The Economics of Budget Deficits

by robekulick

I just finished reading this essay by Greg Mankiw on the economics of budget deficits:

It’s concise, clear, fairly easy to read, and avoids mathematical pyrotechnics. Since there’s been a lot of discussion of deficits recently, it’s a very good introduction to economic thinking on the subject.

Although most people think of a country’s budget deficit as similar to debt incurred by a household, this isn’t necessarily an apt metaphor. Mankiw considers the economics in terms of a dichotomy between national deficits under normal conditions, ie when the debt to GDP-ratio does not undermine faith in financial markets, versus deficits in times of fiscal strain, ie when debt to GDP-ratios become sufficient to raise the specter of default.

A quick summary of Mankiw’s points:

Under normal circumstances , the effects of a deficit are the crowding out of investment, as money that would have gone into private investment is instead loaned to the government, and increased holding of US assets by foreign investors. However, the deficit allows consumption to increase in the near-term.  This situation leads to sets of winners and losers in the economy, but there is no clear determination as to whether we are worse off as a whole.

Since the decrease in capital causes interest rates to rise, holders of capital, that is holders of wealth benefit. Since labor is a complement to capital, a decrease in capital causes the productivity of labor to fall and thus real wages fall.  Since the holders of capital tend to be wealthy and workers tend to be less wealthy, deficits redistribute income from the poor to wealthy in the future which many would view as an undesirable consequence.

Furthermore, since deficits reduce national income in the future but increase present consumption, deficits are effectively a transfer from the future to the current population. You can view this as taking resources from posterity but you can also reason that since people in the future will be richer as a result of better technology, it is fair for us to use greater resources now. Economics doesn’t really provide a simple answer to this question.

So under normal circumstances, deficits have mixed economic effects. Many people will find these effects unpalatable, but there isn’t a definitive answer as to whether deficits are bad are good.  One final note is that some economists have postulated that the level of technological advance in an economy is directly related to the accumulation of capital. To the extent this is how technology evolves (I’ve always subscribed to this view) the crowding out of investment reduce technological advance which is another negative factor.

However, when deficits become very large as a percentage of GDP, the economic consequences of deficits can become much more clearly negative. Although Mankiw wrote this in the 1990s, the economics of unsustainable budget deficits are playing out in Europe as we speak.

Essentially there are two major problems with unsustainable budget deficits. The first is that since the burden of a deficit is very much tied to economic growth, what seemed like a sustainable budget deficit may very quickly become unsustainable in a time of recession. A country (Greece) may very well find itself unable to finance itself leading to a dramatic decrease in consumption (austerity) precisely when consumption has already taken a substantial hit because of recession.

Second, the bonds issues by governments to create deficits are a crucial piece of the banking system. The reserves that banks hold are very often government bonds. Default by governments can then lead to a financial crisis.

I’ll sum up by quoting the last paragraph in Mankiw’s paper because it ties the issues together very well:

“Previous sections of this paper have described well-understood and quantifiable effects of budget deficits, such as crowding out of capital and intertemporal shifts in tax burdens. By contrast, this section has been highly speculative. We can only guess what level of debt will trigger a shift in investor confidence, and about the nature and severity of the effects. Despite the vagueness of fears about hard landings, these fears may be the most important reason for seeking to reduce budget deficits. If the main effects of deficits are moderate redistributions across generations and groups of people, perhaps they should not be a central concern of policymakers. But as countries increase their debt, they wander into unfamiliar territory in which hard landings may lurk. If policymakers are prudent, they will not take the chance of learning what hard landings in G-7 countries are really like.”