Tonight I'd really like to talk about debt, deficits, and interest. I'd like to address some simple facts about it on both a personal and a political level.
Before anything else, I must say that at the heart of my feelings on the subject is a thought, distilled in a quote by J. Reuben Clark:
"Interest never sleeps nor sickens nor dies; it never goes to the hospital; it works on Sundays and holidays; it never takes a vacation; it never visits nor travels; it takes no pleasure; it is never laid off work nor discharged from employment; it never works on reduced hours...; it has no love, no sympathy; it is as hard and soulless as a granite cliff. Once in debt, interest is your companion every minute of the day and night; you cannot shun it or slip away from it; you cannot dismiss it; it yields neither to entreaties, demands, or orders; and whenever you get in its way or cross its course or fail to meet its demands, it crushes you" (Conference Report, April 1938, pg. 103).
With this in mind, we need to make two important distinctions about debt. Debt itself is never good. If debt is ever worthwhile, it is not that the debt itself is good, but that it purchases things that are worth even such a terrible burden. If anything is good, it is the budget deficit which you have, the acquisition of debt, by which you acquire something of greater worth to you. Debt, once you have it, is merely a liability. You may argue that this is splitting hairs, that all debt was once a deficit, that all debt was useful in the moment of its creation, but it is important to remember that the debt itself is bad, especially as you consider the interest that comes with it. Anyway, this distinction between debt and deficit will be essential to further discussion.
The second distinction is that I wish to categorize deficits, specifically into two categories. There is what I will call a structural deficit, one which is part of the very structure of how things operate, and which is, in a sense, permanent. It is a deficit which is just there, which we do not have a plan for eliminating, which we anticipate being a part of the budget essentially forever. There is also what I will call a temporary deficit. It is something that is not structural, which is a deficit for some relatively brief period of time, after which either the budget is essentially balanced or there is a surplus to pay down the debt.
The J. Reuben Clark quote tells almost the whole story of interest and debt on a personal level. There are a few details to add. While this fact about interest makes it clear that living on credit is a foolish thing (personal finance with a structural deficit is impossible), one which will cause more grief than it's worth in the end, this does not say that all deficits are bad. The simplest counterexample to saying so is a mortgage. When you pay rent, all that money is gone forever, it does nothing for you except get you through another month. A mortgage payment includes interest and tax (which are gone forever when you pay them) and payment on principle, equity. Eventually, you own the house free and clear, and the only money that you throw away each month is property tax, far less than rent for an apartment or house. This fact can make a mortgage a wise thing. Of course, this doesn't justify more than a modest home, a large one bought on credit ends up being only a financial burden. Similarly, debt for education which vastly increases your long-term earnings can pay for itself within a few years. But then, if you get $100,000 in debt for an art degree, you may never see the additional earnings you need to make it financially wise. My point is that exceptions exist to the rule that deficits are bad (which is a good rule of thumb), but you must be very careful about it. Don't go into debt for that new car, instead wait a little longer with your old one and then buy a used one, it will get you from place to place just as well. Don't go into debt for furniture, you can live just fine with folding chairs and a card table (or, if you don't even have the money for those, sit on the floor) until you have the money to pay cash for the living room set. Only your pride will be hurt. And, no matter what,
never go into debt without thinking about the quote above, or a similar sentiment, and being 100% sure that what you are buying on credit justifies itself so well that you're willing to enslave yourself (for debt is bondage) to a monster that will crush you if you do not obey it completely. I will never go into debt without thinking hard about it for days first.
That is the essence of my view on debt in personal finance: no structural deficits, and be very,
very careful even of debt resulting from temporary ones. Any other plan will result in grief.
The first thing for considering debt on a large scale is the same: Whether it is a person or a nation, interest never sleeps. Yet people insist that debt is more complicated for a nation than a person, and a nation can exist with perpetual debt, never repaid. Because of this argument, let's break it down a little more.
A temporary deficit is defensible in the same way for a nation as it is for a person. Of course you need to be careful that the debt you will have afterward is worth your while, but there are exceptions to the rule that all deficits are bad. If someone is about to invade, it may be prudent to go into debt to fund a defensive effort, as the alternative may be even more costly. If technology produces something which will require a high-cost infrastructure upgrade, the investment may pay for itself in years to come. These things must be carefully evaluated in much the same way that buying a home or student loans must be.
But when a deficit becomes structural, we have to look at things a little bit differently. Here we can use some math to make some predictions.
In a country, we can always take the deficit as a fraction of GDP, and doing so yields some very interesting results for a structural deficit. For example, if we have a structural deficit of 3% of the GDP and a GDP growth rate of 3%, that means that the debt is growing at the same rate as the GDP. If this continues indefinitely, this relationship will override all initial conditions, so that the national debt will asymptotically approach the same value as the GDP: you'll asymptotically approach a debt to GDP ratio of 100%. Similarly, if the deficit is 6% and the GDP is 3%, you add twice as many dollars to the debt as you do to the GDP each year, and eventually you'll approach a debt to GDP ratio of 200%. In short, your debt to GDP ratio will asymptotically approach your deficit (as a fraction of GDP) to GDP growth rate ratio. This is significant as the debt to GDP ratio is a fair estimate of the debt burden on the country (if you have a larger economy, you can handle more debt).
Now let's add interest to the mix and consider two different scenarios. Let's say that the interest rate that the country pays on debt is 3%, and its GDP growth rate is 3%. Our two scenarios are that the country has no structural deficit, and that it has a 6% structural deficit, and that this has been going on for a long time (we've reached the no debt limit in one case, and the 200% debt to GDP ratio in the other). For the country with debt, you pay 3% of the debt in interest every year, which works out to 6% of the GDP. The country with no debt, of course, pays nothing. Notice anything interesting? The interest paid is the same as the deficit: the whole deficit ends up going to paying interest. This means that there is nothing left of the deficit to pay for extra government programs or service: the deficit buys nothing, it just maintains the debt. Therefore, the country with no debt can have the same government programs and taxes as the one with a large deficit.
I chose nice round numbers for this first example, but work it out with different numbers, and you'll find that the essential relationship is between the interest rate paid by the country and its GDP growth rate. If the interest rate is less than the growth rate, then a structural deficit stabilizing to a debt to GDP ratio will still yield some benefit to the country in terms of the programs that it can pay for. If, in my example, the interest rate had been 2% instead of 3%, it would have worked out that the country with debt had an extra 2% of GDP to use for programs out of its deficit. On the other hand, if the interest rate is higher than the growth rate, the country without a deficit actually has
more money to use for programs than the one operating with a deficit, in the long-term limit. If the interest rate were 4% instead of 3%, the country with a deficit would actually have 2% of GDP
less for its programs, in spite of the fact that it's running a very large deficit.
All of this, of course, assumes that all of these rates are static, and they never are. Things are more difficult and complicated than this. But at the same time, we can certainly make a case for this analysis, as you can always find an average growth rate, an average interest rate, and an average deficit (geometric mean, if you please, at least for the first two).
The other disclaimer on this analysis is that it's all long-term. Certainly if both countries start from the same level of debt, the one running a 6% deficit has an extra 6% of GDP to spend on programs the first year, regardless of interest (as they both pay the same interest starting from the same level of debt). But then, if you have a program that is a part of the very structure of your country, you need it to run in the long-term, and so its effect on long-term debt dynamics is an essential part of the analysis, and if it causes you trouble in the long-term dynamics, I think your plan is bad. No program should be enacted or maintained as if in perpetuity which will be insolvent in the long-term.
A final piece to this analysis is that it runs the other way as well: if a country
receives interest on savings greater than its GDP growth rate, in the long-term dynamics a country with a budget surplus will actually end up having more money for government programs than one with a balanced budget. That does not mean that in such a case a country should instantly cut all programs in order to start such savings, as the short-term does matter as well. But in such a case, any country would be wise to find at least some cuts to begin the process of building long-term savings.
Lastly, a comment, outside the scope of the mathematical analysis. I have considered only the ability of a country to provide funding for extra programs as a result of its long-term structural debt, and shown that for interest rates about the GDP growth rate, the only benefit of a deficit is lost and actually reversed in the long term. However, this is not the only factor. Government programs are not the only effect of government debt. If there is a recession or war, a government with large structural debt is less able to cope with it than one with little or no debt. In the case that the interest rate is low, it may still be better for the government to have a smaller or no deficit. This, of course, is open to debate. But if we anticipate that in the long term the average interest rate is higher than the average GDP growth rate, then I think it clear that we would be wise to operate with only temporary deficits.
And... a final note, poking around the internet as I was mostly through finishing this, I'm guessing that I picked up the term "structural debt" from something I read somewhere. Feel free to look it up, and you'll find that the term is somewhat related to what I've defined, but different, relating to the deficit that a government would run with the economy at its maximum output. If any actual economists read this, my use of a real term for something other than it normally is may be confusing, but I have defined the term as I use it above, so I hope that helps.
Title: Attributed to my grandfather, though I'm not sure if he was the origin. "It" refers to interest.
