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Cutting National Debt = Stimulus

If we’re not careful—and less spendthrift—the U.S. economy will be heading for a state of permanent recession, argues Stanford economist John B. Taylor.

07.20.10 12:12 PM ET

If we’re not careful—and less spendthrift—the U.S. economy will be heading for a state of permanent recession, argues Stanford economist John B. Taylor. Plus, read the complete list of historians and economists who back The Daily Beast manifesto for a new stimulus.

The current slowdown in the U.S. economy is a serious concern. After growing at 5.6 percent in the fourth quarter of last year, the economy slowed to 2.7 percent in the first quarter of this year and likely to only 2 percent in the second quarter. It’s not the V-shaped recovery it should have been, and as a result the economy is not generating enough jobs to bring down unemployment from tragically high levels.

Some argue that we need more deficit spending—another stimulus package— to boost the economy. I agree that the economy needs a boost, but not in the form of increased deficit spending. In my view, the economy is being held back by high deficit spending and related policy uncertainties. The large deficits are causing the federal debt to explode, raising concerns about how it will be financed.

The Congressional Budget Office projects that the debt will reach an unbelievable 947 percent of GDP by 2084 if we stay on the current course.

Data recently released by the Congressional Budget Office give plenty of cause for concern. The CBO focuses on debt in proportion to gross domestic product, a measure of the resources available to service the debt. According to the CBO, the debt will reach 62 percent of GDP this year, a level not seen since 1951 when America was still working off the debt from World War II. But rather than decline as it did in the 1950s and 1960s (to less than 30 percent of GDP), the debt is now expected to rise sharply in the next 20 years—to 146 percent of GDP. In fact, CBO projects that the debt will reach an unbelievable 947 percent of GDP by 2084 if we stay on the current course.

Experience shows that such high debt levels reduce economic growth. Historical studies conducted by the International Monetary Fund reveal that an increase in debt by 10 percent of GDP is associated with a decline in economic growth of 0.25 percent. Thus, the increase in the debt from 44 percent in 2008 of GDP to 62 percent this year is already reducing growth by about one-half a percent and the 84 percentage point increase in the next two decades by another 2 percentage points. That would bring the U.S. economy to less than zero growth—yes, a permanent recession.

Other studies support these findings. Kenneth Rogoff of Harvard University and Carmen Reinhart of the University of Maryland find that economic growth is 2.6 percentage points higher for countries with debt below 30 percent of GDP than for countries with debt above 90 percent of GDP. They also find that ballooning debt makes the economy more susceptible to financial crises, as Greece just demonstrated. Paying interest on the debt is a growing demand on tax revenue, crowding out government programs: The CBO forecasts that interest on the debt will eventually exceed spending on all government programs combined if we stay on the current path. Such high interest payments will eventually lead to high inflation as people realize that inflating the debt away is the only recourse.

In years past, some argued that we should not worry about the debt because it is paid to ourselves, but half of U.S. government debt is owed to foreigners, which is obviously a burden on future generations. In the meantime, our foreign policy suffers: A country’s bargaining position is weaker when a creditor country is on the other side of the negotiating table.

Not all the increase in the deficit is due to the stimulus packages and the recession; unsustainable growth of entitlement programs is a big part of the problem. But a focus on deficit spending distracts from efforts to address the long-brewing entitlement problem. Adding to the budget uncertainty is that many tax provisions are scheduled to expire in just six months, and without legislative action, there will be a substantial tax increase on all Americans.

The reason why a deficit-reduction plan is not being articulated and carried out now is apparently a concern that it would remove needed stimulus from the economy. But for all the reasons listed above, the best economic stimulus would be for the government to set a clear path now to reduce the deficit and to bring down the debt in the future.

John B. Taylor is the Mary and Robert Raymond Professor of Economics at Stanford University and the George P. Shultz Senior Fellow in Economics at Stanford’s Hoover Institution.