An argument that despite ballooning federal debt levels, no proof exists that government budget deficits are related to interest rates or real exchange rates, and that the size and composition of the government's budget are at least as critical as the federal deficit in determining the nation's long-term economic growth.Budget deficits

Owen F. Humpage

English

Research Papers in Economics

eCONOMIG
GOMM0NTCIRY
Federal Reserve Bank of Cleveland
Do Deficits Matter?
by Owen F. Humpage
June 15, 1993
A he federal debt keeps rising, like a
monster from the sea, and now threatens
to take a $ 12,700 bite out of each of us.'
Many observers blame the deficit beast
for—among other things—high real in-
terest rates, an overvalued dollar, and the
deterioration in our international ac-
counts, and they warn that it will inevita-
bly gnaw away at our standard of living.
With national concern rising, President
Clinton has made deficit reduction a fo-
cus of his economic policy, and his oppo-
sition has found it a convenient topic for
political haranguing.
Yet, large budget deficits have persisted
for more than a decade with few, if any,
such dire predictions coming to pass.
This has encouraged many economists
to reexamine the effects of persistent
budget shortfalls. Many now regard
deficits as rather innocuous and focus
instead on the overall level of govern-
ment spending and on how specific fis-
cal programs that underlie the budget
directly affect private decisions to con-
sume, work, save, and invest. Amid a
swirl of proposed tax hikes, expenditure
cuts, and constitutional amendments to
the federal budget process, we should
realize that slaying the deficit behe-
moth may prove of little consequence.
• Budget Deficits
and Government Debt
The federal government runs a deficit
when its expenditures exceed its re-
ceipts, and it must issue debt (Treasury
securities) to cover the difference.
When shortfalls persist year after year,
the outstanding debt of the federal gov-
ernment rises. With an 11-year string
of triple-digit deficits, the ratio of U.S.
publicly held debt has risen from 26.5
percent of gross domestic product
(GDP) in 1981 to 51.1 percent of GDP
last year (see figure 1). According to
Congressional Budget Office estimates,
which assume no changes in current
policies and moderate overall economic
growth, the debt ratio will approach 80
percent of GDP by 2003, higher than at
any time since 1950."
• The Conventional View
According to the conventional view,
deficits can be both a blessing and a
curse. When the economy is in a reces-
sion or otherwise is operating below its
full potential, an increase in govern-
ment spending or a decrease in taxes
can provide stimulus, particularly if the
government borrows to finance this fis-
cal program. As the effects of the initial
tax cut or federal spending program rip-
ple through the economy, aggregate de-
mand expands by a substantial multiple
of the fiscal initiative, and employment
rises. The deficit may put some upward
pressure on interest rates, but because
the private economy is operating below
its full capacity, conventional-view pro-
ponents consider this effect rather mild
compared to the more direct, favorable
effects of the fiscal stimulus on aggre-
gate spending.
In a similar way, government can rely
on fiscal policy—this time tax hikes,
expenditure cuts, and budget sur-
pluses—to rein in economic activity
when the economy returns to its full po-
tential. The government budget then be-
comes an instrument with which to fi-
nesse real economic activity around its
optimal growth path.
Despite widespread anxiety about bal-
looning federal debt levels, there is no
decisive evidence that government
budget deficits are related to interest
rates or real exchange rates. At least
equally critical to determining the na-
tion's long-term economic growth are
the size and composition of the gov-
ernment's budget.
According to common view, when out-
put is below par, a fiscally induced ex-
pansion of current income does not
come at the expense of future eco-
nomic growth. Problems can arise,
however, if the government continues
to borrow after the economy reaches
full employment. To sustain long-term
growth, the nation must save and in-
vest in productive capacity.
The deficit places private and public
borrowers in competition for the avail-
able supply of national savings. Inter-
est rates will rise both to encourage
some additional saving and to discour-
age private investment. Government
borrowing, however, is insensitive to
higher interest rates. With some luck,
the most immediate effect of this
crowding out of private investment
may only be a change in the composi-
tion of national output: an increase in
the relative size of the government sec-
tor. However, conventional belief holds
that a persistent deficit will lower the
economy's long-term potential growth
path, implying an inevitable reduction
in the nation's standard of living.
ISSN 0428-1276The exact nature of this crowding-out
effect depends crucially on the extent to
which capital is internationally mobile. If
persistent government borrowing in-
creases domestic interest rates relative to
foreign interest rates, offshore investors
will begin acquiring interest-earning
assets in the country with the higher
rates. This capital inflow will mitigate the
rise in domestic interest rates, thereby
limiting the crowding out of private
domestic investment.
To purchase assets in the domestic econ-
omy, however, foreigners must first ac-
quire the domestic currency in the for-
eign exchange market. This causes the
domestic currency to appreciate, which
then increases the foreign-currency price
of the deficit country's exports and low-
ers the domestic-currency price of its im-
ports. All else equal, the trade balance
will then deteriorate, according to the
conventional view.
As the discussion reveals, however, the
inflow of foreign capital does not elimi-
nate crowding out. It merely shifts this
effect from interest-rate-sensitive to
exchange-rate-sensitive sectors of the
economy. When financed internally, per-
sistent deficits lower private investment,
leaving future generations with a smaller
stock of capital to sustain real economic
growth at potential. When financed exter-
nally, persistent deficits do not lower the
future stock of capital, but the deficit
country must now devote a greater por-
tion of its future output to servicing its
foreign debts. The domestic standard of
living (what is left per capita for domes-
tic consumption) may then be lower. Pro-
ponents of the conventional view often
point to events of the past decade—the
rapid appreciation of the dollar early on,
the subsequent record deterioration of the
U.S. trade balance, and the eventual shift
in our international investment position
to debtor status—as a classic example
of this type of crowding out.
• Is It the Deficit?
Despite its prominence, the conven-
tional view of budget deficits lacks de-
cisive statistical support. A glance at
figures 2 and 3 reveals no clear correla-
tion between federal budget deficits
Percent of GDP
81
FIGURE 1 THE U.S. FEDERAL BUDGET DEFICIT
AND DEBT HELD BY THE PUBLIC
Percent of GDP
190
1962 1966 1970 1974 1978 1982 1986 1990 1994 1998 2002
Fiscal year
FIGURE 2 THE U.S. FEDERAL BUDGET DEFICIT
AND THE REAL TRADE-WEIGHTED DOLLAR
Change, $ billions Index, March 1973= 100
100
Real trade-
weighted dollar i
1973 1975 1977 1979 1981 1983 1985 1987 1989 1991 1993
SOURCES: Congressional Budget Office, The Economic and Budget Outlook: Fiscal Years 1994-199H, Washington, D.C.:
U.S. Government Printing Office, January 1993; and Board of Governors of the Federal Reserve System.
and either the real trade-weighted dol-
lar exchange rate or real interest
rates. Taken together, sophisticated
empirical studies of the causal relation-
ship between budget deficits and these
same variables are inconclusive. Al-
though these findings do not necessar-
ily refute the standard view, they have
encouraged many economists to con-
sider other possibilities. Perhaps defi-
cits are not the problem. Could a causal
relationship run between these eco-
nomic variables and the types of spend-
ing and taxation policies that also pro-
duced the deficit, instead of directly
between the variables and the deficit it-
self? Does the relative size of the gov-
ernment sector influence a nation's eco-
nomic growth and standard of living?
If so, eliminating the deficit without
changing underlying fiscal programs
might not reduce interest rates or depre-
ciate the exchange rate. It could have
exactly the opposite effect.
• Deficits Don't Matter
An alternative view claims that under
certain assumptions, deficits and taxes
are equivalent. Although the types or
levels of government spending might
affect economic activity, the method of
financing those activities is irrelevant.
Deficits do not matter. This approach
rests on two plausible presumptions:
First, governments must ultimately pay
for their debts, so that the present value
of their expenditures must equal the
present value of their expected re-
ceipts. Second, taxpayers realize that
deficits imply a future tax liability for
themselves or their heirs and, there-
fore, increase their current saving by
an amount equal to the present dis-
counted value of this future tax bill. In
this case, taxes and government debt
become equivalent means of financing
government spending. Because an off-
setting increase in private saving
matches any rise in the deficit, public
borrowing has no effect on real interest
rates or real exchange rates.
Although many find its assumptions
rather stringent, the equivalence theo-
rem nevertheless presents an internally
consistent model, which empirical tests
have not clearly refuted.
7 One can,
therefore, consider how changes in itsFIGURE 3 THE U.S. FEDERAL BUDGET DEFICIT AND THE REAL ONE-YEAR TREASURY BILL RATE
Change, S billions
100
Percent
15
Deficit
Anticipated real rate
a
-10
1973 1975 1977 1979 1981 1983 1985 1987 1989 1991 1993
a. Anticipated real rate equals one-year Treasury bill rate minus Michigan Survey of Inflation Expectations.
b. Actual real rate equals one-year Treasury bill rate minus inflation as measured by the Consumer Price Index.
SOURCES: Board of Governors of the Federal Reserve System; and the University of Michigan, Survey of Consumers.
underlying premise might invalidate the
theorem and create the conventional link-
age between budget deficits, interest rates,
and exchange rates. An important assump-
tion concerns the nature of taxes.
The equivalence theorem presupposes
that taxes are lump-sum; that is, they
are straightforward dollar assessments
as opposed to being a proportion of in-
come, wages, or expenditures. Lump-
sum taxes do not affect individuals'
saving and working decisions. Assume,
for example, that the equivalence theo-
rem holds and that the government of-
fers a deficit-producing tax cut. The in-
clination of taxpayers is to offset their
implied future tax liabilities, and they
will do this exactly if the tax reduction
is lump-sum. The effects of the deficit
and tax cut on national savings will net
out with no impact on interest rates.
If, however, the tax cut also serves to
alter the return on savings relative to
consumption, it will induce consumers
to change their consumption and sav-
ing behavior independent of their de-
sire to finance their future tax liabili-
ties. The effects of the deficit and the
tax reduction on savings will not net
out, in which case interest rates will
change. Accordingly, the non-neutral
effect of taxes on saving decisions may
account for any apparent link between
the deficit and the interest rate.
• A Balanced-Budget Connection
Those unwilling to accept the supposi-
tions of the equivalence theorem can
uncover similar connections between
key economic variables and specific
types of spending and taxation policies
by imagining that the federal budget
were always balanced. A spending in-
crease, financed by a tax hike, would
transfer current purchasing power be-
tween the government and private sec-
tors. The resulting effect on interest
rates and exchange rates would depend
only on how the government's spend-
ing patterns compared to those of the
private sector. Suppose the government
temporarily increased its revenue by
$100 through a lump-sum tax and
spent this on current output. For every
dollar paid in additional taxes, how-
ever, the private sector might reduce
consumption by 95 cents and lower
savings by 5 cents. Because the govern-
ment spent all of its tax revenue on cur-
rent output, and because the public
failed to cut its consumption by the full
amount of the tax, this transfer from
the private to the public sector would
reduce national savings. Real interest
rates would then rise to balance sav-
ings and investment.
Similarly, private individuals spend their
income on a host of domestic and im-
ported goods. If government buys only
domestically produced goods, the result-
ing increase in their demand relative to
foreign goods would tend to appreciate
the domestic currency in world markets.
In these examples, fiscal policies produce
adverse effects on interest rates and ex-
change rates, but these effects do not de-
pend on the existence of a deficit, as sug-
gested in the standard view. They arise
solely because of differences between
government and private spending pat-
terns. When one considers permanent
changes in government spending, even
lower interest rates are possible.
• What's Missing from the Debate?
Popular discussions of the budget fo-
cus almost exclusively on the size of
current and prospective deficits, and
current debates about budgetary poli-
cies typically concentrate on how the
nation might equitably share the burden
of reducing the deficit. Yet, the empiri-
cal evidence and theoretical arguments
outlined above suggest that government
budget deficits may be unrelated to in-
terest rates or real exchange rates and
that they pose no direct threat to our
economic well-being.
This does not mean, however, that gov-
ernments' fiscal actions have no bear-
ing on a country's ability to grow and
prosper. The relationship is substan-
tially more complicated than generally
acknowledged, and depends on the rela-
tive size of government and on the
types of spending and taxation pro-
grams inherent in the budget.
Over the last three decades of persistent
and generally expanding federal budget
deficits, other profound fiscal changeshave taken place in the United States.
Most notably, the federal government has
greatly expanded its influence over the al-
location of economic resources. One di-
rect example is the steady rise in govern-
ment expenditures from approximately 19
percent of GDP in the early 1960s to
roughly 23 percent of GDP in the early
1990s, but others are found in the expan-
sion of federal off-budget spending, loans
and loan guarantees, and other mandates.
In addition, the composition of federal
spending and taxation has changed. Enti-
tlement programs have doubled as a per-
centage of GDP since the early 1960s, and
social insurance taxes to pay for them
have ballooned from 19 percent to 38 per-
cent of total revenues.10
The behemoth deficit casts a long shad-
ow, which seems to have obscured from
our critical review other important as-
pects of fiscal policy. The size and com-
position of a government's budget are
important determinants of its long-term
economic growth. Higher proportions
of nondefense, noneducation govern-
ment spending relative to GDP across
different countries appear to be corre-
lated with lower rates of per capita
GDP growth.'' This relationship may
reflect the distortionary effects of taxa-
tion and spending programs on individ-
uals' decisions to consume, work, save,
and invest. If so, how we attempt to
slay the deficit beast may be more impor-
tant than whether we actually succeed.
• Footnotes
1. The Congressional Budget Office ex-
pects publicly held debt in fiscal year 1993
to be $3,290 billion. See Congressional
Budget Office, The Economic and Budget
Outlook: Fiscal Years 1994-1998, Washing-
ton, D.C.: U.S. Government Printing Office,
January 1993. U.S. population will be ap-
proximately 259 million at the end of fiscal
year 1993.
2. Some economists complain that the fed-
eral budget deficit merely reflects arbitrary
accounting rules and is devoid of economic
meaning. See Alan J. Auerbach, Jagadeesh
Gokhale, and Laurence J. Kotlikoff. "Gen-
erational Accounts: A New Approach to Fis-
cal Policy Evaluation," Federal Reserve
Bank of Cleveland. Economic Commentary,
November 15, 1991.
3. See Congressional Budget Office, The
Economic and Budget Outlook (footnote 1).
4. In figures 2 and 3, the deficit is the
change in outstanding publicly held govern-
ment debt less that held by the Federal Re-
serve System; the anticipated real interest
rate is a 12-month Treasury bill less ex-
pected inflation as measured by the Michi-
gan Survey. The actual real interest rate is a
12-month Treasury bill less the actual infla-
tion rate in the period.
5. For references to the empirical work, see
the articles contained in "Symposium on the
Budget Deficit," Journal of Economic Per-
spectives, vol. 3, no. 2 (Spring 1989), pp.
17-93.
6. An introduction with references to the
literature is found in Robert J. Barro, "The
Ricardian Approach to Budget Deficits,"
Journal of Economic Perspectives, vol. 3,
no. 2 (Spring 1989), pp. 37-54.
7. See John J. Seater, "Ricardian Equiva-
lence," Journal of Economic Literature, vol.
31, no. 1 (March 1993), pp. 142-90.
8. A more detailed discussion is found in
Owen F. Humpage, "An Introduction to the
International Implications of U.S. Fiscal Pol-
icy," Federal Reserve Bank of Cleveland,
Economic Review, vol. 28, no. 3 (1992
Quarter 3), pp. 27-39.
9. Government debts, of course, cannot
grow without bound, and under some sce-
narios can grow explosively. See John B.
Carlson and E.J. Stevens, "The National
Debt: A Secular Perspective," Federal Re-
serve Bank of Cleveland, Economic Review,
vol. 21, no. 3 (1985 Quarter 3), pp. 11-24.
10. For data on budget trends, see Congres-
sional Budget Office, The Economic and
Budget Outlook (footnote 1).
11. See Robert J. Barro, "Economic Growth
in a Cross Section of Countries," Quarterly
Journal of Economics, vol. 106, no. 2 (May
1991), pp. 407-43.
Owen F. Humpage is an economic advisor at
the Federal Reserve Bank of Cleveland. The
author wishes to thank David A/tig, John
Carlson, and Mark Sniderman for comments
and Lydia Leovic for research assistance.
The views stated herein are those of the
author and not necessarily those of the Federal
Resene Bank of Cleveland or of the Board of
Governors of the Federal Resene System.
Federal Reserve Bank of Cleveland
Research Department
P.O. Box 6387
Cleveland, OH 44101
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Do deficits matter?

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Do deficits matter?

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