Should we be concerned that the deficit has passed $1 trillion? At what point does the deficit start to matter economically?

The specific deficit number is not really the thing we should be concerned about. We need a tax system that will raise the revenue over time that we need to pay for the government services we want. And it should do so in an efficient way—that is, without unduly discouraging working, saving, and investing. The non-partisan Congressional Budget Office (CBO) projects that federal spending will run about 21% of GDP over the next few years, while taxes will run under 17% of GDP. That leaves a deficit of nearly 5% of GDP each year—unprecedented for a period of such low unemployment.

While the deficit is very high, interest rates remain extraordinarily low for a range of reasons, including the aging of the American population and elevated foreign demand for U.S. assets. That’s good news because interest rates determine the cost of government borrowing. And there’s every reason to believe that interest rates will stay low for a long time to come. (Indeed, last week the CBO marked down its projection for the trajectory of interest rates, reflecting the persistent low level of rates that we have seen in recent years.) As a consequence, the United States can operate with substantial deficits for some time.

But ultimately very large deficits year after year are a problem—there are limits to how large the national debt can be, though exactly what those limits are is not clear. Currently the national debt is about 80% of GDP, its highest level since the period after the Second World War. But at that time, the government was running surpluses, and the national debt was on a firm downward trajectory relative to GDP. By contrast, the CBO projects that deficits will grow over coming years, reflecting in part interest payments on the outstanding debt, demographic changes, and higher healthcare costs. Even in the absence of a recession, the CBO projects that the national debt will be near 100% of GDP by the end of the decade.

Is it significant that the deficit is so high when the economy is strong? Does that tie our hands in the next recession?

Yes, it is significant. In good times, we should be aiming for relatively small deficits in order to reduce the level of the debt relative to GDP. That would provide us with the space that we will need to use fiscal policy to help fight the next recession. As we saw in the last recession, the zero bound on interest rates can prevent monetary policymakers from providing as much support to the economy as they would like. And while unconventional monetary policy can be used to provide additional support, those policies have their limits too. As a consequence, we will likely want to use countercyclical fiscal policy more forcefully in the next recession than we generally have in the past.

With large deficits in good times and the resulting high and rising level of federal debt, we may not have the flexibility to use fiscal policy aggressively in the next downturn, either because politicians may be uncomfortable with large deficits when the debt is already so high, or because financial markets become concerned about our ability to get deficits onto a sustainable path. If both fiscal and monetary policy are constrained, then recessions will be longer and deeper than would otherwise be the case, which is incredibly costly for our society.

Of course, if the current large deficits reflected heavy government investment in infrastructure and human capital—investments that would pay off in terms of higher growth and productivity in the future—then the deficits could well be appropriate. However, the problem we face is that we are running large deficits while underinvesting in infrastructure and human capital. We need to use our fiscal resources wisely to support a stronger, more stable economy over time.

How does the growing deficit affect the Fed’s thinking?

Government deficits are one of the many factors that the Federal Reserve takes into account in setting monetary policy. In doing so, the Federal Reserve takes the fiscal policy decisions of the Congress and the Administration as given and then decides on the monetary policy that will best foster its objectives of maximum employment and stable prices. Thus, larger deficits will, all else equal, lead the Fed to set a more restrictive path of monetary policy in order to hit its objectives.