regional economy in the world. Unless our government takes the lead, though, chances are the world population will continue to struggle under enormous public debts without realizing there are relatively easy and creative ways to lighten that burden.