The economic shock of the coronavirus has been as sudden and jarring as any in U.S. history. Even if policymakers did nothing to respond to it, the income losses generated by the shock and the automatic expansion of some safety net programs would have led to large increases in the federal budget deficit. But the correct policy response to a shock like the coronavirus is to push deficits even larger than they would go on their own by providing expansions to relief and recovery efforts.
As always, there are some who seem more concerned about the rise in federal budget deficits and public debt than by the rise in joblessness and losses of income generated by the shock. But prioritizing the restraint of debt in coming years over the restoration of pre-crisis unemployment rates is bad economics.
Joblessness and income losses in the wake of the coronavirus shock really are large enough to spark an economic depression that lasts for years. A rising ratio of debt to gross domestic product (GDP), on the other hand, will be mostly meaningless to living standards in the next few years. If baseless fears about the effects of adding to debt block this effective response, then it will cause catastrophic economic losses and human misery. It is often said that economics is about making optimal decisions in the face of scarcity. But we need to be clear what is and what is not scarce in the U.S. economy. The federal government’s fiscal resources—its ability to spend more and finance the spending with either taxes or debt—are not scarce at all. What is scarce is private demand for spending more on goods and services. We need to use policy to address what is scarce—private spending—with what is not.
This FAQ attempts to answer some of the many questions we hear about the deficit and debt in light of the current economic crisis. We will answer new questions as they come up. A common root to the answers of many questions about the effects of deficits and debt concerns whether the economy’s growth is demand-constrained or whether it is supply-constrained (i.e., at full employment). Because this distinction is so important to so many questions about deficits and debt, we provide this background first.
What is the one thing I need to understand first about debt before I can gauge whether it is a threat?
A distinction that you need to make in pretty much every single question about the economic effects of public debt is whether the economy’s growth is constrained by demand or by supply.1
When the economy has resources—particularly willing workers—that are unemployed simply because firms do not expect enough paying customers to justify putting more resources into producing goods and services, then the economy’s growth is constrained by demand. In such a demand-constrained economy, an increase in aggregate demand (i.e., spending by households, businesses, or governments) means more workers will be hired and more output will be produced. Anytime joblessness can be reduced and economic output can be increased simply by boosting aggregate demand, the economy is demand-constrained, and it is not at full employment.
When instead all the economy’s available resources—particularly willing workers—are already employed, a boost to aggregate demand does not cause output to increase or workers to be hired because all potential workers are already employed and hence no additional output can be created. In this case, aggregate demand is rising faster than the economy’s supply side (the labor force and capital stock) can deliver output to satisfy it, and this excess demand pushes up prices, leading to inflation.2
When an economy is at a point where faster aggregate demand growth spills over into inflationary pressures rather than output growth, then the economy is supply-constrained. In such an economy, growth can only accelerate if each worker becomes more productive.
Additions to debt affect the economy very differently depending on whether growth is demand- or supply-constrained. As we’ll see below, the U.S. economy in the midst of the coronavirus pandemic is severely demand-constrained and in urgent need of a boost to demand.
Why are we so sure that debt-financed relief and recovery is the answer to the economic shock of the coronavirus?
The economic shock of the coronavirus and the public health measures undertaken to combat it are unique in their specifics, but not actually all that different from the general cause of all other recessions: They constitute a mammoth negative shock to aggregate demand.3 Basically, all at once, tens of millions of Americans stopped spending money on a whole range of economic outputs (restaurants, hotels, air travel, brick-and-mortar retail, etc.). Because one person’s spending is another person’s income, this type of shock almost inevitably leads to another spending pullback as, say, restaurant workers lose their income and cut back on spending even in sectors still open during the lockdown period.4
The proper response to this sudden and mammoth negative shock to demand is straightforward, if daunting. First, maintain spending power (income and wealth) during the lockdown period by providing relief (unemployment benefits, stimulus checks, etc.) to those who have lost jobs and incomes. Second, foster a rapid recovery by boosting aggregate demand as public health indicators allow a phased “reopening” of economic activity. We have already provided some relief during the lockdown, but we need to provide more. If we don’t expand and extend this relief—if we allow this relief to run out while the economy remains profoundly damaged—tens of millions of families will run down savings and take on debt, making them much less likely to spend robustly once the economy returns to closer-to-normal. This depressed spending will drag on overall recovery.
Because the goal is to maintain spending during the lockdown and boost it during the recovery, we want to finance these relief and recovery measures with debt instead of taxes. Taxes reduce disposable income and spending in the short run (although tax increases for high-income households drag on spending less than tax increases for other households). Given the crucial importance of ending the coronavirus-driven recession as quickly as possible with overwhelming force, it is best to finance relief and recovery efforts with debt instead of taxes.
Absent significant relief and recovery measures, the economic future looks grim.5 A measure of unemployment that accounts for misclassification and declines in labor force participation associated with the coronavirus likely peaked at just under 24% in April,6 but even with a couple of months of rapid job growth, we could see unemployment rates averaging over 10% for 2020 and over 8% for 2021.
Further, the experience of the Great Recession shows us beyond dispute that trying too hard to rein in deficits and public spending while the economy remains weak (i.e., inappropriately contractionary fiscal policy) makes recovery slower and more painful than it has to be.7
Does fast-growing debt ever pose a danger to economic growth?
It is certainly possible in theory for larger deficits and debt to harm economic growth. But the chain of economic effects that leads from higher deficits to slower economic growth only comes into play when the economy is supply-constrained (i.e., is at full employment). And we know when fast-rising debt is harming economic growth because this situation has a clear “data signature”—a noticeable rise in either interest rates or inflation.
Here’s how the chain of effects works.
If federal spending rises faster than taxes (i.e., if the federal budget deficit grows), economywide aggregate demand gets a boost. Federal spending boosts aggregate demand either directly, say, by spending to build a road, or indirectly, by transferring resources to households that use the funds (from, say, Social Security checks) to purchase goods and services. Taxes reduce aggregate demand, all else equal, but as long as spending grows more rapidly than taxes (budget deficits are increased), then large deficits spur aggregate demand.
If the deficit rises when the economy is supply-constrained, then the boost to aggregate demand translates into upward pressure on interest rates and inflation. Take a hotel, for example. If the hotel is already fully booked and then a boost to aggregate demand from an increase in the federal budget deficit sends even more customers looking to book rooms, the hotel owner might want to expand the hotel’s capacity. Tangible business investment like this often requires borrowing, so the hotel owner will try to borrow money in capital markets to finance this investment.
In a supply-constrained economy, if the increased public spending were financed by borrowing rather than raising taxes, the hotel owner would find that they are competing with the federal government for available savings to borrow to finance their desired new investment. This competition for savings would push up interest rates (the “price” of savings) and these higher interest rates would “crowd out” some private-sector investment projects that might otherwise have happened. For example, maybe the hotel company decides not to build a new wing. Or other businesses likewise take a pass on potentially productivity-enhancing investments.
Remember that in a supply-constrained economy, growth can only accelerate if each worker becomes more productive—i.e., if each worker has a greater store of capital (plants, equipment, and research and development spending) to use to increase the amount of income and production generated in the average hour of work. So rising debt in a supply-constrained economy can hurt economic growth in the long run if it pushes interest rates higher and this in turn reduces the pace of productivity-enhancing private-sector investment.
It is important to note that right now, and for the foreseeable future, we are in a demand-constrained economy, not a supply-constrained economy.
What this means is that for now and into the next year, there is next to no reason to think that higher debt used to finance relief and recovery will put enough upward pressure on interest rates or overall inflation to hamper economic growth. In summary, in a demand-constrained economy like the U.S. economy during the coronavirus pandemic, debt provides no countervailing drag on growth.
Won’t debt that is taken on now constitute a burden on our children?
It will not. Think of wealthy parents with lots of assets but also some debt (say, a small mortgage remaining on a valuable home). When they die and their estate goes to their heirs, it is true that the heirs will be responsible for the debt. But the heirs also receive the assets. As long as the assets are more valuable than the debt, the heirs are far better off.
The public debt only tells us part of the bequest we’re leaving to future generations. The nation’s assets determine its ability to generate income. If we fail to act with sufficient scale to provide relief and recovery from the coronavirus shock to the economy now, the nation’s ability to generate income will be damaged for the long run. This is not speculation—estimates of the nation’s productive capacity collapsed after the Great Recession. By 2018, the economy’s potential output was estimated to be $1 trillion lower than predicted in 2008, in large part because of the economic stagnation driven by our failure to solve the chronic shortfall of aggregate demand over the decade.
Finally, because the debt taken on to finance relief and recovery from this shock is occurring during a time of pronounced slack in demand, it is not pushing up interest rates or inflation and is not hence crowding out private investment. In short, there is no reason to think there are any downsides to taking on this debt. It is a slam-dunk that our children’s living standards will be on net higher, not lower, if we take on the debt that is needed to mount a quick and full recovery from the coronavirus shock.
Wasn’t debt too high and rising too fast even before the crisis?
There is scant evidence that public debt or federal budget deficits were dragging on economic growth before the coronavirus crisis hit. As noted above, deficits and debt are only harming growth if we are seeing spikes in either interest rates or inflation. But we have not seen these “data signatures”: In the decade before the coronavirus shock, there was no durable increase in either interest rates or inflation.8
This rule—that fast-growing debt only harms the economy when it’s accompanied by a rise in interest rates or inflation—is probably the single most important thing to remember about the economics of debt and deficits. This rule tells us that—despite the increased deficits from the Trump tax cuts for the wealthy in 2017—there is no reason to be stingy in our coronavirus policy response. We can afford stimulus measures equal to the challenge.
Why didn’t fast-growing debt in the decades before the crisis lead to inflation or interest rate spikes?
Interest rates and inflation were not spiking in the period before the coronavirus shock. Why were they so subdued, even in the face of persistent deficits and fast-growing public debt (which were clearly exacerbated by the 2017 tax cuts)?
The answer is that the economy’s growth for much of this period was held back by aggregate demand that was low relative to the economy’s productive capacity (i.e., this growth was overwhelmingly demand-constrained9). The economy sat far below full employment from 2008 and 2016 as it endured and then slowly recovered10 from what was then the worst crisis since the Great Depression, and it was still demand-constrained even after 2016.
As noted earlier, when the economy sits far below full employment—when there isn’t enough demand for goods and services to have all our producers working at full capacity and all willing workers employed—boosting demand by increasing federal spending and financing it with debt speeds up aggregate demand growth, which spurs hiring and output growth. This extra production of goods and services keeps inflation and interest rates from spiking. A common colloquial explanation for inflation is “too much money chasing too few goods.” In an economy suffering from low demand, the aggregate demand boost provided when the government runs larger deficits to increase spending leads companies to increase production, which relieves inflationary pressure.
Further, the increased output and income generated by the boost to aggregate demand leads to more savings being available economywide to finance borrowing (private or public). If interest rates are in some sense the price of available savings to be borrowed, then an increase in the supply of these savings actually puts downward pressure on these rates.
How do we know that the economy’s growth was unambiguously demand-constrained11 from 2008 to 2016 and that it continued to suffer from a demand shortfall after 2016? A key sign is the Federal Reserve’s decisions about the short-term policy interest rates that it controls. The Fed left interest rates sitting right at near-zero for almost the entire period between 2008 and the end of 2016.12 Even after 2016, as the Fed raised rates, measures of wage and price inflation and interest rates remained quite subdued. Inflation and interest rates did not spike even after enactment of the tax cuts of 2017 (which cost roughly $2.4 trillion over 10 years, when interest costs are factored in, and which should have provided some measure of stimulus to aggregate demand, however inefficient13).
This chronic shortfall of aggregate demand that has plagued our economy for much of the last decade or so has sometimes been labeled “secular stagnation.” Whatever you call it, this demand shortfall is clearly the reason why deficits and growing debt since the Great Recession have done little to damage growth, and in fact kept growth from becoming even more stagnant than it would have been.
I’m OK with a bigger budget deficit during recessions, but we need to pull back and start reducing debt as soon as the economy starts growing at all, right?
No—federal spending that boosts aggregate demand (i.e., expansionary fiscal policy) should be sustained until the economy is back at full employment, and this spending should be financed with debt even if this takes years. Pivoting to rapid deficit reduction too early will severely weaken any recovery. That is what happened in the aftermath of the Great Recession. The Great Recession officially ended in June 2009, with the unemployment rate at 9.5%. In June 2010—a year into the official recovery—the unemployment rate sat at 9.4%. In June 2012—three full years into recovery—the unemployment rate remained over 8%: a worse rate than the highest unemployment rate reached in the recessions of the early 1990s or early 2000s.
Yet by 2012, federal, state, and local officials had begun throttling back on spending growth (i.e., imposing contractionary fiscal policy), which severely hampered recovery. Between 2010 and 2016, for example, 28 million job-years were essentially lost due to the failure to restore the unemployment rate back to its pre–Great Recession levels (where a job-year is one year of potential work not being done because the unemployment rate was elevated). We were not in official recession during those years, but the economy’s growth was clearly demand-constrained. With more expansionary fiscal policy, we could have easily returned the economy to pre–Great Recession levels of unemployment by 2013. Instead, the unemployment rate averaged 7.4% in 2013.
As this example shows, the criterion for whether or not the economy needs policy help to boost aggregate demand (like larger budget deficits) is not simply whether the economy is or is not in a recession: Instead, it’s whether or not growth is demand-constrained. As long as growth is demand-constrained, budget deficits should not be rapidly wound down.
Is it interest rates or inflation that rises when deficits are rising too fast?
In some textbook presentations, when the federal government runs a deficit that it needs to finance with debt, the greater competition for borrowing from private capital markets leads directly to higher interest rates. (Interest rates represent the “price” of available savings and the competition drives up the price, the textbooks claim.)
In the real world of the U.S. economy, interest rates tend not to rise on their own, spurred only by financial market forces. Instead, the Federal Reserve raises short-term rates when it fears that the boost to aggregate demand caused by larger deficits could stoke inflationary pressures, and this tends to put upward pressure on longer-term rates as well. This fear surfaces when the Fed thinks the economy is at full employment, i.e., is supply-constrained. As an example, imagine that the federal government sent $1,000 debit cards to all households, financed by debt and expiring in one month. If households tried to spend these debit cards when the economy was already at full employment, there would be no workers or equipment available to produce the extra goods and services needed to satisfy the new demand. As the greater demand meets an unchanging supply, prices would go up, leading to inflation.
One of the Fed’s two institutional mandates is to keep inflation at roughly 2% annually. If deficit-induced increases in demand threatened to push inflation too far above this target, the Fed would raise interest rates. Higher interest rates would increase the costs of goods financed with debt (think autos and houses and washing machines), thereby lowering demand for these goods. Higher rates would also make it harder for firms to borrow money to invest in tangible assets such as plants and equipment (think of a restaurant owner deciding whether to take out a loan to replace the furniture in the dining room). Finally, higher interest rates increase foreign demand for U.S. assets and thereby increase demand for U.S. dollars in global markets. The resulting stronger dollar makes U.S. exports expensive in global markets and foreign imports cheap for U.S households, which increases the trade deficit and reduces demand for U.S.-produced output.
In short, larger budget deficits run when the economy is already at full employment can threaten to crowd out investment in tangible capital by businesses and can lead to higher foreign ownership of U.S. assets. This, in turn, can potentially lead to slower productivity growth (as the investment slowdown deprives U.S. workers of more up-to-date equipment), and it also means that more of the income that is generated within the U.S. is leaving the country to pay foreign owners of U.S.-based assets. Both of these channels can make future generations poorer than they would have been absent the increase in the deficit.
But the clear sign that the economy’s growth really is supply-constrained is that these higher rates occur in response to accelerating price inflation. If higher rates happen without this higher inflation, this is mostly a sign that the Fed has prematurely raised rates, not a sign that deficits are obviously too large or rising too fast.
Will debt service crowd out other useful spending?
The relief and recovery measures taken in response to the coronavirus shock have led to a nontrivial increase in the public debt. In the past, a prime concern raised about higher debt was that the costs of servicing this debt (paying interest on it) could threaten to crowd out other useful public spending. However, this is quite unlikely to happen.
Currently, we have allocated a bit over $2.5 trillion in coronavirus relief and recovery. Assume this number grows to $5 trillion before the crisis is over. At a 2% interest rate (roughly the average since 2011 and far higher than the current rate), this constitutes roughly $100 billion in extra debt service each year, or less than 0.5% of overall GDP.
Current annual federal expenditures are roughly $5 trillion, so this extra debt service would constitute an increase in those expenditures of roughly 2%. However, it is beyond question that the extra growth spurred by the relief and recovery aid would boost GDP (and hence tax collections) enough to fully pay for the increase in debt service for the foreseeable future. The only way this would not be true is if somehow the economy could have been relied upon to heal itself fully and quickly from the coronavirus shock without any relief and recovery. But we have run a very recent experiment with allowing the economy to try to mount a recovery from a negative demand shock without sufficiently expansionary fiscal policy. It went badly: Recovery following the Great Recession of 2008–2009 was far weaker and took far longer because we shifted fiscal policy too quickly to a contractionary, rather than expansionary, stance.
1. A more in-depth version of the discussion in this section can be found in Josh Bivens, Abandoning What Works (and Most Other Things, Too): Expansionary Fiscal Policy Is Still the Best Tool for Boosting Jobs, Economic Policy Institute, April 2011.
2. We should be clear that it really is this inflation barrier—whether extra increments of aggregate demand lead to more output being produced or just higher prices—that determines whether the economy is at full employment. Often (say, during wartime) the economy can operate far above estimates of full employment. But for this to not lead to inflation generally requires some policy intervention (like wage and price controls during World War II).
3. Neil Irwin, “One Simple Idea That Explains Why the Economy Is in Great Danger,” New York Times, March 17, 2020.
4. It is true that the coronavirus shock also has elements of a supply-side shock. Imported inputs into manufacturing production, for example, have become scarce and expensive. Further, there are some people who could otherwise continue working but are hampered in their ability to do so because public health measures have kept children at home rather than in school or in child care settings. Yet even the elements of this crisis that began as supply shocks (e.g., parents unable to work because of child care complications) have quickly morphed into demand shocks (e.g., as now-jobless parents have cut back their spending even more than they would have simply due to physical distancing measures).
6. Elise Gould, “A Waking Nightmare: Today’s Jobs Report Shows 20.5 Million Jobs Lost in April,” Economic Policy Institute, May 8, 2020.
7. Josh Bivens, Why Is Recovery Taking So Long—and Who’s to Blame?, Economic Policy Institute, August 2016.
8. St. Louis Fed, “10-Year Treasury Constant Maturity Rate,” and “Consumer Price Index for All Urban Consumers: All Items Less Food and Energy in U.S. City Average,” accessed July 2020.
9. Josh Bivens, Inequality Is Slowing US Economic Growth: Faster Wage Growth for Low- and Middle-Wage Workers Is the Solution, Economic Policy Institute, December 2017.
10. Josh Bivens, Why Is Recovery Taking So Long—and Who’s to Blame?, Economic Policy Institute, August 2016.
11. Josh Bivens, Why Is Recovery Taking So Long—and Who’s to Blame?, Economic Policy Institute, August 2016.
13. Josh Bivens, “The ‘Boom’ of 2018 Tells Us That Fiscal Stimulus Works, but That the GOP Has Only Used It When It Helps Their Reelection, Not When It Helps Typical Families,” Working Economics Blog (Economic Policy Institute), October 26, 2018.