Bigger Deficits Don't Always Mean Disaster
The ballooning budget deficits of the early years of President Ronald Reagan's presidency "will insure that real long-term interest rates stay high" and "consume savings urgently needed for investment in new plant and equipment, new infrastructure and new jobs," two Democratic governors 1 warned in the New York Times in 1983. In fact, real interest rates peaked in the late 1980s and began a 30-year decline, while business investment rose as a share of gross domestic product (the governors may have had a point about infrastructure investment).
The gushing red ink emanating from President Barack Obama's budget would eventually lead to tax hikes or "severe inflation," an economist with a long history of advising Republican politicians warned in the Wall Street Journal in early 2010. 2 In the eight years since, the annual inflation rate has gone to 2.2 percent from 2.1 percent, while Congress recently passed a round of tax cuts that the same economist (Stanford University's Michael Boskin) actually endorsed in an op-ed last month.
These not-exactly-prescient warnings are worth recalling after the Congressional Budget Office released new budget projections Monday that show the federal budget deficit growing to $1 trillion, or 4.6 percent of GDP, by the 2020 fiscal year, and not ever really shrinking after that:
The post-2022 rebound in federal revenues projected in the above chart depends in large part on Congress allowing many of the tax cuts approved in December to expire -- which congressional Republicans have been vowing not to let happen. If the cuts are made permanent, and not followed by commensurate spending cuts, budget deficits of more than 5 percent of GDP seem destined to become the norm.
The U.S. has never run budget deficits that big except during major wars and during and just after major recessions. 3 We're currently in the ninth year of an economic expansion. Usually the unemployment rate and the deficit are mirror images of one another, with the deficit shrinking when unemployment falls. Not lately:
So ... this doesn't seem great. But anyone who professes to be worried about it needs to address why past predictions of deficit-induced disaster have proved so wrong. Here's an admittedly incomplete try.
The biggest reason, by far, has been that the U.S. government has found it easier to finance chronic deficits than almost anyone would have predicted back in the early 1980s. Bigger deficits haven't led to higher interest rates, more inflation, or noticeable crowding out of private investment. Strong global demand for the safe, reliable securities that are U.S. Treasuries has been key to enabling this. During and after the last recession, the Federal Reserve boosted this demand with its own massive buying of Treasuries (aka quantitative easing). The Fed stopped accumulating Treasuries in 2014 and started selling them last fall, but interest rates have so far ticked up only modestly.
This may mean that deficits have no impact on interest rates. Or it may just be that deficits haven't had any impact yet. The size of the federal debt could play a role here. Before Congress enacted big tax cuts and spending increases and the Federal Reserve's inflation-fighting campaign pushed the economy into recession in 1981, the federal debt held by the public amounted to just 25.2 percent of GDP; before the Great Recession and efforts to fight it sent revenues plummeting and outlays skyrocketing in 2008, the debt was 35.2 percent of GDP. Now it's above 75 percent. It was even bigger than that (106.1 percent) right after World War II, but rapid economic growth, smallish deficits (and occasional surpluses), and inflation soon sent it plummeting. The CBO sees no such relief in our future, projecting that the debt will be 96.2 percent of GDP by fiscal 2028. And gross federal debt, a less-often-cited figure that includes money owed to the Social Security trust funds, is already 105.4 percent of GDP.
Is that bad? Well, maybe. Harvard economists Carmen Reinhart and Kenneth Rogoff wrote in a 2010 paper that was for a time much cited by those worried by the growing deficit (including Boskin in the 2010 op-ed cited above) that "median growth rates for countries with [gross] public debt over roughly 90 percent of GDP are about one percent lower than otherwise." That paper became the focus of controversy after University of Massachusetts at Amherst economists Thomas Herndon, Michael Ash and Robert Pollin pointed out some embarrassing data errors and disputed the way Reinhart and Rogoff calculated median growth. But the data errors had almost no impact on the result; it's not at all clear that the Reinhart-Rogoff method of calculating median growth rates was wrong; a subsequent paper by Reinhart, Rogoff and Vincent Reinhart again found that public debts over 90 percent of GDP were associated with periods of slow growth; and other researchers have reached similar conclusions. This doesn't necessarily mean that 90 percent is some sort of magical cutoff after which growth will decline, or that reducing deficits would automatically increase growth. It's just an indication that the U.S. is in different and potentially less forgiving territory than during previous deficit increases.
In sum, I'm not going to predict that interest rates or inflation will skyrocket anytime soon. In the CBO's projections, though, just a return of 10-year Treasury note rates from today's 2.8 percent to the 4 percent or so 4 that prevailed before the last recession would lead federal spending on interest to surpass defense spending in 2023 and nondefense discretionary spending in 2025. That doesn't seem great, even if it's not necessarily a disaster.
Colorado's Richard Lamm and Utah's Scott Matheson. Yes, Utahns used to elect Democratic governors on occasion! Matheson, whose second term ended in January 1985, was the last one.
Update: The WSJ seems to have removed Boskin's piece from its website since this column was published (this was the link, in case it goes active again), but Boskin has a slightly longer version on his own website.
The years since 1930 with federal deficits of more than 5 percent of GDP were 1934 (5.8 percent), 1936 (5.4 percent), 1942 (13.9 percent), 1943 (29.6 percent), 1944 (22.2 percent), 1945 (21 percent), 1946 (7 percent), 1983 (5.9 percent), 2009 (9.8 percent), 2010 (8.7 percent), 2011 (8.5 percent) and 2012 (6.8 percent).
The CBO projects a rate of 4.2 percent in fiscal 2020 and 2021, 3.9 percent in 2022 and 3.7 percent for the next five years after that.
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Brooke Sample at email@example.com