Understanding The Budget Deficit
The United States Government is currently sitting on $13.6 trillion dollars of debt and is running a budget deficit of $1.3 trillion. The debt-to-GDP ratio, a common measure used by economists, is around 68%. Worse, the debt is growing at an alarming rate since the government has been spending significantly more than it receives via taxes. But is that a bad thing? What are the consequences of running a deficit?
The Problem with Debt
The current federal budget policy is infeasible. If the federal government continues to finance its expenditures (including interest and the principal of old debt) by issuing more debt, the government inevitably risks defaulting. Public default would irreparably and massively increase the credit risk associated with all future debt issued by the American government. This would mean higher required returns and as a result would constrict the federal government’s ability to debt finance its future activity, limiting its ability to flatten business cycles and jumpstart the economy in low-growth periods.
This does not rule out the government running infeasible policies temporarily, just as long as revenues increase or expenditures decrease at some time in the future. The benefits of federal deficits are well known: in recessions, where all revenues, including government revenues, are deflated, the government can issue debt to maintain its expenditures and flatten business cycles. Historically, countries with high debt were able to escape high levels of debt through large inflation or high growth. Neither are likely in an economy as mature as that of the United States. The real question at hand is when is the right time to implement such an adjustment?
The Consequences of Waiting
Many believe that that fiscal tightening in the current state of the US economy will cause another recession, and therefore whatever necessary adjustments must be made should be made later. Now this might be true, but the consequences of delaying the necessary fiscal adjustments are often understated.
Government expenditures are projected to increase rapidly over the next 30 years due to health obligations such as Medicare and Medicaid coinciding with the aging of the baby boomer generation. And therefore if taxes were immediately brought back to their Clinton-era levels, the government would still be running a deficit so large that the predicted debt to GDP ratio in 2040 would be over 200%. The adjustments necessary to make the budget policy “feasible” right now is quite large, and every year the adjustment is postponed, the debt-to-GDP ratio gets larger as the government must issue more debt to maintain its level of expenditures—the higher the debt, the higher the necessary adjustment. As such, budget deficits are not inherently bad for growth., but they require future fiscal adjustments. The caveat is that a budget deficit must insure that the required future fiscal adjustment is not so large or burdensome that it would cripple the nation., as many say eliminating Medicare and Social Security or raising taxes to far above Clinton-era levels would. I am not suggesting that the fiscal adjustment must occur now, for it is likely that the economic consequences of rashly cutting the deficit now would be so detrimental to recovery that it is favorable to wait. However, the stakes are high, and the federal government must realize that it is walking a fine, dangerous line that without careful management and consideration may inevitably force it to single-handily cripple its own economy.
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