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How I Learned to Stop Worrying and Love the Deficit

Karl W. Smith

(Bloomberg Opinion) -- The U.S. budget deficit will hit $1 trillion in 2020, the Congressional Budget Office announced Wednesday, a big round number that has both Democrats and Republicans worried that the U.S. is on the road to fiscal ruin.

They shouldn’t be. In the current global environment, trillion-dollar deficits may actually decrease the odds of a major economic crisis. In fact, one of the main reasons the global economy has been so fragile over the last decade is that large free-market countries have been reluctant to borrow as much as they could.

In its report, the CBO estimates that increased spending will add roughly $1.9 trillion to the national debt over the next 10 years, while lower tax revenue will add nearly $300 billion. So the cumulative deficit over the next decade will grow from $12.3 to $14.5 trillion.

However — and here is where things get weird — that increase is partially offset by a $1.3 trillion reduction in projected interest costs, bringing the estimate of the overall debt to $13.2 trillion. That is, the CBO expects the government to add some $2 trillion more in debt-financed spending, yet decrease the amount of interest that it pays on its total debt. 

How is this possible? In part the reason is that the CBO routinely overestimates how much interest the government will pay on its debt. Since its last estimate, interest rates have gone down, not up as predicted, and the new estimates have been adjusted accordingly.

But the main explanation for lower borrowing costs is the global shortage of safe assets.

Around the world, people in developed countries are aging, and they are looking to move their money to safer, less volatile investments. That almost always means government bonds. At the same time developing countries, eager to assure foreign investors of their economic soundness, are accumulating large reserves of U.S. government bonds. And multinational corporations are buying bonds because they are taking in profits faster than they can find new investments.

To sum up: The world is awash in savings looking for a safe place to be stored. Right now, government bonds from wealthy free-market democracies are one of the few assets that fits the bill. As a result, the U.S. government can borrow far more money and pay substantially lower interest rates than traditional models would have predicted.

The safe-asset shortage fuels a persistent threat to global financial stability in another way: It encourages financial engineers to design products that they can claim are nearly as safe as U.S. Treasury bonds. The last time this happened, in the early 2000s, they devised ways to package and repackage subprime home loans into bonds that computer models rated as secure as those issued by Fannie Mae and Freddie Mac. Financial companies then sold them to investors desperate for seemingly safe assets. This infusion of capital fueled the issuance of hundreds of billions in subprime loans, and the rest is history.

Just as disconcerting, traditional assets have become volatile. If, say, the Chinese stock market remains stable for a few years, it begins to look safer. That safety attracts more investors, which raises prices, making investment appear even safer. Unfortunately, this process also works in reverse (as investors discovered when Chinese stocks crashed in 2015). Again, investors may now be wary about China, but the hunt for safe assets continues, all the while threatening global stability.

This fundamental instability makes even a mild global slowdown more dangerous. In order to stimulate the economy, central banks will attempt lower interest rates in an attempt to push investors into the private sector. But government bond rates are already near record lows. At the same time, the bubble-like nature of private-sector assets makes investors even more wary of them. The result? Savings pile up and the global economy enters a long recession similar to the last one.

It’s counterintuitive, but democratic free-market governments can reduce the risk of this type of crisis by taking on more debt and issuing more bonds. That would put upward pressure on long-term interest rates, giving central banks more leverage to fight the recession. And by easing the safe-asset shortage, it would reduce the bubbly tendencies of other assets, making investors more willing to hold them even during a recession. Together these effects would mitigate the possibility of a long recession and slow recovery.

Unfortunately, the U.S. is the only major developed country increasing its deficit. Germany is running a surplus, the rest of Europe is edging toward a balanced budget and Japan is planning to raise sales taxes to reduce its already falling deficit.

This means the U.S. is the world’s biggest supplier of safe government bonds. Fortunately, President Donald Trump seems perfectly happy to issue more debt. But the U.S. won’t always be so obliging. The rest of the developed world, and Germany in particular, should follow the example of the U.S. and temper its budget-balancing zeal. Doing so may create marginally more risk domestically — governments may be forced to raise taxes or cut spending later — but it would lower risk for the global economy. And in today’s world, no country can be safe if the global economy is unstable.

To contact the author of this story: Karl W. Smith at ksmith602@bloomberg.net

To contact the editor responsible for this story: Michael Newman at mnewman43@bloomberg.net

This column does not necessarily reflect the opinion of the editorial board or Bloomberg LP and its owners.

Karl W. Smith is a former assistant professor of economics at the University of North Carolina's school of government and founder of the blog Modeled Behavior.

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