Putting strict limits on borrowing is arbitrary IT IS ONCE again time for that most bizarre of economic spectacles, a debt-ceiling showdown in America. In the name of fiscal responsibility, the world’s biggest economy is flirting with an act of brazen irresponsibility: a sovereign default. The government has just about exhausted its current statutory debt limit of $28.5trn, after which it will struggle to honour its obligations. Janet Yellen, the treasury secretary, has warned that the government will probably run out of cash sometime next month. Most economists and executives assume that America will come to its senses before then. After all, Congress simply has to raise or suspend the debt limit, which it has done nearly 80 times since 1960, even if occasionally leaving it to the last minute. Should that occur again—and it almost certainly will—the debt ceiling will fade from view until the next clash, serving mainly as evidence of America’s polarised politics (as if any were needed). America’s ritualistic threats of economic self-harm are unique. But the debt ceiling is an extreme version of something that many other countries do: they limit government borrowing through fiscal rules. Germany applies a “debt brake”, capping its structural deficit at 0.35% of GDP (though it has ignored that cap since the outbreak of the covid-19 pandemic). In Britain the Conservative government aims to match its spending and revenues over a three-year horizon. Rishi Sunak, the chancellor, is expected to unveil even tighter rules in next month’s budget, including a commitment to lower the debt-to-GDP ratio. The purpose of fiscal rules is to deal with what economists call a “common pool” problem—namely, that beneficiaries of government spending ignore the costs imposed on taxpayers and future generations. The fear is that without a strict cap on spending, elected officials will burn through cash. Taken to an extreme, bond and currency markets might punish profligacy. Better not to test them. Hence the need, supposedly, for clear boundaries. Yet the past decade has shown that the boundaries are quite a bit wider and fuzzier than previously thought. In America federal debt was about one-third of GDP in 2000; today it is just about 100%. Far from precipitating a financial meltdown, the rising debt burden has become more, not less, manageable thanks to ultra-low interest rates. In nominal terms the cost of servicing all the debt (the annual interest payments on it) is just over 1% of GDP, nearly half what it was two decades ago. Similar trends have played out throughout the rich world. There may be no such thing as a free lunch, but governments have learned that they can get much larger portions for half the price. One response is to soften the limits. Take the European Union’s rule that member states must cap their debt at 60% of GDP—which is largely observed in the breach, with average EU debt levels now hurtling past 90% of GDP. Economists such as Zsolt Darvas of Bruegel, a think-tank, suggest that this limit should be treated as a long-term anchor rather than any kind of near-term target. Such a softening would help. But it would fail to deal with a more basic flaw with debt limits, which is that they are intrinsically arbitrary. There is little empirical basis for keeping debts to 60% of GDP, much less to exactly $28.5trn in America. The very arbitrariness of these red lines risks creating a boy-who-cried-debt syndrome. As borrowing levels blow past them and yet the economy continues to perform well, some politicians may conclude that any and all calls for fiscal restraint are best ignored. A more sophisticated response is to focus fiscal rules on what really matters about debt: the cost of servicing it. In a paper in 2020 Larry Summers and Jason Furman suggested that governments should aim to stop their real interest payments from rising above 2% of GDP. If they succeed, debt-to-GDP targets would be rendered all but superfluous. More generally, economists recognise that so long as a country’s pace of growth is higher than its interest rates, its path to fiscal sustainability ought to be easier, because its burden of existing debts will steadily shrink. However, these more elegant fiscal rules have their own problems. Why cap debt-servicing costs at 2% of GDP and not, say 3%. Moreover, the confidence that economic growth can surpass interest rates stems from the belief that rates will remain subdued well into the future as the population ages. But America’s ongoing bout of inflation has shown just how uncertain that is. Should central banks need to jack up interest rates to quell price pressures, debts would quickly spiral higher. You only give me your funny paper Doing away with indefensible lines in the sand altogether is a good alternative. In a paper this year Peter Orszag, Robert Rubin and Joseph Stiglitz argue for a new fiscal architecture. An important part would be to index long-term spending to underlying drivers. For example, social-security benefits could automatically be made less generous to take into account increasing life expectancy. This can be thought of as a fiscal rule that would commit governments to sensible budgetary decisions, rather than specifying debt targets with spurious precision. In another paper this year Olivier Blanchard and others proposed general fiscal standards for the EU, such as requiring governments to ensure that their debts are sustainable, but leaving it to them to choose their policy mixes. Independent fiscal councils could then use detailed debt-sustainability criteria to assess their budgets. If done methodically, this would be more scientific than the fiscal rules now seen in America and Europe. Alas, all these clever ideas may amount to nothing in America. There is little chance that the government will abandon its debt ceiling, for in one dimension it is most effective. Republicans have become dab hands at wielding it as a cudgel to stall the agendas of Democrat presidents and to portray them as spendthrifts. No other fiscal rules can deliver that kind of return. ■
