When Do Deficits Matter?

While Democrats and Republicans switch sides, economists try to pin down a tipping point.

On January 5, The New York Times reported that "the incoming Democratic chairmen of the House and Senate Budget Committees today called upon the President to work with them on a deficit-reducing package that would include tax increases and spending cuts." Concerned that deficit projections were unrealistic because they didn't include military costs, Democrats urged the administration to increase taxes on the wealthiest Americans.

That was January 5, 1987. Ronald Reagan was president, and the deficit had reached almost 5.4 percent of gross domestic product (GDP). Now, three decades later, Democrats have changed their minds about the dangers of deficit spending. In February 2009, the nonpartisan Congressional Budget Office estimated that the deficit will reach $1.2 trillion this year—roughly 8.3 percent of GDP. That giant increase is attributable mainly to Washington's September 2008 bank bailout and the federal takeover of mortgage lenders Fannie Mae and Freddie Mac.

And that figure assumes that the 2009 budget issued last year by the Bush administration will stay at its proposed level, which it surely won't. The calculation does not include the cost of the Iraq and Afghanistan wars, and it doesn't include the chunk of the new $787 billion stimulus bill that will be spent in 2009. Add all these numbers together, and the deficit swells to $2 trillion, or roughly 13.5 percent of GDP (see Figure 1).

This is by far the highest share of the economy that deficits have taken up since World War II. It is well over twice the record set by Ronald Reagan in the 1980s. Yet we don't see Democrats denouncing the deficit explosion on the network news, like they did two decades ago.

The Democrats aren't the only ones who have reversed their opinions about deficits. Republicans were relatively comfortable with Reagan's unbalanced budgets. And when President George W. Bush turned a massive surplus into a series of giant deficits, few in the GOP objected. During the administration's internal debates over proposed tax cuts in 2002, Vice President Dick Cheney reportedly told Treasury Secretary Paul O'Neill that "Reagan proved deficits don't matter."

In a 2007 interview with Fortune, Cheney refined his position, explaining that "you've got to evaluate them relative to other priorities. Another priority, for example, would be defending the nation in wartime."

In other words, if the spending that creates deficits supports your party's programs, fiscal irresponsibility doesn't matter. Republicans don't mind deficit spending if the trade-off is tax cuts and more money for the military. Democrats tolerate deficits when they buy goodies for union workers and allow other increases in domestic outlays.

But can you blame politicians for flipflopping on the issue? Economists—even free market ones—can't agree on whether deficits matter either.

The main academic debate over deficit spending is whether it raises long-term interest rates and therefore reduces economic growth. Some economists believe that deficits financed by borrowing increase the demand for capital. This in turn increases the price of capital—i.e., interest rates. Higher interest rates then increase the cost of doing business, which slows down the economy.

Others disagree. In 1987, for instance, the Harvard economist Robert Barro wrote in his textbook Macroeconomics that "this belief does not have evidence to support it." When deficits get bigger, he argued, individuals increase their savings to offset government spending.

Even without assuming Barro's private savings offset, scholars haven't been able to find a clear correlation between interest rates and deficit spending. In 1993, for instance, the North Carolina State University economist John Seater surveyed the academic studies on deficits and interest rates. After reviewing the literature, Seater concluded that the data "are inconsistent with the traditional view that government debt is positively related to interest rates."

Figure 2 shows 30-year mortgage rates, inflation rates, and deficits as a percentage of GDP during the last three decades. Although the federal budget deficit both rose and fell during this period, the 30-year mortgage rate has trended consistently downward.

Still, most free market economists are more cautious about denying a correlation exists. Arnold Kling, an adjunct scholar with the Cato Institute who blogs at EconLog, argues that the reason we haven't seen a correlation between budget deficits and interest rates so far is that foreign investment in American assets has increased over the years, dulling the impact of fiscal policy. The real question—and the real threat—is what will happen if that investment stops, or even if it merely slows down.

Moreover, deficits have reached a level that economists haven't really studied before. Current circumstances remind Kling of "a guy jumping out of a building from the 10th floor, passing the third floor, and saying, 'It's all fine so far.' " Deficits do not matter up to a certain point. But at which level do we hit the ground with a splat? Ten percent of GDP? Twenty percent?

Economic debates aside, deficits certainly do matter if you care about shrinking the size of the state. Budget gaps are a kind of Ponzi scheme. Any year the federal government spends more money than it collects in tax revenue, we have a budget deficit. That means the citizens through their taxes authorize politicians to spend a certain amount yet the government spends more.

The plan is to pay this additional spending back with future taxes, just as Bernard Madoff figured he'd pay off early investors with dollars from pigeons he conned down the road. As with any Ponzi scheme, there will inevitably come a time when the con is exposed, along with all the participants' losses.

John Maynard Keynes, the 20th century's preeminent defender of deficit spending, famously quipped, "In the long run, we are all dead." Keynes did not give much guidance, though, on how we would pay for the funeral.

Contributing Editor Veronique de Rugy is a senior research fellow at the Mercatus Center at George Mason University.