Why We Have to Deal With the Deficit First

Because of the upcoming presidential race, there is a debate among economists about what the Dems should do about economic policy. There are tons of good ideas out there. However, there is a point of contention about the deficit. Should we accept a certain amount of deficit spending in order to promote certain polices/initiatives or should be deal with the deficit first. The former point of view was best outlined in the paper Breaking the Stranglehold on Growth issued by the Economic Policy Institute. The later school of thought -- reducing the deficit -- is espoused by members of the Hamilton Project. For reasons outlined below, I think the Hamilton Projects Proscription of dealing with the deficit first is the best idea for the simple reason the deficit is already at high levels and will only get worse.

The EPI's Primary Argument is a deficit spending is OK if the money spent is for national investment -- education, infrastructure etc.... As stated in the paper Breaking the Stranglehold on Growth:

Deficits can be justified even in times of full utilization of resources if they result from public investment in neglected areas with high potential financial and social returns, such as early education or transportation infrastructure. The nation should begin making formal projections of the future tax revenues and social benefits of such government investment.

I am not debating the wisdom of any of their policy proscriptions because they are all damn good ideas. I wish they were possible. But the reality of our current situation is the deficit is already at incredibly high levels and must be dealt with now.

First, let's look at where we are now. According to the US Treasury, the total amount of US debt outstanding has risen sharply in the last 6 years.

Year Total Government Debt Increase From Preceding Year

09/30/2006 $8,506,973,899,215.23 $574,264,237,491.73

09/30/2005 $7,932,709,661,723.50 $553,656,965,393.18

09/30/2004 $7,379,052,696,330.32 $595,821,633,586.70

09/30/2003 $6,783,231,062,743.62 $554,995,097,146.46

09/30/2002 $6,228,235,965,597.16 $420,772,553,397.10

09/30/2001 $5,807,463,412,200.06

The total amount of debt now stands at 62% of GDP. However, the build-up happened very quietly because of the record low interest rates of the last six years. Here is a chart of the 10-Year Constant Maturity Treasury from the St. Louis Federal Reserve:

As a result of low interest rates, the level of interest payments on the national debt has dropped for the last few years. However, as the chart below illustrates the total amount of interest is increasing.

So far, the US has been pretty lucky when it comes to interest rates. Although we are issuing over $550 billion net new debt per year for the last 5 years, we haven't had an increase in the amount of interest we have to pay on the debt. However, as the amount of total debt outstanding increases, lenders will eventually start demanding a higher interest rate as compensation for the increased risk of a credit default. There is no magic economic line when this will happen. However, the more debt we issue, the higher the possibility of an increase in interest rates.

This is why the US has to deal with the deficit first. While I agree with the idea of deficit spending when the deficit is at a manageable level, the US is simply too far in the hole right now. We have to deal with the deficit, or those increased interest payments will start to deal with us. And that's a place no country wants to be.