Why U.S. Debt Must Continue to Rise

Originally posted at China Financial Markets

Many Americans are worried about the seemingly inexorable rise in U.S. debt, whether government debt, household debt, or business debt. They are right to be concerned. Rapidly rising debt is a problem not just in the United States but in many other countries too, including China, parts of Europe, and most of the developing world. In today’s environment, it seems, reasonable levels of economic growth cannot be achieved unless boosted by even faster growth in debt.

With so much debt in the world, and with debt levels rising so quickly, people tend to think that economists have studied this issue deeply and fully understand it. But there continues to be a great deal of confusion about debt and about whether and why excessive debt levels can harm growth prospects. To try to address these issues, this blog post is divided into two parts. The first part discusses debt and some of the conditions under which it affects the prospects for economic growth.

The second part argues that at least two of the reasons that debt has been rising inexorably in the United States for several years are the country’s rising income inequality and its persistent trade deficit. Surprising as it may seem at first glance, these two conditions operate the same way: they distort the level and structure of American savings. As long as income inequality remains high and the United States runs large deficits, the resulting savings distortions will continue to mean that U.S. debt levels have to rise to prevent the economy from slowing and unemployment from rising.

WHY DEBT MATTERS

What are productive and nonproductive debt?

To begin with, broadly speaking, debt can be divided into two types:

Self-liquidating debt is used to fund investment projects that increase economic productivity enough (after including all associated positive and negative externalities) to service the debt fully. In such cases, an increase in debt is used to create an equal or greater increase in assets. While this usually leaves the overall economy better off, there could still be an argument about whether it is best to fund a particular project with debt (versus equity), about the best (or least risky) way of structuring the borrowing, and about how the debt and its subsequent repayment affects income distribution.

All other debt funds household consumption, nonproductive government activities (such as military spending, welfare programs, and other kinds of consumption on behalf of households), and nonproductive investment by either the government or businesses. In some cases, this debt can have a positive impact on economic welfare, such as when debt is used to smooth out consumption over a person’s life cycle. In other cases, it can be positive or negative for economic well-being or for overall economic growth depending on how it affects the way income is distributed. (Indeed, this is one of its least understood but most important functions.)

Self-liquidating debt adds to the total debt in the economy, but rather than heighten the economy’s debt burden it usually reduces the burden by increasing the wealth or productive capacity created by the project by more than the cost of the project. The most common form this debt takes is business investment or government investment in infrastructure. I say that this type of debt usually reduces a country’s debt burden, rather than saying it always does, because this may not be the case if the debt is badly structured; if, for instance, debt servicing costs are severely mismatched relative to a project’s net increase in production, such a project can raise uncertainty in ways that adversely affect the rest of the economy.

But, except in cases of very badly structured, highly inverted debt, self-liquidating debt is ultimately sustainable because it allows economic actors to service the rise in debt by more than the associated debt-servicing costs. In principle, this means that the debt can be repaid fully out of the additional value created, leaving everyone better off in the aggregate. That said, it is possible in some instances that certain sectors of the economy would benefit disproportionately and other sectors would be worse off, with the winners exceeding the losers.

Debt that is not self-liquidating increases the total debt in the economy and, because it doesn’t improve debt-servicing capacity, usually adds to the economy’s debt burden. Again, I say usually rather than always because, in some cases, this second kind of debt leaves the economy’s debt burden no worse off (if the debt is used for consumption smoothing, for instance); in other cases, such debt can even reduce the debt burden if the debt redistributes wealth in ways that increase the economy’s wealth-producing capacity.¹

Debt that isn’t self-liquidating is necessarily serviced only through implicit or explicit transfers from one economic sector to another. In such cases, the borrower can service the debt by appropriating income from other projects, including taxes if the borrower is the government. If the borrower defaults, on the other hand, the debt-servicing cost is transferred to the creditors.

There are other ways that governments, in particular, can service such debt by effectively transferring the cost. The debt can be eroded by inflation, in which case the debt-servicing cost is effectively forced onto those who are long monetary assets, mainly households that save in the form of bonds, bank deposits, and other interest-sensitive assets. If wages are forced down to make it easier for businesses or governments to service their debts, the debt-servicing cost is forced onto workers. If government debt is serviced by expropriation, the debt-servicing cost is forced onto the rich or onto foreigners. One way or another, in other words, this kind of debt is serviced by explicitly assigning or implicitly allocating the costs by way of a transfer of wealth.

Is excessive debt bad for the economy?

Unfortunately, few economists seem able to explain coherently why a heavy debt burden can be harmful to the economy. This statement may seem surprising, but ask any economist why an economy would suffer from having too much debt, and he or she almost always responds that too much debt is a problem because it might cause a debt crisis or undermine confidence in the economy. (Not only that, but how much debt is considered too much seems to be an even harder question to answer.)²

But this is clearly a circular argument. Excessive debt wouldn’t cause a debt crisis unless it undermined economic growth for some other reason. Saying that too much debt is harmful for an economy because it might cause a crisis is (at best) a kind of truism, as intelligible as saying that too much debt is harmful for an economy because it might be harmful for the economy.

What is more, this sentiment isn’t even correct as a truism. Admittedly, countries with too much debt can certainly suffer debt crises, and these events are unquestionably harmful. But as British economist John Stuart Mill explained in an 1867 paper for the Manchester Statistical Society, “Panics do not destroy capital; they merely reveal the extent to which it has been previously destroyed by its betrayal into hopelessly unproductive works.” While a crisis can magnify an existing problem, the point Mills makes is that a crisis mostly recognizes the harm that has already been done.

Yet, paradoxically, too much debt doesn’t always lead to a crisis. Historical precedents clearly demonstrate that what sets off a debt crisis is not excessive debt but rather severe balance sheet mismatches. For that reason, countries with too much debt don’t suffer debt crises if they can successfully manage these balance sheet mismatches through a forced restructuring of liabilities. China’s balance sheets, for example, may seem horribly mismatched on paper, but I have long argued that China is unlikely to suffer a debt crisis, even though Chinese debt has been excessively high for years and has been rising rapidly, as long as the country’s banking system is largely closed and its regulators continue to be powerful and highly credible. With a closed banking system and powerful regulators, Beijing can restructure liabilities at will.

Contrary to conventional wisdom, however, even if a country can avoid a crisis, this doesn’t mean that it will manage to avoid paying the costs of having too much debt. In fact, the cost may be worse: excessively indebted countries that do not suffer debt crises seem inevitably to end up suffering from lost decades of economic stagnation; these periods, in the medium to long term, have much more harmful economic effects than debt crises do (although such stagnation can be much less politically harmful and sometimes less socially harmful). Debt crises, in other words, are simply one way that excessive debt can be resolved; while they are usually more costly in political and social terms, they tend to be less costly in economic terms.

What are the actual costs of excessive debt?

So why is excessive debt a bad thing? I am addressing this topic in a future book. To put it briefly, there are at least five reasons why too much debt eventually causes economic growth to drop sharply, through either a debt crisis or lost decades of economic stagnation:

• First, an increase in debt that does not generate additional debt-servicing capacity isn’t sustainable. However, while such debt does not generate real wealth creation (or productive capacity or debt-servicing capacity, which ultimately amount to the same thing), it does generate economic activity and the illusion of wealth creation. Because there are limits to a country’s debt capacity, once the economy has reached those limits, debt creation and the associated economic activity both must decline. To the degree that a country relies on an accelerating debt burden to generate economic activity and GDP growth, in other words, once it reaches debt capacity limits and credit creation slows, so does the country’s GDP growth and economic activity.
• Second, and more importantly, an excessively indebted economy creates uncertainty about how debt-servicing costs are to be allocated in the future. As a consequence, all economic agents must change their behavior in ways that undermine economic activity and increase balance sheet fragility (see endnote 2). This process, which is analogous to financial distress costs in corporate finance theory, is heavily self-reinforcing.
• Some countries—China is probably the leading example—have a high debt burden that is the result of the systematic misallocation of investment into nonproductive projects. In these countries, it is rare for these investment misallocations or the associated debt to be correctly written down. If such a country did correctly write down bad debt, it would not be able to report the high GDP growth numbers that it typically does. As a result, there is a systematic overstatement of GDP growth and of reported assets: wealth is overstated by the failure to write down bad debt. Once debt can no longer rise quickly enough to roll over existing bad debt, the debt is directly or indirectly amortized, and the overstatement of wealth is explicitly assigned or implicitly allocated to a specific economic sector. This causes the growth of GDP and economic activity to understate the real growth in wealth creation by the same amount by which it was previously overstated.
• Insofar as the excess debt is owed to foreigners, its servicing costs represent a real transfer of resources outside the economy.
• To the extent that the excess debt is domestic, its servicing costs usually represent a real transfer of resources from economic sectors that are more likely to use these resources for consumption or investment to sectors that are much less likely to use these resources for consumption or investment. In such cases, the intra-country transfer of resources represented by debt-servicing will reduce aggregate demand in the economy and consequently slow economic activity.

Does debt affect demand?

Except for economies in which all resources—including labor and capital—are fully utilized and for economies that have no slack (unutilized resources and labor), increases in debt can boost current domestic demand, although not always sustainably. When households borrow, for example, they usually do so either to buy homes or to increase consumption. I am not sure how much of home buying in the United States spurs new construction and how much represents sales of existing homes, but, in the latter case, the borrowing creates no new demand for the economy, except to the extent that the seller uses the proceeds of a home sale to increase consumption.

Of course, insofar as borrowing for consumption directly increases aggregate demand by increasing consumption today, the repayment of such borrowing reduces consumption tomorrow. This is another area that seems to confuse economists enormously. Standard economic theory states that borrowing simply transfers spending from the lender to the borrower, and that repaying debt reverses these transfers. In such instances, no new demand is created by borrowing nor is it extinguished by repaying.

But this is only true for an economy that is fully utilizing its labor, capital, and other resources and in which investment is constrained by high costs of capital. In such cases, borrowers must bid up the cost of capital to gain access to savings and, in so doing, they prevent someone else from employing these resources. This is when borrowing has no net impact on total demand: it simply transfers spending from one part of the economy to another, and the only thing that matters for the health of the economy is how efficient any particular use of savings might be and what impact that use has on long-term growth.

But for an economy with substantial slack whose investors are reluctant to engage in new investment because of insufficient demand, borrowing does create additional demand, while future repayment usually reverses this added demand. Among the three types of borrowing— household, government, and business—household borrowing is not self-liquidating and directly increases the country’s debt burden. This is because aggregate debt rises with no increase in the country’s debt-servicing capacity or productive capacity, except to the extent that the borrowing encourages businesses to invest in manufacturing capacity.

Increases in government debt, similarly, do not result in equivalent increases in debt-servicing or productive capacity, except insofar as government borrowing is used to fund investment in productive infrastructure. If used to fund consumption, household transfers, military spending, and so on, government debt can boost current domestic demand without boosting debt-servicing capacity or productive capacity, an increase in domestic demand that must later be reversed.³

Increases in business debt, on the other hand, do usually fund productive investment, so these increases usually boost debt-servicing or productive capacity. When businesses borrow capital, however, for stock buybacks, to pay down other debt, to cover losses, or for nonproductive investment projects (usually subsidized by governments), this debt functions just like household borrowing for consumption in the sense that it is not self-liquidating.

HOW AMERICAN SAVINGS ARE DISTORTED

Two reasons for rising U.S. Debt

I have no way of calculating the extent to which recent increases in U.S. debt have funded productive or nonproductive activity, but a substantial portion of increases in American debt over the past several years is probably (almost certainly) unsustainable and not self-liquidating. This is because rising debt is needed to keep growth in economic activity high enough to prevent a rise in unemployment.

Economists don’t generally distinguish between growth in economic activity (which is mostly what GDP measures) and growth in economic wealth or in wealth-producing capacity. They tend simply to equate the two. I discuss this issue in a January 2019 blog post. While the two may be equal over the long run, however, over shorter periods they are not necessarily equal, given that the former can exceed the latter especially as a consequence of an unsustainable increase in debt.

I will not pretend to offer a complete analysis of debt in the U.S. economy here, but there are at least two reasons that the United States has no choice but to encourage an increase in debt to prevent a rise in unemployment. The first reason is the U.S. role in the global balance-of-payments system and the second one is high levels of U.S. income inequality. Although these two factors seem like two different things, they work in the same way and for the same reasons.

Why trade deficits actually matter

I have explained many times before (including here and here) that the United States runs trade deficits mainly because the rest of the world exports its excess savings there. Standard trade theory suggests that, under normal conditions, the United States should run persistent trade surpluses, as I will explain in my next blog post. But because of distortions in income distribution in the rest of the world, developed economies suffer from excess savings and insufficient demand.

The way this works is straightforward although it may seem counterintuitive at first. There are two ways to boost international competitiveness, which in a highly globalized world can lead automatically to higher growth. The high road is to boost domestic productivity, typically by investing in needed infrastructure, education, and technology. The low road is to reduce relative wages, something that can be done directly or indirectly. The direct approach is to lower wages or wage growth as, for example, Germany did during and after the Hartz reforms of 2003–2005. An indirect way of achieving the same effect is for a country to hold down the value of its currency by doing things like imposing explicit or hidden tariffs, subsidizing production factors at the expense of households, or increasing household transfers to other sectors of the economy.

The low road is, of course, easier to embark on quickly, and it effectively entails reducing the household share of what a country produces: directly or indirectly, in other words, households receive less total compensation for producing a given amount. The problem with this low road approach is that it reduces total demand. As households receive a lower share of GDP, they consume a lower share. Unless there is a commensurate rise in investment, the result is that a country is less likely to be able to absorb everything it produces.

In a closed economy, or one in which international trade and capital flows are limited by high frictional costs, a country that produces more than it can absorb domestically must allow unwanted inventory to pile up until, once debt limits are reached, it must close down production facilities and fire workers. In a highly globalized world, however, where the frictional costs of international trade and capital flows are extremely low or even nonexistent, it is much easier for such a country to export both the excess production and the excess savings.

This is the problem. Policies that increase international competitiveness by lowering the household share of GDP reduce total demand within such countries, but these policies also allow these countries to gain a larger share of foreign demand. This is the tradeoff that makes this arrangement work for the surplus country: while domestic demand shrinks, the surplus country more than makes up for it by increasing its share of what is left, at the expense of its trade partners.

Whether this state of affairs benefits or harms the global economy depends primarily on where the excess savings are exported. If they are exported to a developing country whose domestic investment needs are constrained by insufficient domestic savings, they can cause a boost in productive investment that increases the recipient country’s domestic demand. In such cases, the net effect on the world is usually positive. If the increase in investment in the recipient country is greater than the reduction in consumption in the exporting country, the world is better off, although there may still be legitimate disputes about distribution effects.

But if the excess savings are exported to an advanced economy whose domestic investment needs are not constrained by an inability to access domestic savings, these savings do not result in an increase in investment, so the world is left with lower demand. As I will explain below (see Where Might This Argument Be Wrong?), when excess savings flow into the United States, these savings do not cause investment to rise. This is a classic case of beggar-thy-neighbor policies, in which one country benefits at the greater expense of its trade partners.

Much of the world’s excess savings flow to rich countries where these funds are not needed, rather than to developing countries that can use them productively. It is typically the countries with the most open, most flexible, and best-governed financial markets that end up on the receiving end, mainly the so-called Anglo-Saxon economies and especially the United States. The United States runs capital account surpluses, in other words, not because it is capital short, but because the world has excess savings and the United States is the leading safe haven into which to hoard these savings.

Some observers might object to this interpretation. After all, they might say, doesn’t the United States have a low savings rate, well below its investment rate? And doesn’t that prove that the United States needs foreign savings?

Not necessarily. While this was the case in the nineteenth century, when the United States imported capital because it lacked sufficient domestic savings to fund its investment needs, it is no longer true in the twenty-first century. Rather than assuming, as most economists still do, that the United States imports foreign savings because U.S. savings are too low, it is vital to recognize that U.S. savings are low because the United States imports foreign savings.

This is because a country with a capital account surplus must, by definition, run a current account deficit, and because investment in that country must, also by definition, exceed savings. Most economists see this tautology and mistakenly assume an automatic direction of causality in which foreign capital inflows drive U.S. investment above the level of U.S. savings. The main reason for this assumption, it turns out, is because if inflows don’t drive up investment, they must drive down savings, and people have a difficult time understanding how foreign capital inflows can drive down savings. But, as I will show later (see What Drives Down Savings?), there is nothing mysterious or unlikely about this process.

Why income inequality matters

It may seem surprising at first that income inequality has the same economic impact as forced imports of foreign capital. By itself, income inequality tends to force up the savings rate, simply because rich households save more than ordinary or poor households. Put differently, if $100 is transferred from an ordinary American household, which consumes perhaps 80 percent of its income and saves 20 percent, to a rich household, which consumes around 15 percent of its income and saves 85 percent, the initial impact of the transfer is to reduce consumption by $65 and increase desired savings by the same amount.

But that is not the end of the story. In any economic system, savings can only rise if investment rises. If the United States cannot invest the additional savings—for reasons which I will discuss below (again, see Where Might This Argument Be Wrong?)—if rising income inequality causes U.S. savings in one part of the economy (the rich household that benefitted from the increase in savings) to rise, this must also cause savings in some other part of the economy to decline.

Again, the point is fairly simple. Total savings cannot rise unless these savings are invested. If savings in one part of the economy rise because of a transfer of wealth from poorer households to richer households, and if this does not cause investment to rise, this very transfer must then repress savings in another part of the economy. Notice how similar this is to the way the trade deficit works: rising savings in one part of the world are exported to the United States and cause savings in the United States to decline. In either case, if investment doesn’t rise, savings cannot rise, so an increase in savings in one sector or country must cause a reduction of savings in another.

What drives down savings?

There are many ways that the import of foreign savings or the additional savings of the rich can drive down savings in the overall economy.

• Net capital inflows may strengthen the dollar to a level far higher than it would otherwise be. Currency appreciation, by increasing the value of household income at the expense of the tradable goods sector, forces down a country’s savings rate, in effect increasing the household share of GDP and, with it, usually the consumption share.
• U.S. unemployment may be higher than it otherwise would be because of cheap foreign imports that help create the U.S. current account deficit or because income inequality drives down consumer demand (and with it, perhaps, investment). Unemployed workers have a negative savings rate as they consume out of their savings, so rising unemployment would drive down the savings rate.
• If that happens, unemployment would require more government borrowing to fund larger fiscal transfers, most of which would cause consumption to rise and savings to decline.
• To reduce unemployment, the U.S. Federal Reserve might expand credit and the money supply, encouraging additional borrowing.
• The capital inflows, or looser monetary policy, may inflate the prices of real estate, stocks, and other American assets, even setting off asset bubbles, a recurring response (historically speaking) to substantial capital inflows. Higher asset prices can make Americans feel richer, creating a wealth effect that drives up consumption.
• The consequent boost in real estate prices could set off additional real estate development, some of which might be economically justified and some that might not be. Technically, this would not be a reduction in savings but rather an increase in investment, but it would have the same net impact on the capital account.
• To the extent that some real estate development turns out to be economically unjustified, in future periods it may be written down, with the losses representing a reduction in the total stock of savings.
• U.S. banks and shadow banks, flush with liquidity and needing to create loans, may lower lending standards and give loans to households that would otherwise be perceived as too risky. As long as there is a normal distribution of risk-taking and optimism among American households—and this is the case in every country—whenever banks lower their consumer lending standards, there are households who take out loans and spend the proceeds on additional consumption, driving down savings.
• Credit card companies and consumer finance companies with abundant liquidity may make consumer credit more widely available and at cheaper rates than they otherwise would.

Notice that these numerous methods of driving down the savings rate can be summarized as one of two: either unemployment rises or debt rises. Because Washington is likely to respond to a rise in unemployment by increasing the fiscal deficit or loosening credit conditions, in the end, the result of rising income inequality and trade deficits is almost always that debt rises faster than it otherwise would.

That shouldn’t be surprising. Another way of looking at it is that both trade deficits and high income inequality reduce domestic demand, so returning the economy to its expected growth rate requires a new source of demand, and this new source is almost always generated by debt. By the way, this explains in part why economists are generally unable to find a correlation between the trade deficit and unemployment, or between income inequality and unemployment. Rather than cause unemployment to rise, these conditions can simply force an increase in debt.

Where might this argument be wrong?

This is a purely logical argument, so it would be wrong only if any of the underlying assumptions are wrong. The main such assumption is whether investment is not constrained by savings.

The standard argument is that investment is always constrained by savings and that forcing up savings is positive for investment because, even in economies with abundant savings and low interest rates, it lowers the cost of funding, however marginally. If businesses can borrow at a lower rate than before, the argument goes, there always will be some productive investment opportunity that only becomes profitable at this new, lower borrowing cost. This outcome must lead to more investment, which should lead to more growth over the long run.

This is the basic argument behind supply-side economics and the implicit justification for President Donald Trump’s recent tax cuts. Most economists agree that investment levels in the United States are low (probably too low) and that the United States would grow faster over the long term if businesses could be encouraged to invest more. Given that one of the most efficient ways to boost investment is presumably to make more capital available to businesses at lower costs, tax cuts for the rich would theoretically benefit the rest of the country eventually, as the additional wealth generated by higher investment trickled down.

Can policies that result in greater income inequality nonetheless leave a country better off? It turns out that the answer, again, depends on the availability of savings in the economy. In a capital-scare environment, like a typical developing economy, policies that force up the domestic savings rate can result in a substantial, one-for-one increase in domestic investment for every unit reduction in consumption. In such a case, total demand is unchanged (since lower consumption is matched by higher investment); the economy grows as quickly as ever in the short run while getting wealthier in the long run.

However, this isn’t necessarily the case in a capital-rich environment like most advanced economies today. In recent years, the financial system has been awash with liquidity, interest rates have been at all-time lows, and U.S. corporations have been sitting on hoards of cash that they seem unable to put to productive use. In such cases, most economists would agree that every unit reduction in consumption is likely to be matched by a smaller increase in investment, so in the short run total demand would decline.

This means that supply-side policies can reduce short-term growth in the United States because these policies cause a drop in total demand (assuming that lower consumption is only partially matched by higher investment). Nonetheless, as long as at least part of the reduction in consumption is matched by an increase in productive investment, it is still possible to argue that the country would be better off in the long run because investment increases productive capacity. In such cases, the rich benefit immediately from tax cuts for the rich, while the rest of society benefits eventually.

But, counterintuitively for most economists, it might be a mistake to assume that, insofar as supply-side policies increase the availability of capital and lower its cost, conditions that force up the desired savings rate must always lead to additional investment. There are conditions under which such policies may actually lead to less investment, and this outcome is especially likely today in most advanced economies.

All it requires is that, broadly speaking, all or most investment falls into one of two categories. The first category consists of projects whose value is not sensitive to marginal changes in demand, perhaps because they bring about very evident and significant increases in productivity, or because the economy suffers from significant underinvestment. The second category consists of projects whose value ultimately varies as a function of changes in demand.

In the former case, these projects—often in infrastructure—are typically and for obvious reasons more likely to be found in developing countries in which capital is scarce than in today’s advanced economies. In the early 1980s, for example, China reportedly had only a handful of commercial airports. A country as big as China urgently needed far more than it had, so it could be argued that whether China was expected to grow at 10 percent annually, 5 percent, or even zero percent, it nonetheless needed additional airport capacity. In that case, the need to invest is not sensitive to the expected growth in demand.

At some point, however, once China has filled the obvious airport gap, whether or not the country needs to build more airports depends on its growth prospects. A rapidly growing China will need more additional airport capacity than a slow-growing China, in which case investment in airports would fall into the second category, which consists of projects whose profitability is sensitive to demand conditions.

By dividing investment into these two categories, it becomes clear that policies that aim to force up desired savings and constrain consumption can have two contradictory effects on total investment:

• Forcing up savings increases investments that aren’t sensitive to marginal changes in demand by making more capital available at lower costs.
• Constraining consumption, however, reduces investments that are sensitive to marginal changes in demand by lowering the demand that drives the profitability of such investments.

What matters is simple arithmetic: the relative size of these two categories. In economies where only some investment is sensitive to demand fluctuations and most investment isn’t (most developing economies), conditions like income inequality that boost the savings rate can lift total investment and, by extension, long-term growth.

But in economies where the profitability of most investments is a function of changes in demand, income inequality can result in less total desired investment, rather than more. Greater capital availability at lower interest rates may cause certain additional marginal investments to be made, but the resulting increase in investment can easily be overwhelmed by a reduction in investment set off by slower consumption growth.

Put differently, if U.S. companies are reluctant to invest not because the cost of capital is high but rather because expected profitability is low, they are unlikely to respond to the trade-off between cheaper capital and lower demand by investing more. With less consumption, businesses that manufacture consumer goods are more likely to close down factories or postpone investment plans.

The claim that higher desired savings can lead to less investment may at first sound outlandish, and Marriner Eccles (1890–1977), a former chairman of the Federal Reserve Board, struggled to make just this point in the 1930s. This seems to be what happened in Germany after the Hartz reforms as well. As income was transferred from German workers to German businesses in the form of soaring profits, income inequality in Germany worsened. As expected, German savings rose, but (unexpectedly) investment actually declined, perhaps in partial response to the increase in savings.

The same seems to have happened in the United States following last year’s $1.5 trillion tax cut by the Trump administration. As an article this week in Reuters reminds us:

The White House had predicted that the massive fiscal stimulus package, marked by the reduction in the corporate tax rate to 21 percent from 35 percent, would boost business spending and job growth. The tax cuts came into effect in January 2018.

But rather than cause an increase in business investment, the tax cuts seem to have had no impact, or even a slightly negative one, which shouldn’t come as a surprise if American businesses already had access to as much capital as they needed:

The National Association of Business Economics’ (NABE) quarterly business conditions poll published on Monday found that while some companies reported accelerating investments because of lower corporate taxes, 84 percent of respondents said they had not changed plans. That compares to 81 percent in the previous survey published in October.

…The NABE survey also suggested a further slowdown in business spending after moderating sharply in the third quarter of 2018. The survey’s measure of capital spending fell in January to its lowest level since July 2017. Expectations for capital spending for the next three months also weakened.

What can be done?

Given these facts, the expected effects of income inequality and capital account surpluses (and the accompanying trade deficits) on the U.S. economy all depend almost exclusively on what people assume about investment. If policies or conditions that increase savings cause U.S. investment to rise, then income inequality and capital account surpluses (trade deficits) can be positive for American growth. If not, these effects will necessarily either increase U.S. unemployment or, more likely, U.S. debt.

So assuming that income inequality and capital account surpluses (trade deficits) are not positive for American growth, what can the United States do to mitigate these effects?

1. Limit foreign capital inflows. The United States must reduce its trade deficit with the world, but not by addressing the trade deficit directly through import tariffs or quotas. Remember that because the U.S. trade deficit is the automatic consequence of the U.S. capital account surplus, as long as the country is forced to import foreign capital, it will run a trade deficit, meaning that debt must rise if the country is to avoid a rise in unemployment. Import tariffs or quotas will only reduce the U.S. trade deficit to the extent that they reduce foreign capital inflows. And it is not at all clear that they will do so—in fact, they are at least as likely to increase inflows. Instead, the United States must address foreign capital inflows directly, perhaps by taxing them.
2. Reverse income inequality. There are many ways in which the United States can reverse income inequality. Washington could make the income tax code more progressive, for example, strengthen the country’s social safety net, raise minimum wages, or increase infrastructure spending.⁴
3. Force up productive investment domestically. If the US decides that it cannot choose but to tolerate high levels of income inequality and run large capital account surpluses, it can at least decide to match the resulting increase in savings availability with higher investment, especially by boosting funding for infrastructure. In this way keeping unemployment from rising doesn’t require that debt rise. Otherwise, debt must continue to rise to prevent savings to adjust in the form of high unemployment.

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NOTES

¹ Because this may seem surprising to many, it is probably worth specifying how the wealth-redistribution impact of debt can leave an economy better off, even when the debt is nonproductive. First, debt leaves an economy better off in cases in which productive investment is constrained by low savings if it takes purchasing power from sectors of the economy that save a very low share of their income, or from sectors that save in nonproductive ways (by hoarding gold, foreign currency, or other assets), and gives that purchasing power to sectors that save a high share of their income in productive ways. Second, debt leaves an economy better off in cases in which demand is low and savings excessive if it redistributes wealth from sectors of the economy that save a high share of their income to sectors that consume a high share of their income. Of course, in these cases, the debt itself matters only because of its role in income redistribution, which I address in the next paragraph, and which in principle can be managed more efficiently in other ways, even if these other ways are sometimes politically harder to implement.

² As I will explain more in a future book, a country has excessive debt when there is enough uncertainty about how future debt-servicing costs will be allocated to cause economic agents to change their behavior in ways that adversely affect the economy. In such a scenario, the rich would take money out of the country, for example, while business owners would disinvest and investors would speculate on short-term investments. Meanwhile, workers would organize and become more militant, the middle class would save by hoarding nonproductive assets (like gold, collectibles, or foreign currency), and policymakers would shorten their time horizons.

³ Some economists argue that government debt need not ever be repaid and that it can simply be monetized or inflated away. But, of course, that doesn’t mean that the debt isn’t repaid. It simply means that the repayment takes the form of a hidden tax on monetary savings rather than an explicit tax.

⁴ Throughout history, income inequality also has been reversed in ways that destroy wealth rather than redistribute it, such as war, revolution, or massive debt defaults (either at home or abroad). Historically, very high levels of income inequality in the United States and elsewhere in the world have always eventually been partly reversed, either in positive ways or negative ways. Rather than discuss whether or not reversing income inequality is desirable, perhaps it would be better to recognize that it will almost certainly happen eventually anyway. It is, therefore, more important to discuss how it should be done.