Who Cares About the Deficit, and Why?

The numbers seem staggering: The federal budget deficit is projected to reach a record $521 billion this year, equaling about one-fourteenth of the federal debt accumulated over the nation’s history. And the figure would be far higher if it included supplementary appropriations for Iraq and some other items President Bush left out of his recent budget proposal.

 

Democrats accuse Bush and the Republican Congress of squandering the surplus achieved in the Clinton years and forcing future generations to pay for today’s spending excesses and tax cuts. But the White House and its supporters insist the deficit, while a record in dollar terms, is not so bad given the economy’s size.

 

Is the deficit a ticking time bomb or not?

 

Although deficit hawks warn that growing deficits cause interest rates to rise and undermine economic growth, that hasn’t happened. Yield on the 10-year U.S. Treasury note has been holding just above 4% for seven months, even as deficit estimates have been repeatedly raised.

 

“The deficit matters if it raises interest rates, and it hasn’t raised interest rates, so one could say it doesn’t matter,” says Wharton finance professor Jeremy Siegel. “If you want to know the truth, the financial markets are pretty sophisticated, and if they’re not worried then I don’t think others should be worried,” he notes, adding that he expects the economy to grow faster than the deficit, reducing any problems the deficit may cause.

 

Wharton finance and economics professor Andrew Abel believes deficits do tend to drive interest rates up, but that it’s impossible to predict when that will happen, or to know if other factors will blunt the effect. Deficits are to the economy as cigarettes are to a smoker, he suggests: bad in the long term, although the effects may take a long time to show.

 

According to Abel, the total debt is more important than any single year’s deficit figure, and debt is not yet at an alarming level. The current debt equals about 40% of annual gross domestic product, compared to 49.5% in 1993 and well over 100% during World War II. Many economists argue debt is not a serious problem until it exceeds 50% of GDP. “It can go much higher [than the current level] before it’s a problem.”

 

In theory, deficits hurt the economy by forcing the government to sell Treasury bonds to borrow. As borrowing grows, the government must pay ever-higher interest rates to lure bond buyers. Higher rates ripple through the economy, raising borrowing costs for businesses and consumers. In addition, as investors pour money into Treasuries, they have less to put into stock and corporate bonds, reducing the flow of capital that businesses need to grow. As bond yields rise, money shifts from stocks to bonds, causing stock prices to flatten or fall. Economic growth is stifled.

 

As bond traders sense this process beginning, they anticipate a future rise in interest rates by bidding rates up in the present. Older bonds with lower yields cannot compete with new bonds, so bond prices fall.

 

In the early 1980s, heavy military spending and tax cuts under President Reagan began to drive deficits upward. By 1992, the deficit stood at a relatively high level of about 5% of gross domestic product, and the 10-year Treasury yielded more than 7%. Tax increases under the first President Bush and President Clinton, coupled with spending cuts and rising tax revenues from the stock market boom, caused deficits to shrink in the mid-1990s, and the government enjoyed surpluses from 1998 through 2001. Ten-year Treasury yields fell to just over 4% in 1998.

 

Since 2001, spending increases, tax cuts and smaller tax revenues due to the weak economy and the bear market have caused deficits to mushroom. This year the deficit will likely match the early ‘90s level of 5% of GDP.

 

“No Single Trip Wire”

Yet the 10-year Treasury has been relatively steady in the low- and mid-4% range since last summer. One reason for that, says Siegel, is the Federal Reserve, which has held short-term rates at 1% to stimulate the economy.

 

Also, China , Japan and some other countries have been buying enormous amounts of U.S. Treasuries. Their goal is to create greater demand for the dollar to prevent it from falling in value in relation to their own currencies, allowing Americans to continue buying products from those countries. The high demand for Treasuries helps keep yields low.

 

“Relative to past periods of high deficits, where the deficit was clearly having an impact on interest rates, I think no one could argue [with the statement that] the effects are much smaller,” says Wharton finance professor Joao Gomes. Because other factors influence rates, it’s impossible to say that a deficit of a given size will cause rates to go to a specific level, adds Nicholas Souleles, finance professor at Wharton. “There’s no single trip wire.” He says most economists agree that deficit spending is appropriate in times of emergency, such as war. During recessions, governments borrow so they can continue spending to stimulate the economy.

 

“I think the deficits are large, and they are worsening,” Souleles notes. “So you can ask yourself, are the reasons good enough to be borrowing at this large and growing rate? It can be perfectly reasonable to borrow … You just have to be aware of the cost.” While he declines to express a view on whether the current deficit is acceptable, he agrees with those who say deficits cannot grow indefinitely without affecting the economy. “If fewer funds are available for the private sector, you will see some combination of less investment or higher interest rates.”

 

Gomez, however, calls the deficit “unsustainably large. It is not the highest it’s ever been, but it’s fairly big. It has to be reduced … We are adding at such a fast pace that it will get out of control.”

 

Tax Cuts in Time of War: Huh?

Indeed, many argue that the problem is not so much the current deficit and debt level as it is the prospect for an enormous growth in both figures in the future. The president said his budget would cut the deficit in half in five years, but left a lot of costs, such as the Iraq war, out of the calculation. Also, he did not address the years after that. Most of his 2001 tax cuts expire after 2010, but he wants to make them permanent. There also is the looming problem of funding Social Security and Medicare when baby boomers start retiring in a few years.

 

While deficits have long been considered acceptable during times of war, the situation in Iraq is not analogous to World War II , Korea or Vietnam . Abel notes that if war is a compelling justification for increasing the deficit, isn’t it also a reason to raise taxes? In the midst of the Iraq war, Bush pushed through tax cuts in 2003, and he now proposes making the 2001 cuts permanent. “I think that’s probably unprecedented – to cut taxes in wartime,” Abel notes.

 

While deficit spending is also a commonly accepted way to stimulate the economy to recover from a recession, the economy is clearly recovering already, eliminating the need for enlarging the deficit, Abel adds. “You could argue about whether the [2001 tax cuts] were appropriate or not. There are different points of view on that. Maybe they made the recession less bad. But by the time you got to the 2003 tax cuts, that was really inappropriate.”

 

For the time being, the growing deficit does not appear to be a drag on the economy. But there’s no guarantee that foreign purchases of Treasuries will continue indefinitely, or that the Fed will continue to keep interest rates low. “The Fed has been working aggressively to try to keep rates down, but I don’t think the Fed can do that forever,” Abel says.

 

According to Siegel, bond traders have refrained from driving yields up because they expect the economy to grow faster than the deficit. “We could, in my opinion, grow out of this deficit,” he says, arguing that in the next 12 months or so, the economy may grow enough that the deficit will be only 3% of GDP, a level many countries have shown to be sustainable. “Anything up to 3% is not a long-run threat.”

 

Bond traders may also be looking at deficit history and finding that Washington tends to come to the rescue eventually, by cutting spending or raising taxes. So the sanguine mood in the bond markets isn’t because deficits are painless. It’s because traders know that sooner or later the public will be forced to suffer the consequences.

Citing Knowledge@Wharton

Close


For Personal use:

Please use the following citations to quote for personal use:

MLA

"Who Cares About the Deficit, and Why?." Knowledge@Wharton. The Wharton School, University of Pennsylvania, [25 February, 2004]. Web. [01 October, 2014] <http://knowledge.wharton.upenn.edu/article/who-cares-about-the-deficit-and-why/>

APA

Who Cares About the Deficit, and Why?. Knowledge@Wharton (2004, February 25). Retrieved from http://knowledge.wharton.upenn.edu/article/who-cares-about-the-deficit-and-why/

Chicago

"Who Cares About the Deficit, and Why?" Knowledge@Wharton, [February 25, 2004].
Accessed [October 01, 2014]. [http://knowledge.wharton.upenn.edu/article/who-cares-about-the-deficit-and-why/]


For Educational/Business use:

Please contact us for repurposing articles, podcasts, or videos using our content licensing contact form.

 

Join The Discussion

No Comments So Far