Thomas Palley
Bernard L. Schwartz Fellow, 2011
Fiscal
conservatives are opportunistically looking to use the recession induced spike
in the budget deficit to revive their crusade for fiscal austerity. The case
for fiscal austerity is based on flawed economic analysis and it is not
supported by thoughtful budget analysis. It was the wrong agenda before the
crisis and it is even more wrong now.
Though there is understanding of the
need for budget deficits to provide short-term Keynesian fiscal stimulus, there
is little understanding of the medium-term need for budget deficits to
facilitate the process of private sector deleveraging and to restore growth.
The U.S. economy needs a new engine of
growth and deficit-financed public investment has an important role to play.
Deficit financed investment can create a “virtuous” circle whereby public
investment spurs growth, in turn improving the budget outlook. The fiscal austerity
agenda risks creating a “vicious” circle in which austerity slows growth,
necessitating further austerity.
The budget numbers show the U.S. has
a health care cost problem rather than a budget deficit problem. Fiscal
austerity does not solve the health care cost problem and it also risks
undermining growth. That makes fiscal austerity economic malpractice.
Finally, the politics of fiscal
austerity does a double disservice. First, it pushes public understanding in
the wrong direction by presenting government as the problem when the crisis has
shown it is the private sector that has failed and needs reform. Second, by
misleading the public it opens the door for all sorts of policy mischief – most
notably cutting Social Security.
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Table of Contents
II The role of budget deficits in combating
recessions
III The role of budget deficits in helping
deleveraging
IV The need for a growth strategy with public
investment
V Other arguments for budget deficits
VI Deficits, inflation, and interest
rates
VII Budget deficits, fiscal policy and the
crowding-out fallacy
VIII Other incorrect arguments of fiscal
conservatives
IX What is a sustainable budget
deficit?
X Is the current budget outlook sustainable?
Tables & Illustrations
Table 1 The determinants of sustainable deficits
Table 3 Projected annual average budget deficit as a percent of GDP, 2009 –2050
Figure 1 The “virtuous” circle linking growth and deficit financed public investment
I Déjà vu all over again
The U.S. economy is still struggling to
find a bottom in face of the deepest recession since the Great Depression of
the 1930s. The recession is due to massive financial excess within the private
sector. Yet, even as the recession rages, much of the economic policymaking
community is already back to arguing government is the problem in the form of
massive budget deficits that threaten future financial stability.
Budget deficit alarmism has been a
perennial feature of the Washington policy landscape for the past thirty years,
and the return of budget deficit alarmism represents a case of “déjà vu all
over again.” The push for fiscal austerity was the agenda of Concord Coalition
Republicans and Hamilton Project New Democrats long before the crisis, and
these groups have now opportunistically seized on the crisis-induced spike in
the budget deficit to revive that agenda. With economic policy largely controlled
by former Hamilton Project personnel, there is a grave risk the Obama
Administration could go along with this renewed alarmism.
The fiscal austerity program is
rooted in wrong-headed economic analysis. It was the wrong economic agenda
before the economic crisis, and it is even more wrong in light of the deep
economic weaknesses the crisis has revealed.
Not only is fiscal austerity the
wrong economic agenda, it is also the wrong political agenda. At a time when
the nation is trying to recover from three decades of laissez-faire excess, the fiscal austerity agenda revives
neo-liberal anti-government sentiment by presenting profligate government as
the problem. The real problem is flawed market arrangements that have promoted
income inequality and financial excess that has undermined shared prosperity
and can no longer deliver growth.
The fiscal austerity message does
triple damage. First, it makes reform of existing flawed market arrangements
more difficult by misdirecting public understanding and saying government is
the source of problem. Second, it uses budget deficits as a “Trojan Horse” for
launching an assault on vital public programs – including Social Security,
Medicare, and spending on education and public infrastructure. Third, it threatens
to create a fiscal austerity trap in which fiscal austerity lowers growth,
thereby lowering tax revenues and necessitating more austerity.
Fiscal conservatives claim that
closing the budget deficit represents “fiscal responsibility.” That claim is
absolutely wrong. The reality is fiscal austerity under current circumstances
would constitute “fiscal irresponsibility.” The U.S. likely confronts an extended
period of economic weakness in which budget deficits will be needed to ensure
adequate aggregate demand (AD).
Budget deficits also have an
important role to play in spurring growth. The old growth model, based on debt
and asset price inflation, is broken. That calls for a new growth model in
which deficit-financed public investment should be a central part.
The economic crisis has discredited
neo-liberal economics. It should also have discredited the neo-liberal
obsession with fiscal austerity. The fact that the fiscal austerity agenda has
managed to regain traction so easily shows how deeply ingrained are the
misunderstandings of neo-liberal economics, and how far there is to go to
establish a new healthier economic conversation.
II The role of budget deficits in combating
recessions
One reason for the revival of the
fiscal austerity agenda is the spike in the budget deficit due to the recession
and financial crisis. Fiscal conservatives have opportunistically seized upon
this as further proof of government profligacy, yet the reality is the
recession would have been far worse if policy had not allowed the deficit
spike.
The recession is due to a fall in AD
caused by a sharp decline in private sector spending. That decline was itself due
to a collapse of consumer and business confidence, destruction of household
wealth due to the implosion of the house-price bubble, and contraction in the
supply of credit caused by the banking crisis.
The budget deficit increased in
response to these developments through a combination of reduced tax revenues,
increased government spending including the financial sector bailout, and
increased transfers (such as unemployment insurance) from government to
households. This increase in the deficit prevented a financial sector collapse
and offset the fall in AD, thereby helping maintain employment and income.
These developments represent a
validation of Keynesian economics. In a slump, the private sector is either
unwilling or unable to spend, resulting in a demand shortfall. If that
shortfall is not plugged, employment and output fall. The way to plug the
shortfall is for the public sector to step in with policies that increase
demand such as increased spending, tax cuts, and transfers. As shown in Technical Box 1, such policies
serve to sustain aggregate spending and economic activity, thereby helping a recovery
of confidence and lending that can restore private sector demand.
In response to recessions,
responsible fiscal policy calls for increasing the budget deficit at a time
when the deficit is already automatically increasing because of reduced tax
revenues. Yet, many fiscal conservatives are using public misunderstanding of
deficits, built up over the last three decades, to argue for immediate fiscal
austerity. That call poses a danger that premature reversal of fiscal stimulus and
a shift to fiscal austerity could trigger a second leg to the recession. In
this regard, history holds lessons. In 1937, in the midst of the Great
Depression, the Roosevelt administration
succumbed to political pressure to reduce the government deficit, causing a
second recession.
III The role of budget deficits in helping
deleveraging
The short-run role of deficits in
combating recession is reasonably well-understood by many policymakers and
journalists. However, less well understood is the medium-term role of deficits
in combating debt over-hangs and re-building private sector balance-sheets.
The current recession is not a
normal recession. Instead, it is a balance-sheet recession brought about by two
decades of financial excess. The private sector is over-borrowed and must now
deleverage, which has amplified the fall in demand by causing additional saving
to repay debt.
Budget deficits have an important
role to play in facilitating the deleveraging process so that it does not
produce massive economic contraction. A feature of monetary economies is that
for every seller there must be a buyer and for every saver there must be a
taker. This argument was recognized long ago by James Tobin (1963) in his
discussion of budget deficits. Private sector deleveraging represents an
attempt to rebuild financial net worth and it involves increased saving to pay
down debt. The important implication is that the private sector as a whole is
trying to save more out of income than it is willing to invest.
In this event, the private sector
must find a taker for that extra saving. One possibility is that the private
sector sells to foreigners (i.e. increases exports) and saves by accumulating
foreign assets. However, that requires increased exports, which is difficult in
the current environment of globally weak demand and “export-led growth”
policies that many foreign countries have adopted.
A second possibility is for
government to run budget deficits so that private sector saving is directed
into government bonds. This enables the private sector to build up its
financial wealth, but there is no adverse impact on aggregate demand because
deficit spending offsets private sector saving.
This logic is illustrated in Technical Box 2. The critical
Keynesian insight is that if the private sector wants to save more than it
wants to invest and no party is willing to take that savings and spend it,
national income will contract and force private sector net saving into
alignment with deficit spending plus net exports. That will worsen the effect
of the debt over-hang by deepening the economic contraction and slowing the
de-leveraging process of restoring balance-sheet health.
This logic means that at a time of
sharply increased private sector desire to save, weak domestic investment
demand, and weak global demand for exports, the public sector has a vital role
in helping the private sector deleverage so as to avoid a huge contraction in
income. Having the public sector step-in and run deficits that absorb excess
private sector net saving can accelerate the process of restoring private
balance sheets, thereby accelerating the return to more normal growth.
IV Economic growth and deficit-financed
public investment
Another area in which the affirmative
role of budget deficits is not adequately appreciated concerns economic growth.
In this regard, there is an extensive economic literature that documents how
public capital formation can make a large positive contribution to growth
(Aschauer, 1989; Munnell, 1990). The economic logic is that public capital –
such highways, airports, and other infrastructure – has a multiplier effect
that raises the productivity of private capital. Additionally, public capital
can contribute to a higher standard of living and improved quality of life by
saving individuals’ time.
This positive growth effect means deficit-financed
public investment can create a “virtuous circle” as is illustrated in Figure 1.
The logic of the circle is as follows. Deficit financed public investment
raises demand and private sector productivity. That raises growth which
generates higher income and tax revenue. That in turn creates fiscal space,
helping resolve the long-term budget concerns that fiscal conservatives are
worried about. In contrast, a fiscal austerity agenda could transform that
pattern into a vicious circle. Thus, fiscal austerity would lower public
investment, thereby lowering growth, reducing fiscal space and compelling more
fiscal austerity.
This vital contribution of deficit-financed
public investment to growth is missing in the budget policy debate, and it is
doubly troubling given the widely acknowledged weak extended economic outlook.
The Obama administration has rightly argued for classic Keynesian policy
whereby fiscal stimulus temporarily fills in for a shortfall of private sector
AD. The goal is to support demand and “pump prime” the private sector, setting
the stage for a revival of growth. However, the current recession is different
from past recessions in that it marks the end of an era of growth based on debt
and asset price inflation (Palley, 2009). The old growth model is broken, which
means pump priming will not be enough because the well is dry.
That means there is need for a new
growth strategy to which deficit-financed public investment can make a
significant contribution. Consequently, not only are deficits justified in the
shorter term to provide fiscal stimulus and help with the deleveraging process,
they are also needed in the longer term to finance public investment that contributes
to reviving growth.
The combination of thirty years of
neglect of the public capital stock and collapse of the neo-liberal growth
model make the current moment the right time to increase public investment. This
will create jobs in a time of recession and install public capital that will
increase income in future when the nation will face the increased obligations
that go with an older population.
V Other economic arguments for budget
deficits
In addition to the above arguments
there are several financial and inter-generational equity arguments for long
term budget deficits. First, government bonds perform an important financial
function, providing a safe, liquid store of value that acts as collateral and
helps determine the pure risk-free interest rate. Ensuring a supply of bonds
that grows with the economy needs a non-zero deficit. A budget surplus would
mean declining debt, while a balanced budget implies no deficit and constant
debt which means the debt-to-GDP ratio must fall to zero over time as GDP
grows.
Second, balanced budgets and
surpluses would create significant problems for our current monetary system. A
growing economy requires a growing money supply in order to avoid the adverse
effects of deflation. Under current arrangements, the Federal Reserve validates
the creation of money by purchasing government bonds. However, if the bond
supply was contracting this would become increasingly difficult to do.
Third, as noted earlier in the section III, budget
deficits facilitate private sector financial wealth accumulation. Budget
surpluses are a permanent tax on the private sector that drains it of financial
wealth. Rather than increasing private investment, sustained planned budget
surpluses will decrease investment. This is a critical point that casts in
doubt the entire economic logic of the fiscal austerity argument.
Fourth, much government spending is
on long-lived human and physical capital that provides benefits long into the
future. This capital includes education, infrastructure, public buildings,
defense equipment, and publicly financed R&D that adds to the stock of
knowledge. Just as households and businesses borrow to finance long-lived
capital investments, so too there is reason for government to borrow to finance
such investments so that payment is matched against future use.
Fifth, much of the benefit from
long-lived public capital expenditures will accrue to future generations who
will also have higher incomes due to increased productivity. That suggests it
is appropriate for future generations to contribute to their cost. This can be
done by financing public capital expenditures with debt that future generations
pay back, thereby contributing their share.
VI Do deficits pose an immediate inflation
and interest rate threat?
A major claim of fiscal
conservatives is that budget deficits increase inflation and interest rates.
Though there are circumstances in which that can be true, in the current
economic environment budget deficits pose neither an inflation nor interest
rate threat.
Currently, the U.S. economy is
characterized by significant demand shortage and massive excess capacity, as
reflected in low rates of capacity utilization and high rates of unemployment.
In this environment, where unused productive resources are plentiful, increased
deficit-financed government spending will not cause inflation.
With regard to interest rates there
is also little danger. Interest rates are determined by demand and supply in
the bond market. The conservative argument is budget deficits add to the supply
of bonds, which drives interest rates up in order to entice buyers for the
increased supply.
However, on the demand side there
are now several favorable factors:
a)
First, there has been a big increase in household saving reflecting a
combination of precautionary saving, wealth re-building, and a return to
long-run patterns of saving from saving rates that were abnormally low. This
increased saving has increased demand for bonds, which will keep interest rates
down.
b)
Second, the Federal Reserve has lowered the short-term interest rate that it
controls, which has lowered yields on financial investments such as money
market funds. That has caused wealth-holders to shift their portfolio demands
toward bonds, which now have a relatively attractive yield compared to money
market funds and bank deposits. This too will keep rates down.
c)
Third, the Federal Reserve has signaled that it expects short-term interest
rates to remain low for an extended period because it anticipates a weak and
anemic recovery. That too will increase demand for bonds. Indeed, both the U.S.
and global economy may have entered a new secular period in which interest
rates are permanently lower because structural weakness in global demand.
d)
Fourth, the Federal Reserve has been a large buyer of bonds as part of its
“quantitative easing” monetary policy. Given the absence of an inflation threat
owing to the existence of extensive excess capacity, the Federal Reserve has
room to continue this policy. That again will keep bond rates down by providing
additional demand for bonds.
On the supply side, there are also
favorable factors. Though government issuance of bonds is up, consumer
borrowing is down and consumers are actually repaying debt. Moreover, given the
experience with excess leverage, consumer borrowing looks like it will be
subdued for an extended period. This will dampen bond supplies, creating room
for government to issue bonds without increasing interest rates.
For twenty-five years fiscal
conservatives have argued budget deficits cause higher interest rates. Yet,
empirically, it is nearly impossible to find an effect of budget deficits on
interest rates after controlling for Federal Reserve monetary policy and
economic conditions. The implication is current conditions provide room for
large deficits without any adverse effect on interest rates.
If there is a long-run threat to
interest rates, it will only emerge after the economy has returned to full
employment and households have restored their balance-sheets. That is a future
problem that is not helped by fiscal austerity now. Indeed, fiscal austerity now could prevent a
return of full employment by undermining demand and impeding the deleveraging
process, and that could worsen the long-run fiscal outlook by lowering growth,
reducing tax revenues, and raising budget deficits.
That said, there is one current
danger to interest rates. This danger is bond market vigilantism whereby bond
holders sell bonds owing to mistaken understanding of the true economic
situation. Thus, if bond holders believe current budget deficits inevitably
entail higher inflation and higher interest rates, they may sell now to avoid
future losses. This is an instance when bad economic theory can cause
self-fulfilling economic outcomes. Ironically, deficit alarmism invoked by
fiscal conservatives actually encourages this vigilante trap.
For the time being, economic
fundamentals appear sufficiently weak to keep the bond market vigilantes at
bay. However, there is a perennial danger that economic recovery may be
truncated by bond market vigilantism that causes a spike in interest rates that
kills growth. That makes bond market vigilantism the one real and present threat
to the immediate interest rate outlook.
VII Budget deficits, fiscal policy and the
crowding-out fallacy
The belief that budget deficits
drive up interest rates is part of a family of arguments known as
“crowding-out.” These crowding-out arguments repeatedly appear in both the
media and policymaking circles even though they are fundamentally flawed.
One type is “financial
crowding-out,” the argument being that budget deficits raise interest rates
which in turn lower (i.e. crowd-out) investment.[1]
This argument is flawed on two grounds. First, there is little evidence that
budget deficits raise interest rates. Second, budget deficits raise demand and
income and higher income likely raises investment. Thus, far from
“crowding-out” investment, budget deficits likely “crowd-in” investment.
A second type of crowding out is
“perfect offset” which claims private households perfectly and fully offset
government activity so that government has no effect on economic activity.
Thus, if government increases spending by a dollar, private households decrease
their spending by a dollar. Similarly, if government lowers taxes by a dollar,
private households increase saving by a dollar.
This perfect offset argument relies
on implausible assumptions. For instance, for government spending to fully
displace private spending it must be a perfect substitute, which is like saying
roads and bridges are a perfect substitute for shoes. For tax rebates to be one
hundred percent saved households must have no need for extra liquidity today
and must believe they are fully on the hook for future tax increases exactly
equal to the amount they receive today. These arguments have been theoretically
(see Haliassos and Tobin, 1990) and empirically (see Auerbach and Gale, 2009)
discredited.
Interestingly, the perfect offset
argument is also inconsistent with financial crowding out since the former
claims budget deficits have no effect on overall economic activity or interest
rates. Moreover, it also claims budget deficits can be any level up to one
hundred percent of GDP because they have no effects. That position is
implausible, which casts grave doubt on the entire argument.
A third type of crowding-out is
known as the “Treasury view.” This view was popular with the British Treasury
in the 1930s and was invoked against Keynes in the Great Depression. The
argument is the economy has a fixed amount of resources and if government
claims more that means less for the private sector. The modern incarnation of
this Treasury view is the twin deficit hypothesis, the claim being in a
globalized world, increased government spending or tax cuts just suck in more
imports (i.e. increases the trade deficit) with no effect on economic activity.
The fallacy of the Treasury view is
it assumes the economy is at full employment so that no resources are available
to increase production. However, if the economy has unemployment and unused
capacity, resources are available. Budget deficits that increase demand can
then cause those resources to be put back to work. Consequently, in the
presence of unemployment, budget deficits can increase output.
The fourth and most primitive type
is “credit crowding out.” This is more of a layman’s argument but it can be
viewed as the monetary twin of the Treasury view. It holds that the supply of
money credit is fixed, so that government borrowing leaves less credit for
private sector borrowers. However, the reality is money credit is infinitely
expandable in our system of fiat money. The critical constraint is not the
quantity of money credit, but rather the Federal Reserve’s base interest rate
that significantly influences the cost of money credit.
VIII Other incorrect arguments of fiscal
conservatives
Along with the fallacies of
crowding-out, fiscal conservatives also make a number of other incorrect
arguments.
(a) The
fallacy that governments and households are the same.
One such error is inappropriate and
inaccurate comparison of households and government. With regard to inaccuracy,
fiscal conservatives often rail against budget deficits on the grounds that
government is living outside its budget constraint in a way that households do
not. This claim is clearly wrong since households also run deficits, as
evidenced by household borrowing – especially to finance large expenditures
like home and auto purchases and educational expenses.
Beyond this, having government mimic
household behavior (i.e. cut spending when income is down) would destabilize
the economy by making the budget pro-cyclical. Government has special financial
powers to issue money and bonds that households do not, and sensibly using that
power can stabilize the economy. In particular, government can use that power
to offset swings of private sector demand. It does so by increasing budget
deficits in bad times and reducing them in good times. Fiscal conservatives,
who recommend government mimic households, would have government cut spending
in recessions when households also cut back, which would deepen recessions.
(b) The
fallacy that budget surpluses increase investment.
Another fiscal conservative error is
the claim that government surpluses increase capital accumulation (De Long,
2008). This argument is a variant of the Treasury view. The thinking is that if
budget deficits drain the pool of saving and lower investment, surpluses add to
the saving pool and raise investment.
Such thinking reflects a mistaken view of the economy as an agricultural
“corn” economy in which corn must be saved (saving) to be planted (investment).
The reality is we inhabit a monetary production economy in which industrial
production takes place in response to money orders.
The fiscal conservative error
follows from interpreting accounting identities as causal explanations. The
national income accounting identity (for a closed economy) states the
following:
[Taxes
– Government spending] = [Investment – Saving]
This makes it look as if increased budget surpluses, T – G, increase
investment. However, basic Keynesian logic shows if government sets out to run
a surplus by increasing T or decreasing G, it will decrease demand causing
output to fall. Aggregate investment and saving will then tend to fall, leaving
them both lower.
At the financial level, a permanent
surplus is a form of permanent tax on the private sector that drains it of
financial wealth (see Technical Box
2). The government is effectively building up its wealth at the
expense of the private sector, which is deflationary.
In practice, low household saving
and increased consumption spending generate budget surpluses by increasing
income and tax revenues. That was the lesson of the U.S. experience in the 1990s.
Increased consumption spending on “domestically produced” goods also stimulates
investment by getting firms to invest more.
Fiscal conservatives and mainstream
economists have lost sight of this commonsensical Keynesian logic, which is why
they are continually offering contradictory advice. On one hand they recommend
more household saving, yet on the other hand they also recommend more
consumption spending to maintain growth. Harvard professor Ken Rogoff (2009), a
leading fiscal conservative, exemplifies this confused thinking. At the same
time as advocating fiscal austerity and higher household saving to increase
growth, Rogoff argues that economic growth after the crisis will be permanently
lower because of lower consumption spending:
“U.S. consumption,
the single biggest driver of global growth, is surely headed to a lower level,
on the back of weak housing prices, rising unemployment, and falling pension
wealth. During the boom, U.S.
consumption rose to 70% of GDP. In the wake of the crisis, it could fall
towards 60%.” (Rogoff, 2009)
Such
contradictory thinking is common among mainstream economists and the media.
(c) The
twin deficits fallacy
A third fiscal conservative canard
is the so-called “Twin Deficits” hypothesis that blames the trade deficit on
the budget deficit. The trade deficit
has always been unpopular because of its impact on manufacturing and it has
played a huge role in fostering the crisis (Palley, 2009). Fiscal conservatives
seek to harness this unpopularity to push fiscal austerity by arguing budget
deficits cause trade deficits.
By now, the twin deficits hypothesis
ought to be thoroughly discredited by the evidence. Germany
and Japan
have both persistently run large budget deficits and trade surpluses. The U.S., in the
1990s, ran record budget surpluses and record trade deficits. In the current
recession, the U.S.
trade deficit has fallen at the same time the budget deficit has hit new record
highs.
At the theoretical level, budget
deficits have a second order impact on trade deficits, and trade deficits are
principally determined by other factors such as exchange rates. Moreover, trade
deficits can cause budget deficits. This is because trade deficits cause
leakage of spending on imports out of the economy. That lowers demand for
domestic production, which lowers output and income, in turn causing lower tax
revenues.
Despite this, the twin deficit
hypothesis is back. For instance, Fred Bergsten, Director of the Peterson
Institute for International Economics, writes:
“There is a very strong
case for initiating, and maintaining, preventive policies that will limit the
external imbalances of the United
States to a modest (perhaps 3 percent) share
of GDP. This could be achieved by running the economy at subpar rates of growth
on a continuing basis but that is obviously undesirable…. The only prudent
alternative is to run a responsible fiscal policy, including at least modest
surpluses in periods of above-normal growth. ”
(Bergsten, 2009, p.9)
In
similar vein, Harvard University professor Martin Feldstein writes in the Wall Street Journal (July 25, 2009)
“A large fiscal deficit
increases the need for foreign funds to avoid crowding out private investment….
Unfortunately, the U.S. fiscal
deficit is projected to remain high for many years….That would mean the U.S. would
continue to need substantial inflows of foreign capital to fund business
investment and housing construction.”
There
is neither empirical nor theoretical support for these claims, yet they
persist. The reality is the trade deficit is the result of the flawed model of U.S. international
economic engagement (Palley, 2009), which should be focus of trade deficit
adjustment. But that cannot be acknowledged by fiscal conservatives as it
brings into question their parallel agenda of corporate globalization.
(d)The
fallacy that China should
determine U.S.
budget deficit policy
A fourth and final argument for
budget austerity, made by Eichengreen (2009), is that the U.S. needs to cut its budget deficit to placate China,
which is a big holder of bonds. This argument effectively has China stepping in to play role of bond market
vigilante, thereby forcing U.S.
government budget policy to capitulate to the Chinese government’s investor
sentiment. However, there are several objections to this argument.
First, though China has the
ability to cause financial disruption, its own self-interest mitigates against
this. Large-scale bond sales would inflict enormous capital losses on China.
Moreover, to the extent bond sales drove up interest rates and damaged the U.S. economy
that would rebound and damage the Chinese economy. This is because economic
contraction in the U.S. reduces
U.S. demand for Chinese
exports, which hurts China’s
economy. Given China’s
dependence on exports for jobs and growth, it is unlikely it would engage in
actions that sabotage the U.S.
market and risk roiling the global economy. That means fears of a large-scale
Chinese bond sell-off are misplaced and Chinese talk of such a possibility is
rhetorical saber-rattling.
Second, the Federal Reserve could
step-in and buy bonds if China
exits. Such actions would be similar to the quantitative easing the Fed has
already undertaken to combat the recession, whereby it has bought hundreds of
billions of dollars of Treasury bonds. Third, in dire circumstances that
threaten economic stability, the U.S. could impose administrative
restrictions that freeze Chinese holdings and prevent sales.
IX What is a sustainable budget deficit?
The previous sections have presented
the theoretical case for budget deficits, including refutation of fiscal
conservative arguments for fiscal austerity. That in turn raises two pragmatic
questions. First, what is a sustainable level of federal debt and budget
deficits that the U.S.
economy could support? Second, where does the current projected extended budget
outlook stand relative to that sustainable level?
By themselves, both the federal debt and budget
say little. Instead, their true significance depends on the size of the deficit
and public debt relative to GDP. From that perspective, a sustainable debt is one
that keeps the debt-to-GDP ratio constant, which requires the debt to grow at
the same rate as GDP.
A sustainable deficit is one that is
consistent with a sustainable debt. It cannot be too large or else the debt
ratio will grow, and it cannot be too small or else the debt ratio will fall.
Given this, the level of the sustainable deficit depends on (1) the growth rate
of GDP and (2) the target debt-to-GDP ratio. Faster GDP growth supports a
higher sustainable deficit because the sustainable debt can grow faster, which
means the deficit can be larger. This logic highlights the critical significance
of growth for fiscal sustainability, linking back to earlier arguments
regarding the importance of public investment.
Table 1 reports calculations of the sustainable
deficit using alternative assumptions about the target debt-to-GDP ratio and
rate of growth. Doubling the rate of growth of GDP doubles the rate at which
the debt can grow, and it also doubles the sustainable deficit.
For instance, assuming a target
debt-to-GDP ratio of 50 percent (i.e. approximately the current ratio) and a
1.5 percent growth rate, the permanent sustainable deficit is 0.75 percent of
GDP. If the growth rate rises to 3 percent, the sustainable deficit rises to
1.5 percent of GDP.
If the target debt-to-GDP ratio is 75
percent, a 1.5 percent growth rate supports a permanently sustainable deficit
of 1.125 percent of GDP. A 3 percent growth rate supports a 2.25 percent
permanently sustainable deficit.
The other dimension of deficit
sustainability is the impact of deficits on the interest burden. Deficits add
to debt and debt imposes interest costs on the budget. Table 2 shows the
interest burden of alternative debt-to-GDP profiles. If the real interest rate
is one percent, a 75 percent debt-GDP ratio imposes a budget cost equal to 0.75
percent of GDP. If tax revenues are 20 percent GDP, that burden is equal to
3.75 percent of tax revenues, which is supportable.
If the real interest rate is two
percent, a 75 percent debt-GDP ratio imposes a budget cost equal to 1.5 percent
of GDP. If tax revenues are 20 percent GDP, that burden is equal to 7.5 percent
of tax revenues, which is again supportable.
X Is the current budget outlook sustainable?
Table 1 provides measures of the
sustainable deficit under alternative economic scenarios. That leads to the
second question whether the current actual budget outlook is sustainable or
not. For this purpose assume the maximum tolerable debt-to-GDP ratio is 75
percent, a level that was shown to yield reasonable outcomes in Tables 1 and 2.
The most recent Congressional Budget
Office budget outlook (August 2009) projects the publicly held debt, as a
percent of GDP, will increase from 53.8 percent in 2009 to 67.8 percent in
2019. If the real interest rate is 2 percent the interest cost of the debt in
2019 will be 1.36 percent of GDP. If tax revenues are 20 percent of GDP, the
interest cost will be 6.8 percent of tax revenues. These calculations show the
existing ten year budget outlook is sustainable and there is even room to
increase deficit spending to finance public investment since the debt-to-GDP
ratio in 2019 will be below the 75 percent threshold.
What about the sustainability of
longer term budget projections? Here, the answer is more nuanced and
sustainability will require sensible tax policy and health care cost
containment.
The Center for Budget and Policy
Priorities (Kogan et al., 2008) reports that at the end of 2008, based on then
current policy, the debt-to-GDP ratio was predicted to rise from 46 percent in
2009 to 279 percent in 2050. That increase is equivalent to a projected average
annual deficit over the next 40 years of 4.2 percent of GDP. These estimates
remain little changed.
On the face of it these are daunting
and unsustainable numbers. However, reading below the headline reveals a
starkly different picture as shown in Table 3. First, if the Bush – Cheney tax
cuts from 2001 and 2003 are allowed to expire in 2010, the 40 year projected
average annual deficit drops by 1.9 percent of GDP to 2.3 percent of GDP. Those
tax cuts were part of the failed Bush – Cheney growth agenda and they should
now be jettisoned as required under current law.
Second, the reality is that the bulk of the
deterioration in the budget deficit outlook is explained by excessive health
care cost growth. If health care cost growth is held equal to per capita GDP
growth, the deficit drops another 3 percent of GDP and the projected long-run
average annual budget outcome becomes a surplus of 0.7 percent of GDP. If we
are less successful on health care cost control and cost growth is held equal
to “per capita GDP plus one percent,” the deficit only drops by 1.5 percent of
GDP. That would imply an average annual deficit of 0.8 percent, which is still
completely manageable.
Putting the pieces together, Table 3
shows the real problem is health care costs, but that is a problem which is not
solved by fiscal austerity. Instead, it needs health care cost reform.
Moreover, even without health care cost containment, simply eliminating the
Bush – Cheney tax cuts puts the budget projections close to sustainability.
Such a picture does not support budget deficit alarmism.
XI Conclusion
The U.S. economy faces a difficult
period of transition and renewal following the deep recession caused by the
bursting of the house-price bubble and the ensuing financial crisis. Whereas there
is widespread understanding of the need for budget deficits to provide
short-term Keynesian fiscal stimulus to combat the recession, there is far less
appreciation of the need for budget deficits in the medium term to facilitate
the process of private sector deleveraging and to spur growth.
The demise of the bubble economy means
the U.S.
needs a new engine of growth and deficit-financed public investment has an
important role to play. Deficit financed investment can create a “virtuous”
circle whereby public investment spurs growth which in turn will improve budget
outcomes. In contrast, fiscal austerity risks creating a “vicious” circle in
which austerity slows growth, necessitating further austerity.
The budget numbers show the U.S. has immediate
fiscal space for a public investment agenda. Longer term, the budget outlook is
more problematic but that is due to health care costs. Fiscal austerity does
not solve the health care cost problem and it also risks undermining growth
which would further weaken the fiscal outlook. That makes fiscal austerity
economic malpractice.
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[1] The financial crowding-out argument was
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in the media.
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