Economics

When Do Deficits Matter?

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

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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.

NEXT: What Part of "Congress Shall Pass No Law" Don't You Understand, Pt. 472

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  1. Reckless borrowing got us into this mess”

    “I’ll gladly pay you Tuesday, for a hamburger bailout, today.”

  2. When asked if Obama was bankrupting the US, Ron Paul said: (and I’m paraphasing…)

    “I don’t think so… We’re already bankrupt!”

    The thing that is shaking my confidence in my belief system is that I keep waiting for the bottom to fall out and it never seems to happen. It’s like the entire world thinks the United States is “too big to fail” so they’re burying their heads. What’s the big deal about debt when no one ever expects us to pay it.

    I guess it’ll keep happening this way until China decides to stop bailing us out. However, it is not in their interest to have us go bankrupt.

    …Yet

  3. I don’t understand why this issue is always discussed in terms of each individual year’s deficit. As large as the national debt is, the rate at which it grows in any particular year hardly seems relevant. It’s like bickering over whether an alcoholic drinks 12 beers or 13 beers.

  4. Great article. I’ve been thinking off and on about the debt problem for a while now. Put me in the “I have NO idea where the bottom could be” column. Theory and practice are two completely different things concerning people.

  5. A 3% of GDP deficit is tolerably bad.

    A 30% of GDP deficit is reckless insanity.

  6. I guess it’ll keep happening this way until China decides to stop bailing us out. However, it is not in their interest to have us go bankrupt.

    …Yet

    China is busy constructing an exit from the “dollar trap” as we blog. They are increasing their holdings of commodities and other foreign exchanges, doing bilateral forex facilities with their trading partners, etc. It will probably take them a few years, but they are definitely planning for the end of the dollar as the global currency, the end of US treasuries as safe havens, etc.

    Fun fact: there is no income or other direct taxation in China. They have become the world’s number 2 economy. Coincidence?

  7. RC,

    Still no substitute for American consumers, though. The rest of the world is too poor and too protectionist.

    I think people misunderstand China’s motives. They haven’t been financing our debt for any reason other than to make their own goods cheaper here.

  8. “Fun fact: there is no income or other direct taxation in China. They have become the world’s number 2 economy. Coincidence?”

    I call BS.

  9. Sorry, there is income tax in China. I expect much of the rural economy is barter so the rate would be pretty low on 80% of the population. And, they fact that many of the peasants are dirt poor makes it hard to collect from them.

    But, yes there is a progressive income tax and a capital gains tax.

  10. If we just repeal the 16th amendment we wouldn’t have direct taxation either.

  11. What percentage of the budget is dedicated to debt service, not including the temporary surpluses in the Social Security and Medicare accounts? How much will it increase in the future?

    THe U.S. seems to be following the Argentina path. How much debt service did they carry before their economy collapsed?

  12. I think we all need to read up a bit more on mercantilism. There used to be a time when you could price your goods low and suck a country’s gold reserves dry. Then when they were out of gold you invaded that country (defenseless, with no money for an army) and took its natural resources.

    There are definitely losses being accumulated domestically and one day we will have to pay back those losses in higher taxes and interest rates. Everything will be more expensive, and you will keep less of what you earn. That is not happening right now because of market manipulation, but that can’t go on forever.

  13. One party has always been the party of Big Government: The Incumbent Party.

  14. I call BS.

    You are correct. I am full of shit on that one. I think it must have been a misreading of the way China doesn’t require you to file a return if all of your income is subject to withholding.

    Google is my friend.

  15. I think we’re way TOO close to the critical point where the EU, Russia or some country other than the US will become the haven for foreign investment. The 1st major economy to adopt the FairTax plan will explode. It’ll be an order of magnitude greater than Ireland’s

  16. What percentage of the budget is dedicated to debt service, not including the temporary surpluses in the Social Security and Medicare accounts? How much will it increase in the future?

    According to the Wikipedia page on the budget, in the FY ’08 budget debt service was $249 billion, about 8% of the total official budget. I’m not sure what the numbers are for FY ’09.

  17. “Fun fact: there is no income or other direct taxation in China. They have become the world’s number 2 economy. Coincidence?”

    I call BS.

    Around the millionth time a stranger dialed my number, I started to put them all to my answering service.

  18. I’m not sure what the numbers are for FY ’09.

    They should be a hell of a lot higher, if debt service includes the $800BB bond buy-back (and I don’t know why it wouldn’t).

  19. It looks to me like the correlation in fig. 2 is that less deficit spending leads to stability in interest rates, where more deficit spending leads to instability. I wonder if you plotted deficit spending vs. volatility in interest rates how it would look; I bet they’d line up rather cleanly.

  20. What!? How dare you write such a nuanced article! An article that actually considers the possibility that there might not be a single, “cut and dry” answer to the problem! What are you, some kind of flip-flopper!?

  21. RC,

    China is busy constructing an exit from the “dollar trap” as we blog….

    The truth is more nearly that China is dreaming of finding an exit from the dollar trap. Because there isn’t anything in sight to replace it. Or is there some other economy on some other planet, that the Chinese have suddenly started trading with?

    Who else has an economy the size of ours? What several countries would we have to merge in order to equal the US? I mean, that idea is just working out so nicely in Europe.

    We owe China loads of cash. But ultimately, the only way they get paid back is if we produce and provide them with something they want in exchange. This can happen through indirect exchanges, but China has every reason to not want to see our economy fail.

    HerseyK,

    I think we’re way TOO close to the critical point where the EU, Russia or some country other than the US will become the haven for foreign investment.

    Nope. Nobody is even close to matching the size of the US economy. Why do you think we can spend roughly as much on our military, as half the rest of the planet combined?

    The Chinese have basically told us, “We hate you and what you’re doing to your economy scares the shit out of us, but there’s really nothing we can do about it.”

    True fact: if the US economy really does fail, it’s going to crash much of the rest of the planet with it.

    The 1st major economy to adopt the FairTax plan will explode. It’ll be an order of magnitude greater than Ireland’s

    Dream on.

  22. The element you are missing is debt monetarization.

    When the chips are really down, the government does not sell bonds to other people, they sell bonds to themselves with fresh banknotes.

    It is this crude buying-from-themselves that creates inflation, not bond sales to the public.

  23. When I see that the US national debt is now over:
    $11, 200, 000, 000, 000, not counting future obligations and entitlements. It makes me think that Bill Clinton was a very good fiscally responsible president. As far as I’m aware, he started paying back the debt in the late 90’s with a growing budget suplus.

    For all his mistakes, I give him full credit for that.

  24. By 2019, the yearly deficit will be $1.2 trillion!!!! According the CBO, the deficits shrink to “only” $650 billion dollars in 2012 and then skyrocket.

    We could argue all day about whether the stimulus package is sensible or not but no one really knows. However, deficits of $1.2 trillion (5.7% of GNP) during good times are despicable. My daughter will be $70,000 in debt before she gets to vote. At 5% interest, she will be paying $3500 a year for our irresponsibility.

    I hated Bush for his fiscal extravagance but he is piker compared to Obama. I was hoping for another Clinton. Boy, was I wrong.

    http://www.cbo.gov/ftpdocs/100xx/doc10014/03-20-PresidentBudget.pdf

  25. The plan is to pay this additional spending back with future taxes, …

    No, it isn’t. The plan is to recycle the debt perpetually by always borrowing further to repay it. Furthermore, Congress “borrows” the debt service from a central monetary authority that it created itself, by writ of its authority to create money. It simply authorizes itself to consume by creating more certificates of entitlement to consume.

    It’s been happening continuously since the day I was born, and everyone knows it. Why does anyone pretend that we’ll ever repay the debt?

    If we raise taxes in the future, we’ll do it to finance pensions, and that’s what the current bailout mania is really all about. It’s about rent seeking. We’re replacing failed “investments” with taxpayer obligations to create an illusion of “capitalism”.

    When the “crisis” is over, Bernanke will use his “tools” to control the inflation he’s now brewing with the cooperation of Congress, i.e. he’ll sell Treasury securities to the public, thus driving down their price and driving up their interest rate. The burgeoning class of “capitalists” (retired baby boomers) will be perfectly happy with this result as long as taxpayers keep producing goods for them to consume, even if the taxpayers must consume fewer goods themselves.

    These security sales by the Fed require the tax increases, not the current spending, because Congress doesn’t really pay either interest or principal on Treasury securities held by the Fed. It doesn’t pay interest, because the Fed’s “profit” returns to the Treasury, and it doesn’t pay principal, because it always borrows further to repay.

    Without the security sales by the Fed, we’ll have inflation rather than the tax increases, or equivalently, we’ll impose an inflation tax on the value of fixed incomes, even if tax rates don’t change. Frankly, I favor this outcome. I’ll be in the labor force for quite a while longer, and considering the looming labor shortage, labor might keep more of its yield this way. I certainly don’t want the general tax rate increases.

    The payroll tax surplus peaked last year, because this measure of the supply of rents relative to demand just peaked, and we have one hell down the other side of this roller coaster ride ahead of us.

    The more things change, the more they stay the same.

  26. … we have one hell of a ride down the other side of this roller coaster ahead of us.

    Someday, I’ll learn to proofread thoroughly … or not.

  27. According to the Wikipedia page on the budget, in the FY ’08 budget debt service was $249 billion, about 8% of the total official budget. I’m not sure what the numbers are for FY ’09.

    Here are stats on who (or what) holds the Federal debt.

    The Federal government itself (including the Federal Reserve) holds roughly half. State and local governments (including their pension funds) hold another 11%. Foreign interests (mostly foreign governments) hold 28%.

    Nearly 90% is held by governments. The public hardly matters.

  28. We owe China loads of cash. But ultimately, the only way they get paid back is if we produce and provide them with something they want in exchange.

    Right. That’s food. China’s feeds a population over four times greater than the U.S. population on roughly the same area, but Chinese agriculture is much less productive.

    Twenty percent of the Chinese labor force still works in agriculture, compared with two percent of the U.S. labor force, Because of the one child policy, the Chinese population also ages more rapidly, and the farming population probably ages faster than the general population.

    So Chinese demand for U.S. agricultural exports grows in coming decades, and the Chinese have very good reason to stockpile entitlement to this output. Thus the “let them eat rice” debacle is particularly embarrassing.

    The good news is that U.S. agricultural output can easily double or triple in a decade if market forces are allowed to operate. The bad news is that market forces are not being allowed to operate, and we’re instead charging down the “let them eat rice” path with guns a blazin’.

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