Do deficits matter?
Just like people, governments that spend more than they collect go into debt. This year the federal government will overspend by $422 billion. That has budget hawks biting their nails and criticizing the Bush administration’s profligate spending and huge tax cuts.
Why care about deficits? In theory, like a spendthrift approaching bankruptcy, big budget deficits threaten future prosperity. That’s because when governments run deficits they must borrow to make up the difference. That means they compete with companies, home buyers, and others for scarce funds, which can bid up interest rates. That makes it more expensive to start new companies and invest in new equipment, and that can slow productivity growth—the engine of rising living standards.
So much for theory. What about the evidence?
The historical relationship between deficits and interest rates is murky. Partly this is because lots of things in the economy affect interest rates besides how much government borrows. Some academic studies find a slight relationship between them (see here), while others find none at all (see pp. 69-129 here). Often, the two variables move in opposite directions altogether (see here).
The bottom line? At some level, deficits are clearly harmful. But they must be very large to do so.
So how large is “large”? Over the last 42 years the average deficit has been about 2.1 percent of GDP, with a standard deviation of about 1.9 percent (see here for data). Given this, a statistically reasonable criteria for calling a deficit “large” might be: one that’s two standard deviations from the average, or about 5.9 percent of GDP or larger.
According to the Congressional Budget Office, this year’s deficit will hit 3.6 percent of national income—far from the 4-5 percent deficits of the 1980s and 1990s and hardly cause for panic.
So much for fears about the current deficit. Although with booming Social Security, Medicare and Medicaid liabilities on the horizon, it may be time to panic soon enough.
Posted by Andrew on Monday September 20, 2004 | Feedback?
