Why Deficits Matter
This publication has spared no ink opining about our nation’s deteriorating fiscal situation. But perhaps too much was taken for granted. After all, deficits aren’t always bad – only under certain conditions.
Cyclical deficits, for example, are desirable. These arise when the economy falters and tax revenues – based mostly on income and profits – weaken. Under such circumstances, containing the deficit would require commensurate declines in spending, which would exacerbate the already weak economy. This is why economists generally welcome cyclical deficits.
Structural deficits, however, are another story. These arise not because of a temporary dip in the tax base but because of a fundamental imbalance between government revenues and spending. In other words, even when the economy is operating at full capacity or beyond, it still doesn’t generate enough government revenue to meet its spending commitments. This gap – the deficit – is ultimately financed by U.S. and foreign investors.
According to the Congressional Budget Office, baseline projections now show the deficit persisting for a decade, averaging 1.3% of GDP. In all likelihood, this will prove too optimistic, however, as the CBO itself concedes. Four of its six alternative scenarios show worse outcomes, with only two showing modest improvements.
Even still, what’s wrong with borrowing? People borrow to buy homes and businesses borrow to expand operations, so why shouldn’t the government borrow to provide goods and services?
Herein lies a key distinction. Those borrowing to purchase homes, machines and factories acquire assets that provide useful service for years or that may later be sold. Government borrowing, alternatively, is increasingly used to finance retirement and health care, and to service previously accumulated debts. Such outlays now account for a record 62% of spending and are projected to reach 68% in 10 years, accelerating thereafter as the baby-boomers retire. In essence, the federal government is becoming a giant insurance company rather than a builder of roads, bridges, dams and other productive assets.
Moreover, persistent government borrowing directly competes with private sector needs for a limited pool of available savings. According to one estimate from the Federal Reserve, such “crowding out” raises long-term interest rates by one-quarter percent for each sustained rise in the deficit equal to 1% of GDP.
Extending this reasoning further, investment spending can only suffer as businesses forgo marginal investments that fail to meet higher return requirements. And as investment suffers, so too does the growth of our capital stock, which in the end is the principal determinant of productivity gains and future living standards.
If this convoluted process was more direct – like hitting one’s thumb with a hammer- it would probably never happen. But the allure of spending now and paying later seems too appealing to overcome, especially when those doing the paying aren’t yet old enough to vote.
