The Trouble with Deficit Finance
Elisabeth Bumiller reports in the Washington Post ("Bush's $2.2 Trillion Budget Proposes Record Deficits," 2/04/03) that a budget deficit of $304 billion is forecast for the current fiscal year—with higher deficits to follow. (These figures, she notes, leave the costs of a war with Iraq out of account.)
Mitchell E. Daniels Jr., the White House budget director, is reported as claiming that the current deficit, "representing 2.7 percent of the nation's gross domestic product, was not large enough in percentage terms to cause trouble or to raise interest rates...."
Didn't Everett Dirksen used to say that the main purpose of GDP (GNP in his day) was to make everything else look small by comparison?
Even at that, Mr. Daniels made the deficit look a little smaller than it actually is. His 2.7 percent suggests a GDP of about $11,300 billion. The readily available Federal Reserve Economic Data (FRED) provided by the St. Louis Fed shows that current GDP is closer to $10,300 billion, making the $304 billion deficit equal to 2.95 percent.
More to the point, GDP makes for a politically attractive but economically irrelevant denominator. How much is government borrowing relative to the funds available for borrowing? The relevant denominator is total saving and not total output. FRED shows the current annual rate of gross saving to be $1,574 billion. And the government is borrowing just under 20 percent of it. Does Mr. Daniels believe that this percentage is not large enough to cause trouble or to raise interest rates? And if so, just what percentage would be large enough?
Even more to the point: At that level of borrowing, the effect of the deficit will be:
- higher interest rates (if the government borrows domestically) OR:
- increased inflation (if the Federal Reserve monetizes the debt) OR:
- weakened export markets (if the government sells debt abroad) OR:
- tax hikes (possibly in the form of a Johnsonesque "surtax") OR:
- all the above in some combination.
In recent years changes in international capital flows have been the primary consequence of increased deficits. This means that the US Treasury is going head-to-head with the US exporting industry. Foreign funds flowing directly or indirectly into the Treasury are funds that are not spent on US-produced goods and services. Maybe Mr. Daniels should express the budget deficits as a percentage of total US exports. FRED reports the latest figure on annual exports as $1,036.2 billion, making for a deficit-to-export ratio of nearly 30%.
Again: more to the point, there is no basis for believing accommodating changes in international capital flows will continue indefinitely. Our foreign trading partners may not keep saving us from the more direct consequences of high federal budget deficits. If US markets begin to lose their attractiveness or if US exporters begin to get their way in Washington, then we're back to inflation, high interest rates, and/or tax hikes.
All the while, entrepreneurs in the private sector will have to make their guesses about the particulars of the deficit accommodation, hedge as best they can, and take their chances. And if they guess wrong, they can lose big. The private sector is good at satisfying consumer demand, but it's not much good at guessing what's in that grab bag that we call a budget deficit. Many, in fact, will stay liquid until the deficit problem is addressed. (This is not to deny that there are other problems [e.g. war] that contribute more to current attractiveness of liquidity.)
It's important to recognize that there is a tax code but there is no deficit code. The uncertainties associated with large federal budget deficits warn against exclusive focus on the total spending done by government. It does matter how that spending is financed. My supply-side friends never tire of reminding me that taxes have bad effects as well. And surely they do. So too does inflation. But in the long run big deficits are not an alternative to taxes and/or inflation but rather a grab-bag bundling of them. The uncertainty about just which bad effect the economy will ultimately have to cope with is itself a bad effect.
It's all well and good to work towards a reduction in the amount of government spending, all of which has to get financed somehow. In the meantime, however, we should not let the deficit apologists get away with trivializing a twelve-digit deficit by comparing it to GDP.