On the Economics of Deficits

What caused the deficits and rising public debt? The answer comes in two parts: present deficits and projected future deficits.

The first point to appreciate is that current deficits and rising debt levels were caused primarily by the financial crisis. The financial crisis, the fall in asset values (especially housing), and withdrawal of bank lending to businesses and households have meant a sharp decline in economic activity. This decline has led to a sharp drop in tax revenues and an increase in unemployment insurance and the like. According to a new International Monetary Fund staff analysis, fully half of the large increase in budget deficits in major economies around the world is due to collapsing tax revenues. Less than 10 percent is due to increased discretionary public expenditure, such as stimulus packages.

This point is important because it shows that the claim that deficits have resulted from "overspending" is false. This is the case both in the United States and abroad.

Second, future deficit projections are both too optimistic and too pessimistic. They begin with unrealistic forecasts that assume full recovery. The principal forecasting authority is the Congressional Budget Office. The CBO's projections proceed in two steps. First, they wipe out the current deficits, over a very short time horizon, by assuming a full economic recovery. Second, they create an entirely new source of future deficits, essentially out of whole cloth.

HOW THE CBO GETS IT WRONG

The critical rosy near-term assumption concerns jobs. The CBO projects a relatively rapid return, over five years, to high levels of employment, with accompanying rapid economic growth. If this were to happen, then tax revenues would recover and the projected deficits would fall -- as they did in the late 1990s.

Under present financial conditions, however, this scenario is highly unrealistic. It can only happen if the credit system finances economic growth, which implies a rising level of private (household and company) debt relative to gross domestic product. That clearly isn't in the cards. Private-sector de-leveraging will continue for a long time, as mortgages and other debts default or are paid down. Already, with the slow economic growth reported for the second quarter of 2010, we are seeing clear signs that -- at best -- slow growth and sustained high unemployment are going to persist.

With high unemployment, high public deficits are inevitable. The only choice is between an active deficit, incurred by putting people to work or otherwise serving national needs -- such as providing decent income-support for retirement and health care to the aged -- and a passive deficit, incurred because at high unemployment, tax revenues necessarily fail to cover public spending. Cutting public spending or raising taxes, now or in the future, by any amount, cannot wipe out a deficit due to high unemployment. Similarly, cuts in Social Security and Medicare, no matter how severe, will only impoverish vulnerable Americans. They will not reduce the deficit because they will add nothing back to jobs.

So are deficits caused by high unemployment the problem? No. Joblessness is the problem. The deficit is partly symptom and partly palliative. The government's deficits relieve -- in part -- the losses that economic hardship imposes on households and on businesses. This is a good thing -- and without it we would be in much worse shape than we are.

Having cured the deficits with an unrealistic forecast, the CBO re-creates them with another, very different but equally unrealistic forecast. In the CBO models, high future deficits and rising debt relative to GDP are projected. But their source is not a weak economy. Rather, the source is a set of assumptions describing the economy after full recovery from the crisis. In the CBO forecasts, deficits and debt arise from a combination of rapidly rising health-care costs and rising short-term interest rates, in the context of a rapid return to high employment and continued low overall inflation. This combination produces, mechanically, a very large net-interest payout and a rapidly rising public debt in relation to a slowly rising nominal GDP.

Even if the CBO were right about recovery, which it is not, this projection is internally inconsistent and wholly implausible. Low overall inflation (at 2 percent) is inconsistent with the projected rise of short-term interest rates to nearly 5 percent. Why would the central bank carry out such a policy when no threat of inflation justifies it? But the assumed rise in interest rates and interest payments drives the projected debt-to-GDP dynamic.

Similarly, the rise in projected interest payments is inconsistent with low inflation. Interest payments rising to over 20 percent of GDP by midcentury would constitute new federal spending equivalent to four times the current level of Pentagon expenditure. Obviously (unless we brought back price controls!) this cannot happen with 2 percent inflation. And although a higher inflation rate is undesirable, arithmetically it means a lower debt-to-GDP ratio.

Finally, rapidly rising health-care costs and low overall inflation are consistent only if all prices except health care are rising at less than that low overall inflation rate -- including energy and food prices in a time of increasing scarcity. This too is extremely unlikely. Either overall health-care costs will decelerate (relieving the so-called Medicare-funding problem) or the overall inflation rate will accelerate -- reducing the debt-to-GDP ratio.

In sum: The economic forecasts on which plans to reduce deficits are now being based are a mess. The unemployment and growth forecasts are implausibly optimistic, while the projections for inflation and interest rates are implausibly pessimistic and mutually inconsistent.

Good policy cannot be based on bad forecasts. In reality, large deficits going forward are likely to have the same source as they do right now: stubbornly high unemployment.

MARKETS ARE NOT CALLING FOR AUSTERITY

Most informed laymen believe that the federal government must borrow in order to spend. They believe that the interest rate on Treasury securities is set in a market for government bonds. The markets impose discipline on the government. Thus "fiscal responsibility" will produce low long-term interest rates for the federal government, while "irresponsibility" will be punished by higher, and eventually intolerable, debt service.

But clearly, were that true, markets should be terrified by the long-term deficit and interest-rate projections of the CBO. No rational investor would buy a 30-year bond at 4 percent if they really believed the CBO's interest-rate forecast, with short-term Treasury bill rates rising to near 5 percent in five years. It would be much better to hold cash.

And yet, as of early September, 30-year Treasury bonds are yielding well under 4 percent. On the argument just given, this must be an extraordinary success of virtuous policy. Clearly Wall Street has confidence in the fiscal probity of Team Obama! This confidence is unqualified, backed by money, contingent on nothing. And in this real world, Wall Street is every day rejecting the CBO's doomsday scenarios and all other deficit-scare stories.

But wait a minute, some may say. Yes, interest rates are low at the moment. But bond markets are fickle; they can turn on a dime. And what then? Yes, it is possible that interest rates could rise. But this argument takes us away from the premise of rationality. If bond markets are fickle and arbitrary, who is to say what they will do in response to any particular policy?

In the face of irrational markets, the sensible policy is to borrow heavily for as long as markets are offering a good deal. If markets are irrational, then logically you cannot prevent this by "good behavior." Either the markets are rationally unworried about deficits, or they are acting irrationally right now, in which case they can hardly "insist" on anything.

There is a further reality. The U.S. government doesn't need to "borrow" in order to spend. In the post-gold-standard world, the U.S. government spends (and the Federal Reserve lends) by writing checks. Those numbers then appear in the bank accounts of the payees, who may be government employees, private contractors, or the recipients of Social Security.

The effect of this check-writing is to create a deposit in the banking system. This is a "free reserve." As long as U.S. banks are required to accept U.S. government checks -- as long as the Republic exists -- then the government can and does spend without borrowing. If bonds are then issued, that's just a convenience for the banks, which prefer to earn interest on their reserves. The extent to which those bonds are held locally or abroad (another common source of worry) depends on the U.S. foreign deficit. It has nothing to do with whether the Chinese like our policies. Foreigners hold bonds, because, just like domestic banks, they like the interest.

Insolvency, bankruptcy, or even higher real interest rates are not among the actual risks to this system. The actual risks in this system are inflation, and to a larger degree, depreciation of the dollar. Since at the moment inflation is practically impossible and there is wide agreement that a lower dollar would be a good thing, the goal of deficit reduction as such serves no coherent economic objective. Sacrificing Social Security or Medicare to the goal of a lower deficit projection would be dumb. It would be cruel. And it would be crazy.

HOW TO REDUCE DEFICITS CONSISTENT WITH RECOVERY

The only way to cut a deficit caused by unemployment is to create jobs. And -- if the public deficit is to be reduced -- this must be done with a substantial component of private financing, namely bank credit or some close substitute for bank credit. This is a fact of accounting. The surest way to grow out of our deficit is to cure the financial crisis.

To cure the financial crisis would require two comprehensive measures. The first is debt restructuring for the household sector, to restore private borrowing power. The second is a reconstruction of the banking system, purging the toxic assets from bank balance sheets and also reforming the bank personnel, compensation, and other practices that produced the financial crisis in the first place.

Further, if private-sector finances could be fixed, then public debt would fall without austerity. The entire national experience from 1946 to 1980, when public debt fell from 121 percent to about 33 percent of GDP, proves this. So does the experience from 1994 to 2000 -- when the government went into budget surplus on the strength of private credit.

If private credit doesn't recover, the only other way to get deficits down is for the government to create off-budget credit institutions -- like the New Deal's Reconstruction Finance Corporation, which kept many major American corporations going through the Depression when they couldn't get bank loans.

The right economic objectives must address real problems -- not those conjured from thin air by economists. Creating jobs, caring for an aging population, cleaning up the Gulf of Mexico, and coping with energy insecurity and climate change are all far more important objectives than reducing a projection of future budget deficits.

In fact, as Wall Street knows, reducing those projections isn't important at all.

REAL RECOVERY: WHAT MUST BE DONE

It is by now clear that the "green shoots" of 2009 have withered in the heat of 2010. In familiar Washington fashion, we now hear that "no one could have foreseen" how weak and shallow the recovery would be. This is baloney. There was in fact a phalanx of economists who said exactly that in early 2009, including this author, Joe Stiglitz, and Paul Krugman -- and for the correct reasons. Our views were not secret or hard to find. Inside the White House, we now know, similar arguments were made also by Christina Romer. But they were ignored, or repressed, by the president's leading economic advisers and political team.

So now the White House is beset by deficit hysterics, preparing the ground for a post-election assault on Social Security and Medicare. The first task of a proper policy must be to defeat them and to protect those vital programs. That battle can be won, in the lame-duck session. Then, in the new Congress, let there be voices that begin to articulate the long-term view.

The politics of "stimulus" -- with the false promise that everything will be fixed by one more burst of spending -- has exhausted itself. The predictable consequence is a snake-oil bazaar -- every quack remedy ever thought of has its merchant. And yet, in this cacophony, perhaps the voices of clarity, reason, and vision may be heard. They should call for true reform of the banks, private-debt resolution, reconstruction finance, and public investments as necessary to rebuild the country.

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