Do Deficits Matter?

Posner
September 15, 2009

Vice President Cheney is reported (I don't know whether accurately or not) to have said that "deficits don't matter." Certainly the Bush Administration ran big ones, as a result of which the public debt (which is the national debt less federal liabilities to Americans created by the social security and other entitlement programs) doubled. It has continued mounting as the deficit continues growing, and has now reached $7.5 trillion, which is more than half the (annual) Gross Domestic Product. It will continue to grow rapidly, because of the fall in federal tax revenues as a result of the economic downturn, because of the aging of the population which along with the continued acquisition of advanced medical technology is causing a continuing rapid increase in Medicare costs, because of the reluctance of Congress to raise taxes or cut any spending programs, and because of the likely cost of the ambitious new programs of the Obama Administration. How much money will actually be appropriated for the programs, such as health-care reform and climate control, is, at this writing, unclear. The public debt is funded by Treasury borrowing (actually a bit of it is being funded as an emergency measure by the Federal Reserve, but I will ignore that), of which more than 40 percent comes from foreign governments and other foreign entities and the rest from Americans, including banks and other financial institutions. Much of this borrowing is in the form of 10-year Treasury bonds, which are now commanding an interest rate of about three and a third percent. The government is having no difficulty at present in borrowing at moderate interest rates to fund the public debt, large as it is. The reason is partly that Treasury securities are safe in the sense that there is no risk of default and the current global economic downturn has increased the demand for safe investments, and partly that the world is awash in dollars because of the policy of a number of major nations, such as China (but not only China--others include Germany, Japan, and the oil-exporting small nations of the Middle East), of running very large current-account surpluses (i.e., trade surpluses). These surpluses are largely in dollars because the dollar is the principal international reserve currency, which is to say a currency used in international transactions in preference to using local currencies that fluctuate more than the dollar does. As the world's principal sourcce of international reserve currency, the United States

in effect sells dollars to the rest of the world to provide liquidity in international trade, and many of the dollars come back to the United States in the form of investments in Treasury securities, especially from countries that have large dollar reserves because they export much more than they import. A country that supplies a major international reserve currency must run a current-account deficit because otherwise the rest of the world wouldn't have enough of the currency for their transactions. The fact that foreign countries need large dollar reserves for this purpose means that there are a lot of foreign dollars available for the purchase of U.S. securities, quite apart from current-account surpluses. This makes it easy for the United States to borrow at reasonable interest rates to fund its public debt, even if Americans, unlike Japanese, are not big savers. (The fact that Japanese are big savers enables Japan to fund a public debt that is proportionately much greater than ours, without much difficulty.) Americans are saving much more nowadays than they were a year ago, but this may change as the economy recovers. As long as Americans are saving a lot, and wanting their savings to be safe, and foreigners as well, and as long as nations like China are running huge current-account surpluses, we can fund our public debt at reasonable interest rates. But that is provided it doesn't grow too fast, and it is growing very fast and there are no signs of its slowing. As the economy recovers, federal tax revenues will rise, but federal expenditures will be rising too, and rising all the faster if a significant part of the Administration's ambitious program is authorized by Congress, because there don't seem to be any serious efforts at either increasing any taxes (even by reducing deductions) or cutting any spending programs. The perfection of interest-group politics seems to have created a situation in which taxes can't be increased, spending programs can't be cut, and new spending is irresistible. Judging by the Bush Administration's profligacy and its impact on the public debt, the situation is bipartisan. At some point the wheels may start coming off the chassis. Assume that the public debt continues its rapid growth because government spending increases rapidly but Congress refuses to authorize significant increases in taxation. The Treasury will have to borrow more and more, yet at a time when recovering economies need investment capital, forcing interest rates up and hence deepening our deficits. We already pay more than $400 billion a year in interest on the public debt, and that amount will rise rapidly as both the size of the public debt and interest rates rise. Assume further that political pressures prevent the Federal Reserve from raising interest rates in order to head off inflation caused by the banks' finally deciding to lend (as the economy recovers) the huge excess reserves that they have accumulated as a result of the Fed's openmarket operations during the current economic crisis. Fear of inflation will push up long-term

interest rates, including rates paid by the Treasury to fund the growing public debt. Fear of inflation will also make foreign countries worry about the value of their dollar reserves, and wonder whether the dollar should continue to be the predominant international reserve currency. As the dollar falls in value, however, the public debt will become cheaper to repay, the demand for U.S. exports will grow, and our demand for imports will fall. The increase in the ratio of exports to imports will reduce the current-account deficit and thus reduce the rate of increase of the public debt. But increasing exports relative to imports, by tending to reverse the long-term decline in U.S. manufacturing relative to services, may be a painful and protracted one. We have grown accustomed to financing our consumption by borrowing heavily abroad to pay for manufactured imports and for our elaborate systems for distributing goods and providing other services. Our economic productivity has become heavily dependent on the immigration of highIQ professionals, but one casualty of the current economic crisis has been restrictions on immigration that are designed to protect Americans' jobs. Moreover, even with a reduced current-account deficit, U.S. public debt will be rising because of increasing unfunded expenditures on medical care and other social programs, and for all one knows on military activity as well since the United States remains the world's policeman. And lenders will charge higher interest rates to continue to fund our public debt if they think the dollar is losing value because of inflation. If inflation persists, then given that there are other international reserve currencies, namely the euro and the yen, and in time the renminbi (the Chinese currency), the dollar will decline as an international reserve currency, and, with the demand for dollars thus reduced, its value will fall further. As real interest rates rise as a consequence of the growing public debt and decline in demand for the U.S. dollar as an international reserve currency, U.S. savings rates will rise, and by reducing consumption expenditures this will slow economic activity. Economic growth may also fall as more and more resources are poured into keeping elderly people, most of whom are not highly productive members of society from an economic standpoint, alive. The United States may find itself in the kind of downward economic spiral in which "developing" countries often find themselves. As an economic power we may go the way of the British Empire, which occupied approximately the same position in the world economy in the early twentieth century as the United States does today.

Posted by Richard Posner at 7:10 PM | Comments (1) | TrackBack (0)

How Much Should We Care About Government Deficits? Becker

Deficits arise when government spending exceeds the revenues raised from various taxes. Deficits add to the stock of government debt. In evaluating the consequences of deficits for an economy, it is first of all crucial to know whether the source of a larger deficit is greater government spending or reduced tax collections, possibly due to reductions in tax rates. The second issue is the burden to the economy of financing the interest payments due on the government debt. I take these issues up in turn. To the extent that the source of the rise in a deficit is increased government spending, then whether that rise is justified depends on how socially valuable are these government expenditures. By that I mean the social rates of return on these expenditures, such as longer lives for the elderly, relative to the interest cost of raising the required funds, and relative to the returns on other investments in the economy. Much of the increased government spending in different countries during this recession went to help out banks that were in danger of going under. While numerous mistakes were made that will be argued about for a long time, such spending on the whole was necessary in order to limit the financial crisis that had developed. Other parts of the increase in spending in most countries are far more dubious and may even have harmed their economies. I include in that most of the $800 billion Obama stimulus package, much of which is still not spent even though the brunt of the recession is over This package was promoted as a way to fight the recession, but mainly it is an attempt to reengineer the economy in the directions of larger government favored by many liberal Democrats. I believe much of this reengineering will hurt the functioning of the economy, and of course at the same time will add to the debt burden. A very small example was the cash for clunkers program in the US that ended a short time ago. The 19th century French essayist Frederic Bastiat discussed facetiously the gain to an economy when a boy breaks the windows of a shopkeeper since that creates work for the glazier to repair them, and the glazier then spends his additional income on food and other consumer goods. The moral of that story is to hire boys to go around breaking windows! The clunkers program was hardly any better than that (see our discussion of the clunkers program on August 24th). Deficits also arise automatically during recessions because tax revenues fall as the growth in aggregate incomes slows down, and even becomes negative, as it did during this recession. This automatic effect on deficits during recessions from falling tax revenues is supposed to be

balanced by automatic surpluses during prosperity times as tax revenues grow because income are expanding faster. Unfortunately, the period prior to the recession also had budget deficits, even though incomes grew quite fast, because Congress and President Bush pushed for greatly expanded spending. To turn to the second question, will financing the debt become a serious obstacle to rapid US growth as the current and projected sizable US deficits increase the ratio of government debt to American GDP? That depends on four critical variables: the size of the debt/GDP ratio, the level of interest rates, taxz rates, and the rate of productivity growth in the American economy. Suppose the debt held by the public-which excludes government debt held by other government agencies- reaches 100% of present or near term GDP, which is not unlikely. The burden on the government budget that this imposes depends on the interest rates on the debt. At an average interest rate of 5%, that means 5% of GDP would go to servicing the debt, which is a little less than 20% of total federal government spending. This might be manageable but it is not trivial. On the other hand, if average interest rates were only 3%, servicing costs would be far more tolerable. In fact, the US has been paying about 3% on its debt, so even a considerable increase of the debt to 100% of GDP would still be manageable. But if the Fed starts raising real interest rates to head off the inflation potential in the $800 billion of excess reserves, the debt burden could become a major problem. Another factor is the savings rates coming from the Asian countries, like China. If their savings decline sharply, that too would raise world interest rates and increase the debt burden for all countries. Rapid productivity growth and an improved tax structure could save the situation because the expansion of GDP caused by such growth and better taxes lower the ratio of the debt to GDP, and makes financing the debt easier. To maintain rapid productivity growth requires that an economy provide powerful incentives to invest in physical and human capital and R&D. It also requires that Congress and other legislatures do not start growing government spending as GDP grows rapidly. But members of Congress and other legislatures are tempted to use much of the growing tax revenue on their pet projects. One important determinant of the incentives to invest is the tax rates on the rewards of investments in new knowledge and capital. Rich people should pay a larger share of the tax burden, and they do. However, if the emphasis changes from encouraging investments to redistribution, the poor as well as the rich will suffer. Probably the poor will suffer more since the rich can more their capital and themselves to the many low tax jurisdictions in the world.