The Economic Consequences of Disappearing Government Debt

Federal budgetary developments in the United States of late have been fast moving and nothing short of outstanding: The latest projections of the Congressional Budget Office (CBO) peg the federal surplus for fiscal year 2000 in excess of $230 billion, around $50 billion more than its forecast of just six months earlier. For a generation accustomed to mounting government obligations and dire warnings of adverse macroeconomic consequences, a surplus in 2000 amounting to 2.4 percent of nominal GDP—the largest since 1948—would seem to imply a changed economic landscape.

Yet these developments are not limited to the United States. Several factors have combined to improve fiscal positions in a number of countries worldwide. Among these factors are cyclical recoveries that have boosted income tax revenue, increases in equity values that have produced capital gains tax windfalls, and spending restraint due in part to spending caps and, in many European countries, a desire to satisfy the fiscal criteria in the 1993 Maastricht treaty. In its latest OECD Economic Outlook, the Organization for Economic Cooperation and Development projects that fourteen of twenty-three countries covered will achieve fiscal balance or surplus over the immediate two-year projection period. Indeed, if one excludes Japan, whose fiscal position is moving in the opposite direction, the aggregate fiscal balance of the Group of Seven large industrial countries (the G-7) will have swung from a deficit of more than 3 percent of their combined GDP in 1996 to a projected surplus of about ¾ percent by 2001. These developments represent a general shrinkage of governments' claims on the world pool of saving, rather than a shift in the U.S. government's demands alone.

Will these worldwide shifts from deficits to surpluses, and the consequent declines in government debt, have important economic consequences? For some the self-evident answer is no. An influential body of opinion holds that government debt, because it implies a future stream of taxes to meet interest payments, should not be counted as part of household wealth. In that view the decline in government debt, by itself, has no implications for economic activity or financial market prices.¹ Instead, any effects that occur stem only from changes in fiscal policies that condition that path of declining debt. Our interpretation of recent events, however, is inconsistent with this view. After reviewing the recent fiscal experience of the industrial countries, we focus on three separate ways in which the disappearance of government debt has economic effects.

In our interpretation the U.S. budget surplus and its projected continuation and deepening represent a change in policy comparable in magnitude to the creation of massive deficits in the 1980s. At that time several prominent economists, including Olivier Blanchard, William Branson, Rudiger Dornbusch, and Martin Feldstein, stressed mechanisms through which a policy conventionally viewed as providing current fiscal stimulus could actually have contractionary effects.² The core of this insight was that fiscal policy in the 1980s was on a path that implied ever-widening deficits, which would require increasing real interest rates over time.³ Investors in capital markets would bring forward to the present their expectations of higher short-term real interest rates, in the form of higher long-term interest rates, lower stock prices, and a stronger foreign exchange value of the dollar, before the direct stimulus of additional spending would be felt.

One channel for this "expectational crowding out" was thought to be the appreciation of the dollar on foreign exchange markets, as the prospect of a rise in real interest rates in the United States relative to those of its trading partners gave investors an incentive to increase their dollar holdings immediately. There is less reason, however, to bring that aspect of the argument to bear on the present situation. To a first approximation, if mounting surpluses are a generalized world phenomenon, rather than specific to the United States, there would seem to be no need for the dollar's exchange value to adjust to tilt spending into better balance worldwide. However, the other two mechanisms—those operating through changes in long...