This Q&A on the federal deficit is a preview of the "Dialogue with the Fed" that the public is invited to Oct. 18 at the St. Louis Fed.Budget deficits

William R. Emmons

English

Research Papers in Economics

The St. Louis Fed’s new discussion series 
for the public, “Dialogue with the Fed:  
Beyond Today’s Financial Headlines,” 
is under way.  Economists and others 
from the Bank talk about pressing issues 
related to the economy, after which the 
audience asks questions.  William R. 
Emmons, an economist in the Banking 
Supervision and Regulation division,  
will be the featured speaker Oct. 18.   
His talk will be titled “What’s Driving 
the Federal Budget Deficit, and What 
Can We Do About It?”  What follows  
is a preview of his talk, based on ques-
tions he often receives.
Q. Do we really have a problem with our 
federal budget, or has this been blown out of 
proportion?
A. We really do have a problem—in both 
the short-term and long-term.  The reasons 
behind the former are, of course, the recent 
recession and financial crisis; their sever-
ity led to a huge expansion of the deficit.  
It would have been virtually impossible 
to prevent this large increase in the deficit 
after such an economic and financial shock. 
That’s because our laws include many provi-
sions that operate automatically (“automatic 
stabilizers”) with no input from Congress 
or the president unless they choose to revise 
those laws—which they would be loath to do 
during a recession.  Examples of spending 
categories that increase automatically when 
the economy slows include unemployment 
insurance and income-based benefits for 
health care and food.  On the other side of 
the ledger, tax payments by individuals and 
businesses go down when their incomes fall.  
Q. How much are we talking about?
A. Automatic stabilizers were $34 billion 
(7 percent of the deficit) during fiscal year 
2008, $312 billion (22 percent of the deficit) 
during 2009 and $359 billion (28 percent of 
the deficit) during 2010.  (The total deficits 
for these years were $459 billion, $1.413 
trillion, and $1.294 trillion, respectively; the 
Congressional Budget Office [CBO] expects 
the 2011 deficit to come in at about $1.284 
trillion.)  These amounts will taper off if and 
when the economy picks up steam.
Q. But that still leaves about three quar-
ters of the 2009 and 2010 deficits that weren’t 
automatic.  What else was going on?
A. Congress and the president agreed 
to significant increases in federal spend-
ing and decreases in tax revenues intended 
to cushion the blow of the severe recession 
and prevent the economy from sliding into 
a repeat of the Great Depression.  These 
included increased infrastructure spending,  
substantial assistance for state and local 
governments, and purchases of financial 
assets and entire financial institutions—for 
example, Fannie Mae and Freddie Mac.  
Some types of taxes were decreased, and the 
large tax cuts of President Bush’s era that 
were scheduled to expire at the end of 2010 
were extended.
Q. Help me with the math—how much do 
these discretionary deficits amount to?
A. The discretionary components of the 
federal budget deficit during fiscal years 
2008, 2009 and 2010 were $425 billion,  
$1.1 trillion and $935 billion, respectively.  
Q. And what is driving the long-term 
federal budget problem?
A. Two main factors, according to the 
CBO: an aging population and the rapid 
increase in spending on health care.  (See 
related article on pp. 4-5.)
Q. Which budget problem is more serious 
—the short-term or the long-term?
A. The long-term.  In the short term, 
renewed economic growth and a few budget 
adjustments would bring the deficit back 
down to a reasonable level.  Investors both 
at home and abroad show limited concern 
about short-run deficits.
On the other hand, we know the long-
term problem is being taken more seriously 
by investors because, in part, Standard & 
Poor’s downgraded the Treasury’s long-term 
debt recently.  And financial history is full 
of countries that let their deficits run out of 
control to the point that the interest on the 
debt itself starts to compound at a frighten-
ing pace.  At some point, these countries 
cannot raise enough tax revenue or borrow 
from investors, and they default. 
 
Q. Couldn’t the government refinance its 
debt at low interest rates for the long haul, 
just as an individual combines his credit-card 
and other debts and takes out a home equity 
loan at a fixed low rate for 30 years? 
A. The Treasury could, in principle, 
borrow a lot more at very long maturities 
to lock in current rates.  It is unlikely to do 
that.  Among the reasons: 
a) The Treasury’s debt-management strat-
egy targets an average maturity of closer to 
five or six years.  This lowers the short-term 
cost of borrowing (shorter maturities are 
cheaper to issue) and conforms to long-
standing practice and market expectations.  
The Treasury believes that it can minimize 
with William R. Emmons
Questions about the Budget Deficit 
of the U.S. Have No Easy Answers
6   The Regional Economist  |  October 2011
DiAlogUE witH tHE fEDits borrowing costs over time by maintain-
ing deep and liquid markets all along the 
Treasury yield curve, from a few days out 
to 30 years.  As for going further out—50 or 
100 years, for example—I don’t think such a 
move would conform to the Treasury’s strat-
egy.  It would also be difficult to maintain 
liquid markets at maturities that extend that 
far into the future.
b) There is no guarantee that current 
long-term rates would be favorable for the 
Treasury.  Long-term rates could go lower—
look at Japan.  
c) Long-term rates are comparatively 
expensive today.  The Treasury pays 3.5 
percent to borrow at 30 years, but it pays 
essentially zero to borrow for a few months. 
Q. What is the tipping point for the debt—
the point where, as you say, deficits run out 
of control and interest on the debt starts to 
compound at a frightening pace?
A. No one really knows.  Some well-
known economists have been preaching 
that a debt-to-GDP ratio of 90 percent is the 
tipping point, based on their study of other 
countries’ debt crises.  Critics of these econ-
omists, however, say that this is a simplistic 
and naïve number based on countries that 
are not relevant for comparison to the U.S.  
As a counter-example, Japan has outstand-
ing government debt of over 200 percent of 
GDP, and that country has had no trouble to 
date in borrowing at very low rates. 
Another approach to this question is to 
look at the very long term—say, 50 or 100 
years out or more—and define the deter-
minants of a sustainable long-run debt 
roll-over strategy.  Economists have done 
this and have concluded that a country 
with a primary budget balance of zero (the 
budget balance excluding interest payments) 
can roll over its debt indefinitely, however 
large it may be, as long as the average inter-
est rate it pays is no higher than the growth 
rate of its potential revenue—essentially, 
the growth rate of the economy.  Looking 
back, the U.S. has been in this position for 
significant parts of its history.  
To be in this position again, we would 
need to bring our primary budget deficit 
down and hope that the economy continues 
to grow while investors continue to accept 
very low Treasury interest rates.  Using fiscal 
year 2011 (Oct. 1, 2010-Sept. 30, 2011) as an 
example, the growth rate of nominal GDP 
was 3.7 percent (through the second quarter 
of 2011), and the average rate of interest 
paid on the outstanding debt was about 3 
percent.  Thus, if these rates persisted indefi-
nitely, we could “afford” a primary deficit of 
about 0.7 percent of GDP each year and still 
roll over our debt successfully, even after 
making interest payments.
Unfortunately, our primary deficit 
during fiscal 2011 was about 7 percent of 
GDP—far too large to be covered by our 
modest financing advantage relative to GDP 
growth.  The point remains, however, that 
it is conceivable the U.S. could roll over a 
very large stock of outstanding debt forever 
under the right circumstances.  In fact, the 
CBO projects that our primary deficit will 
be close to zero by fiscal year 2014 if current 
policies—including the expiration of all 
temporary tax cuts and other scheduled 
provisions—are carried out.
Q. These discussions always end up with 
the experts saying that the only solution is 
to trim Medicare/Social Security for baby 
boomers.  Is that true?
A. Yes, unless we are willing to raise 
taxes a great deal, which would harm the 
economy.  The aging population and federal 
spending on health care are the two issues 
the CBO highlights in its long-term budget 
outlook.  The way the CBO explains it, the 
aging of the population creates big budget 
pressures for a few decades, but then it 
recedes a bit.  The aging of the population 
goes beyond the baby-boom generation, 
however, because even after all baby boom-
ers have died, demographers expect the 
remaining population structure to be per-
manently older on average.  That’s because 
people will keep living longer, and the birth 
rate is flat or declining. 
So, the aging population is a huge issue 
until about 2035; then, it becomes “just” a 
big issue.
Federal health-care expenditures, on the 
other hand, threaten to grow faster indefi-
nitely than the economy and tax revenues 
unless we find a way to bring them under 
control.   
The Regional Economist  |  www.stlouisfed.org   7
On Oct. 18, economist William R. 
Emmons of Banking Supervision 
and Regulation will discuss the 
federal deficit. 
 
On Nov. 21, Christopher J. Waller, 
research director, will discuss the 
ramifications of lingering high 
unemployment rates.
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vides a multitude of ways to learn about the 
economy and economics.  There is something 
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THE FEDERAL RESERVE BANK OF ST. LOUIS: CENTRAL TO AMERICA’S ECONOMY
®  |  STLOUISFED.ORG
CENTRAL
NEWS AND VIEWS FOR EIGHTH DISTRICT BANKERS
F
A
L
L
 
2
0
1
1
FEATURED IN THIS ISSUE:  Earnings Growth Stalls  |  Local House-Price Changes Now Following National Trends
By Gary S. Corner
T
he domestic agriculture industry 
has been thriving over the last 
decade.  According to the U.S. Depart-
ment of Agriculture (USDA), six of 
the past eight years rank among the 
top 10 income-producing years for 
the industry (adjusted for inflation) 
since 1980.  As commodity prices and 
farm incomes soared, farmland prices 
Agriculture Banks Are Outperforming  
Their Peers, But How Long Will It Last?
also surged.  Ancillary agricultural 
businesses, such as farm equipment 
manufacturers and dealers, have also 
benefited from recent farm prosperity.  
As a result of strong industry con-
ditions in recent years, agriculture 
banks have generally outperformed 
community banks without an agri-
cultural focus.  The level of problem 
continued on Page 7
Agriculture Bank Performance Assessment
District Ag Banks 
(137)1
District Non-Ag Banks  
(483)
U.S. Ag Banks  
(1,517)
U.S. Non-Ag Banks  
(4,381)
2011 2010 2011 2010 2011 2010 2011 2010
ROA 1.05% 0.73% 0.80% 0.77% 1.06% 0.96% 0.49% 0.29%
Nonperforming Loans + OREO / Total Loans + OREO2 2.39 2.37 4.27 3.71 2.51 2.56 5.66 5.38
Tier 1 Capital Ratio 10.31 10.41 9.70 9.44 9.91 9.93 9.69 9.44
Net Interest Margin 3.97 4.00 3.88 3.80 3.91 3.99 3.84 3.79
Average CAMELS Rating3 1.89 1.84 2.18 2.16 1.89 1.86 2.44 2.39
Provision Expense / Average Assets 0.36 0.64 0.39 0.45 0.24 0.41 0.54 0.77
Loan Loss Reserve / Nonperforming Loans 95.21 86.74 68.29 70.38 93.12 79.87 54.71 50.27
Ag Production Loans / Total Loans 11.60 12.09 1.94 2.04 20.96 21.75 1.40 1.42
Farmland Loans / Total Loans 25.17 25.46 5.21 5.21 21.26 20.33 3.00 2.88
Total Ag Loans / Total Loans 36.77 37.55 7.15 7.26 42.22 42.08 4.40 4.30
SOURCE:   Reports of Condition and Income for Insured Commercial Banks.  This assessment covers only banks with less than $1 billion in assets.
NOTES:  1 The Federal Reserve’s Eighth District has 137 agriculture banks, with most having less than $1 billion in assets.  The average asset size of an agricul-
ture bank nationwide is $128 million.  A bank is defined as an agriculture bank if the combined agricultural production and farmland loans account for 
25 percent or more of its total loans.
  2  The nonperforming loans + OREO (other real estate owned) ratio measures the percentage of problem loans and real estate property held by banks 
after foreclosure.  High percentages of these types of assets undermine a bank’s health and severely impair earnings.
  3 CAMELS stands for the composite supervisory rating for Capital, Asset Quality, Management, Earnings, Liquidity and Market Sensitivity.
To keep abreast of this series,  
see www.stlouisfed.org/dialogue
The first Dialogue with the Fed 
was Sept. 12.  Julie Stackhouse, 
senior vice president of Banking 
Supervision and Regulation, 
discussed lessons learned from 
the financial crisis.

Questions about the budget deficit of the U.S. have no easy answers

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Questions about the budget deficit of the U.S. have no easy answers

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