The policy debates over government debt have many facets. So far we have considered the traditional and Ricardian views of government debt. According to the traditional view, a government budget deficit expands aggregate demand and stimulates output in the short run but crowds out capital and depresses economic growth in the long run. According to the Ricardian view, a government budget deficit has none of these effects because consumers understand that a budget deficit represents merely the postponement of a tax burden. With these two theories as background, we now consider several other perspectives on government debt.

In the United States, many state constitutions require the state government to run a balanced budget. A recurring topic of political debate is whether the U.S. Constitution should require a balanced budget for the federal government as well. Most economists oppose a strict rule requiring the government to balance its budget. There are three reasons that optimal fiscal policy may at times call for a budget deficit or surplus.

Stabilization A budget deficit or surplus can help stabilize the economy. In essence, a balanced-budget rule would revoke the automatic stabilizing powers of the system of taxes and transfers. When the economy goes into a recession, taxes automatically fall, and transfers automatically rise. Although these automatic responses help stabilize the economy, they push the budget into deficit. A strict balanced-budget rule would require that the government raise taxes or reduce spending in a recession, but these actions would further depress aggregate demand. Discretionary fiscal policy is more likely to move in the opposite direction over the course of the business cycle. In 2009, for example, President Barack Obama signed a stimulus bill authorizing a large increase in spending to try to reduce the severity of the recession, even though it led to the largest budget deficit in more than half a century.

Tax Smoothing A budget deficit or surplus can be used to reduce the distortion of incentives caused by the tax system. As discussed earlier, high tax rates impose a cost on society by discouraging economic activity. A tax on labor earnings, for instance, reduces the incentive that people have to work long hours. Because this disincentive becomes particularly large at very high tax rates, the total social cost of taxes is minimized by keeping tax rates relatively stable rather than making them high in some years and low in others. Economists call this policy tax smoothing. To keep tax rates smooth, a deficit is necessary in years of unusually low income (recessions) or unusually high expenditure (wars).

Intergenerational Redistribution A budget deficit can be used to shift a tax burden from current to future generations. For example, some economists argue that if the current generation fights a war to preserve freedom, future generations benefit as well and should bear some of the burden. To pass on some of the war’s costs, the current generation can finance the war with a budget deficit. The government can later retire the debt by levying taxes on the next generation.

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These considerations lead most economists to reject a strict balanced-budget rule. At the very least, a rule for fiscal policy needs to take account of the recurring episodes, such as recessions and wars, during which it is reasonable for the government to run a budget deficit.

In 1985, Paul Volcker told Congress that “the actual and prospective size of the budget deficit … heightens skepticism about our ability to control the money supply and contain inflation.” A decade later, Alan Greenspan claimed that “a substantial reduction in the long-term prospective deficit of the United States will significantly lower very long-term inflation expectations.” Both of these Fed chairmen apparently saw a link between fiscal policy and monetary policy.

We first discussed such a possibility in Chapter 5. As we saw, one way for a government to finance a budget deficit is simply to print money—a policy that leads to higher inflation. Indeed, when countries experience hyperinflation, the typical reason is that fiscal policymakers are relying on the inflation tax to pay for some of their spending. The ends of hyperinflations almost always coincide with fiscal reforms that include large cuts in government spending and therefore a reduced need for seigniorage.

In addition to this link between the budget deficit and inflation, some economists have suggested that a high level of debt might also encourage the government to create inflation. Because most government debt is specified in nominal terms, the real value of the debt falls when the price level rises. This is the usual redistribution between creditors and debtors caused by unexpected inflation—here the debtor is the government and the creditor is the private sector. But this debtor, unlike others, has access to the monetary printing press. A high level of debt might encourage the government to print money, thereby raising the price level and reducing the real value of its debts.

Despite these concerns about a possible link between government debt and monetary policy, there is little evidence that this link is important in most developed countries. In the United States, for instance, inflation was high in the 1970s, even though government debt was low relative to GDP. Monetary policymakers got inflation under control in the early 1980s, just as fiscal policymakers started running large budget deficits and increasing the government debt. In 2014, the debt–GDP ratio was high by historical standards, but inflation was a bit below the Fed’s announced target of 2 percent. Thus, although monetary policy might be driven by fiscal policy in some situations, such as during classic hyperinflations, this situation appears not to be the norm in most countries today. There are several reasons for this. First, most governments can finance deficits by selling debt and don’t need to rely on seigniorage. Second, central banks often have enough independence to resist political pressure for more expansionary monetary policy. Third, and most important, policymakers in all parts of government know that inflation is a poor solution to fiscal problems.6

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Fiscal policy is made not by angels but by an imperfect political process. Some economists worry that the possibility of financing government spending by issuing debt makes that political process all the worse.

This idea has a long history. Nineteenth-century economist Knut Wicksell claimed that if the benefit of some type of government spending exceeded its cost, it should be possible to finance that spending in a way that would receive unanimous support from the voters. He concluded that government spending should be undertaken only when support is, in fact, nearly unanimous. In the case of debt finance, however, Wicksell was concerned that “the interests [of future taxpayers] are not represented at all or are represented inadequately in the tax-approving assembly.”

Many economists have echoed this theme more recently. In their 1977 book Democracy in Deficit, James Buchanan and Richard Wagner argued for a balanced-budget rule for fiscal policy on the grounds that it “will have the effect of bringing the real costs of public outlays to the awareness of decision makers; it will tend to dispel the illusory ‘something for nothing’ aspects of fiscal choice.” Similarly, Martin Feldstein (once an economic adviser to Ronald Reagan and a long-time critic of budget deficits) argued that “only the ‘hard budget constraint’ of having to balance the budget” can force politicians to judge whether spending’s “benefits really justify its costs.”

These arguments have led some economists to favor a constitutional amendment requiring Congress to pass a balanced budget. Often these proposals have escape clauses for times of national emergency, such as wars and depressions, when a budget deficit is a reasonable policy response. Some critics of these proposals argue that, even with the escape clauses, such a constitutional amendment would tie the hands of policymakers too severely. Others claim that Congress would easily evade the balanced-budget requirement with accounting tricks. As this discussion makes clear, the debate over the desirability of a balanced-budget amendment is as much political as economic.

Government debt may affect a nation’s role in the world economy. As we first saw in Chapter 6, when a government budget deficit reduces national saving, it often leads to a trade deficit, which in turn is financed by borrowing from abroad. For instance, many observers have blamed U.S. fiscal policy for the relatively recent switch of the United States from a major creditor in the world economy to a major debtor. This link between the budget deficit and the trade deficit leads to two further effects of government debt.

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First, high levels of government debt may increase the risk that an economy will experience capital flight—an abrupt decline in the demand for a country’s assets in world financial markets. International investors are aware that a government can always deal with its debt simply by defaulting. This approach was used as far back as 1335, when England’s King Edward III defaulted on his debt to Italian bankers. More recently, Russia defaulted on its debts in 1998, and Argentina did the same in 2001. The higher the level of the government debt, the greater the temptation to default. Thus, as government debt increases, international investors may come to fear default and curtail their lending. If this loss of confidence occurs suddenly, the result could be the classic symptoms of capital flight: a collapse in the value of the currency and an increase in interest rates. As we discussed in Chapter 13, this is precisely what happened to Mexico in the early 1990s when default appeared likely.

Second, high levels of government debt financed by foreign borrowing may reduce a nation’s political clout in world affairs. This fear was emphasized by economist Benjamin Friedman in his 1988 book Day of Reckoning. He wrote, “World power and influence have historically accrued to creditor countries. It is not coincidental that America emerged as a world power simultaneously with our transition from a debtor nation … to a creditor supplying investment capital to the rest of the world.” Friedman suggests that if the United States continues to run large trade deficits, it will eventually lose some of its international influence. So far, the record has not been kind to this hypothesis: the United States has run trade deficits throughout the 1980s, 1990s, and the first decade of the 2000s and, nonetheless, remains a leading superpower. But perhaps other events—such as the collapse of the Soviet Union—offset the decrease in political clout that the United States would have experienced because of its increased indebtedness.