“Historically, GDP growth has been the key ingredient for reducing the effective size of the U.S. debt.”

from David Ruccio

As the St. Louis Fed explains, 

Historically, GDP growth has been the key ingredient for reducing the effective size of the U.S. debt. Figure 3 shows that the U.S. gross debt-to-GDP ratio declined from a post-war high of over 120 percent in 1946 to just under 38 percent by 1970. Figure 3 also shows that this decline was not due to the government running surpluses, but almost entirely due to GDP growth: The average budget gap was a deficit equal to a half percent of GDP, as the government ran deficits in over two-thirds of the years covered. But because GDP grew on average 3 percent per year over this period, the ratio of gross debt to GDP fell precipitously.

One fair charge is that, in the current situation, we cannot rely on GDP growth to magically wipe away the debt. In particular, the assertion that a causal link exists between high debt and low growth is particularly worrisome, as it would imply a reinforcing cycle between low growth and rising debt. But this is where it is important to remember that the government differs critically from businesses and individuals.

As the sole manufacturer of dollars, whose debt is denominated in dollars, the U.S. government can never become insolvent, i.e., unable to pay its bills. In this sense, the government is not dependent on credit markets to remain operational. Moreover, there will always be a market for U.S. government debt at home because the U.S. government has the only means of creating risk-free dollar-denominated assets (by virtue of never facing insolvency and paying interest rates over the inflation rate, e.g., TIPS—Treasury Inflation-Protected Securities). Together with the unusually high, but manageable, level of the current debt, these facts imply that the current U.S. government can wait out any short-term economic developments until long-run growth is restored. Further, without an immediate need to drastically reduce the debt, the mechanism between high debt and slow growth loses most of its credibility.

Of course, as we have already seen with health care, the government does not have the ability to systematically increase spending without any regard for funding it. And government borrowing can be extremely costly. The cost of government borrowing is the “crowding out effect”: Investment funds mobilized by the government cannot be used in the private sector. It is in this framework, though, that classical economic theory argues the government should neither borrow nor lend, not because it has a moral obligation to run balanced budgets, but because it must consider the cost of diverting investment funds away from potentially more-productive uses.

In an economic environment like today’s, where real interest rates are practically zero, if not negative, and the unemployment rate remains high, the opportunity cost to society of the government’s mobilizing capital and labor is unprecedentedly low: The private sector is not fully utilizing these resources; so, no opportunities are lost if the government uses them. Assuming investment projects with a positive net expected return exist, as they surely do, there has hardly been a less costly time to start such projects. What no country can afford, however, are permanent increases in government spending without increasing tax revenue.