Deficits: I cried wolf . . .

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I had planned to do a post on Robert Hall and Michael Woodford, as I am a big fan of both of their work. But I’ve been pretty sick the past few weeks—beginning with a flu that gave me a 104 (40C) temperature, and then pneumonia. So I haven’t felt like blogging. Below is a post I wrote a month ago but hadn’t gotten around to posting. I may be slow in responding to comments, but I’ll try. I hope to do a Hall/Woodford post later.

Back in 2018, I warned that the budget situation was becoming unsustainable:

Pundits have been complaining about deficits for decades, so why haven’t we already paid the price in one form or another?It turns out that the U.S. government has been a bit less irresponsible in the past than advertised. While we run deficits during most fiscal years, they have not been large enough to push the national debt to the sorts of levels seen in Greece, Italy and Japan, which have even larger public debts as a share of national income.As with the boy who cried wolf, the public is becoming numb to the constant warnings about a debt crisis.Today, however, there really is reason to be concerned about the budget deficit.For the first time in history, America is seeing its budget deficit rise dramatically higher during a period of peace and prosperity. While there have been even bigger deficits on occasion — measured as a share of GDP — they were always associated with a temporary situation such as war or high unemployment.The deficit would then shrink sharply when the economy returned to normal. The current situation is unusual because the deficit has been soaring dramatically higher even as unemployment has fallen to the lowest level since the 1960s (3.7 percent).Unsustainable budget deficits can be seen as a sign of political dysfunction. The United States last ran budget surpluses during 1998-2001. These surpluses created fiscal space for the politically popular tax cuts and spending increases of the George W. Bush administration.

My complaints about deficits put me far outside the mainstream. In the late 2010s, most pundits suggested that we didn’t need to worry about deficits because interest rates were low. That attitude continued into the Biden administration, which rejected the warnings of economists like Larry Summers. Under the past two administrations, economists have been excluded from the halls of power and policymaking has been turned over to populists.

Last year, a few of my commenters suggested that the fiscal situation would improve due to tariff revenue. I was highly skeptical. According to the Committee for a Responsible Federal Budget (CRFB), the deficit is worsening despite a booming economy:

When looking at the budget deficit, it is essential to put the figures into context. The government should run deficits during recessions and wartime, offset by surpluses (or at least much smaller deficits) during booms. In the late 2010s, the US abandoned that longstanding practice, which is why I raised the alarm in 2018. The deficit of 2019 might look small, but the trend was extremely worrisome given the booming economy.

Today, things are far worse. We ran budget surpluses during the internet boom of 1999, 2000 and 2001, but we are running enormous deficits during the AI boom.

And it could easily get even worse. As longer-term Treasury bonds with low yields mature and need to be rolled over with new debt, the interest cost of our national debt will continue to rise. Here’s the CRFB:

For FY 2026, we estimate:

• A budget deficit of $2.0 trillion, or 6.2% of Gross Domestic Product (GDP).
• Debt held by the public of $32.3 trillion, or 100% of GDP.
• Spending of $7.4 trillion, or 22.9% of GDP.
• Revenue of $5.4 trillion, or 16.7% of GDP.
• Interest costs of $1.1 trillion, a record 3.4% of GDP.
• Interest was the second largest line item in the budget, costing more than defense or Medicare.

And they include this graph:

And of course there’s also the aging population.

Some people suggest that AI will somehow save us. But how? It’s not clear that an AI boom would reduce government spending as a share of GDP. After all, spending on health care tends to rise rapidly as countries get richer, and Social Security benefits for new recipients automatically rise with the level of nominal wages.

It is possible that AI has actually made the deficit worse, by shifting income from workers to less heavily taxed corporate income. Here’s Bloomberg:

Instead, the end of civilization as we know it will likely be caused by income tax erosion.The logic is straightforward. Ever since the First Industrial Revolution saw peasants pushed off the land, governments have relied on taxing people and their paychecks. Rand estimates that 66% of US federal revenue in 2024 came from either individual taxes or payroll taxes due directly to labor. Even in Australia, where resource exports generate vast wealth, individual income tax accounts for almost half of federal government revenue.Despite barely scratching the surface of usefulness, AI is already threatening to erase entire categories of white-collar work around the world.

And here’s The Economist:

You might think of AI as a godsend for governments, many of which are accumulating vast debts (see chart 2). Economists expect AI to lift productivity growth, which should create a bigger economy. . . .One problem is that AI may create value in areas which governments tax lightly while destroying value in the more heavily taxed bits. The economy could expand rapidly while leaving the government increasingly starved of funds. At present governments get most of their revenues from workers. Across the OECD club of mostly rich countries, personal-income taxes and social-security contributions account for a high and rising share of overall tax revenues (see chart 3). In America about three-quarters of all federal tax revenues come from labour. Taxes on consumption and capital (including corporate profits and capital gains) are smaller.

On the other hand, some people are too fatalistic about the situation, assuming nothing can be done. Don’t all countries face similar problems? Not at all. AI Overview suggests that many developed countries have net public debts below 50% of GDP:

Negative Net Debt (Net Creditor Governments)These unique advanced economies possess sovereign liquid assets that completely exceed their total liabilities. Norway (Maintains a massive sovereign wealth fund, pushing its net position heavily positive)Singapore (Gross debt is high due to bond issuances for domestic investment, but it holds zero net debt)Denmark (~ -6.0% of GDP)Luxembourg (~ -4.0% of GDP) [1, 2]Ultra-Low Net Debt (0% to 25% of GDP)These nations exercise high fiscal restraint or possess exceptional asset backings. [1]South Korea (~ 9.3% of GDP)Estonia (~ 10.1% of GDP)Sweden (~ 12.2% of GDP)Switzerland (~ 19.2% of GDP)Taiwan (~ 20.5% of GDP) [1]Moderate Low Net Debt (25% to 50% of GDP)While their gross public debt might sit higher, their net debt burden remains comfortably below the 50% threshold. [1]Ireland (~ 26.3% of GDP)Lithuania (~ 37.1% of GDP)Latvia (~ 37.7% of GDP)Finland (~ 41.8% of GDP)New Zealand (~ 42% to 45% of GDP)Iceland (~ 45.8% of GDP)Germany (~ 47.2% of GDP)

Conservatives like to say the problem is simply too much spending. OK, explain Denmark and Sweden, which have very high spending levels and low debt burdens. Here are some of the worst offenders, again from AI Overview:

Extreme Net Debt (Over 100% of GDP)These nations possess heavy sovereign debt loads where liabilities greatly outpace their current asset reserves. Japan: ~136.5% net debt (While its gross debt is the highest in the world at over 204%, its massive domestic asset holdings bring the net figure lower—though it remains the highest among developed economies).Italy: ~127.7% net debt (Driven by long-term structural deficits and low growth).United States: ~100%+ net debt (The U.S. gross debt sits at roughly 125.8% of GDP; adjusting for government financial assets leaves the net burden sitting right around the 100% threshold). Elevated Net Debt (75% to 100% of GDP)These advanced economies maintain sizable fiscal burdens, heavily exposed to shifts in global interest rates. [1]France: ~108.8% net debtSpain: ~92% to 94% net debt (Gross debt remains close to 98.2%)Belgium: ~93.3% net debtUnited Kingdom: ~88% to 92% net debt (Gross debt hovers around 103.6%)

The problem is easily solvable in a technical sense. Although I’d personally favor some spending cuts, federal spending is still only 23% of GDP. Lots of developed countries raise far more than that amount of revenue. It’s a political problem. All you need is good governance. At one time, the US had relatively good governance. And then we threw it all away.

PS. Long time readers know that I’m obsessed with three models: Denmark, Switzerland and Singapore. Not surprisingly, these three countries all show up in the top ten for low levels of public debt. Note that all three are also in the top 7 for economic freedom, according to both the Fraser ranking and the Heritage ranking.

I like these three countries, as they each excel at one of the three most essential aspects of governance:

Singapore: The economic (neoliberal) superpower

Switzerland: The political (decentralized democracy) superpower

Denmark: The ethical (utilitarian) superpower

They answer the three key questions: What should be the goal? (Denmark-utilitarianism.) How best to achieve the goal (Singapore-neoliberalism). How best to decide how to achieve the goal in a world of uncertainty (Switzerland-decentralized democracy.)

Three paths to the same destination—good governance.

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