Hit or Myth
Separating fiction from fact in sizing up the national debt. By Paul Harrington
The Truth about the National Debt: Five Myths and One Reality, by Francis X. Cavanaugh, Harvard Business School Press, 172 pages, $22.95
Political leaders in the United States have long been of two minds about the federal budget deficit and its result, the national debt. Condemning government deficits is a time-honored tactic in American politics sure to arouse the support of hardworking people who demand that government live within its means, just as they do. "Stop the deficits" was the battle cry of Franklin Roosevelt in the 1932 presidential race against Herbert Hoover. Yet deficit spending has been a mainstay of national economic policy for both Republican and Democratic administrations since the Great Depression. Roosevelt went on to oversee an enormous increase in federal spending that by 1945 had resulted in a federal debt double that of today's, in relative terms.
Longtime senior Treasury official Frank Cavanaugh, LA'54, brings forty years of federal debt management experience to examining the politics and economics of the national debt in The Truth about the National Debt. This timely volume examines the central elements of the national debt debate and finds them wanting in either economic theory or fact. More troubling, Cavanaugh sees much of the politics of federal debt policy based in an especially virulent brand of political cynicism that converts the fundamental creditworthiness of the nation into a political football to be kicked at the expedient moment by Democrat and Republican alike.
The warning cries of Warren Rudman and the late Paul Tsongas of the antideficit Concord Coalition, along with the campaign rhetoric of Ross Perot and sometimes Bill Clinton, and even the Zen master of debt creation, Ronald Reagan, have generated, according to Cavanaugh, a lot of political heat but little economic light-mostly because their interpretations of the problem of the debt have been flat-out wrong. The general view of the deficit is that like a family that fails to keep spending in line with income, the current national debt will burden future generations with reduced living standards.
This likening of the nation's money management to personal finances is a poor analogy indeed. The national debt represents not simply a liability but an asset as well. When the federal government borrows money to finance the deficit, it issues bonds. Those bonds are a liability to the U.S. government but an asset to people who hold them. National debt creates exactly as much wealth for bondholders as it does liabilities for the Treasury. The national debt is a burden to the next generation of Americans only if, as they inherit the liability of the debt, they fail to inherit the assets of U.S. government bonds. Yet since the overwhelming majority of government bonds are held by American interests, it is future generations of Americans who will inherit the assets of government bonds. Unlike most family mortgages, we owe the national debt to ourselves. Cavanaugh states it succinctly: "As any business executive should know, a liability that is offset by an asset of equal value should not be viewed as a burden."
While the intergenerational burden of the debt is the most widely articulated debt myth, its falsity is a point upon which virtually all economists agree. Not so with the remaining four myths Cavanaugh identifies, all of which generate considerable debate among economists.
The second debt myth, according to Cavanaugh, is that as the Treasury borrows an increasing proportion of the nation's available savings, upward pressure on demand for credit causes interest rates to rise. That higher cost of money would prevent private investors from borrowing. During the 1980s, real interest rates did increase with the growth of the federal deficit. But Cavanaugh maintains that other factors, including Federal Reserve money supply policy, have far more significant impacts on real interest rates than fiscal "crowding out," as this argument is called. Yet notable economists on both sides of the political fence believe that crowding out matters. Clearly, the economic jury is still out on this question.
Cavanaugh's third debt myth is that interest payments on the debt are becoming an unsustainable burden on the federal budget. Interest payments as a share of the annual federal budget have skyrocketed to keep pace with the relative increase in the size of the national debt. The result is that relatively fewer resources are available to meet critical national needs. By 1998, the annual outlay for net interest payments will exceed expenditures made by the entire Department of Defense. President Clinton and others have called for deficit reduction to try to limit the portion of federal spending devoted to debt service and thus retain the ability of Congress and the president to fund important programs.
Along with most economists, Cavanaugh argues that government interest payments by themselves do not have a substantial effect either on economy-wide demand for goods and services or on resource allocation. Although interest payments are a large and "uncontrollable" part of the federal budget that will cause Uncle Sam to feel a pinch in his spending purse, it's more a political problem than an economic one. The real economic consequences of interest payments are actually quite small. Debt service doesn't diminish aggregate demand, since tax payments used to finance debt service are themselves paid to bondholders as interest payments, which are then saved or spent like any other form of income. Consequently, interest on the debt has little practical meaning for most Americans because it is primarily an activity that transfers income from taxpayers to bondholders, who are often one and the same person.
What if taxpayers and bondholders are not the same person? Then, of course, a redistribution of resources occurs, making most Americans either winners or losers in the debt sweepstakes. Critics on the left and right have argued that large federal deficits contribute to growing gaps in the distribution of income in American society because they redistribute income from lower-income taxpayers to higher-income bondholders. Once again, Cavanaugh finds the conventional wisdom at odds with the facts. The investment firms, banks, and government agencies owning most of the federal debt hold it on behalf of middle America. In fact, he maintains, the distribution of interest payments is more equitable than the distribution of the tax burden.
The final myth Cavanaugh tackles is the concern that the United States is confronted with a growing dependence on foreign investors to finance American debt. In 1995, foreign nations held twenty-three percent of all Treasury securities. Thus our dependence on foreign borrowing means that instead of owing the debt to ourselves and thus simultaneously owning the asset and liability, increasingly we own the liability but the asset is held by a foreign nation. Yet Cavanaugh believes that this in itself poses no serious threat to the health of the American economy. He notes that only 1.6 percent of all American assets is held by foreign investors-hardly a threat to American sovereignty. Furthermore, foreign investment helps provide jobs for American workers.
So does Cavanaugh think an ever-increasing federal deficit is a benign accounting artifact cruelly manipulated by politicians for their own ends? The answer is a resounding no. He labors to dispel the myths of the debt so that he can get at the source of what he considers a root problem in both the American economy and American politics: too much government spending. Deficits develop because political leaders are unwilling to underwrite spending increases with tax increases. In Cavanaugh's view, as a nation we are purchasing more government than taxpayers are willing to finance. He readily admits that he doesn't know how big government should be, but believes that its operating budget should be no larger than the amount that taxpayers are willing to fund directly through taxes.
The problem with the deficit is that it allows the political process to be unaccountable for its behavior. "Politicians should not have the pleasure of spending (getting votes) without the pain of taxing (losing votes)," Cavanaugh maintains. Moreover, he argues, we need to balance the budget to restore confidence in the government. Year after year of politicians damning budget deficits while voting for their continuation is a prime suspect for the growing skepticism that Americans have toward their political leadership.
The dust jacket of this book reveals the contentious nature of the debate that the author undertakes. While reviewers lavish praise on Cavanaugh, they are quick to note that they disagree with many of his ideas. I find myself in the same position. When Cavanaugh speaks from his experience in the Treasury, his writing and analysis are surefooted and insightful. When he drifts from his area of expertise and has to rely on the work of others as his sole source of information, his analysis weakens. Nonetheless, this is a highly informative and useful book that needed to be written. Cavanaugh asks the right questions about the deficit and the debt and provides important insights into their nature and their significance for the future well-being of the American economy.
Paul Harrington is associate director of Northeastern's Center for Labor Market Studies.
