Here’s a neat figure from Wonkbook today, showing the difference, in CBO’s opinion—one that matches mainstream econ—between the deficit’s impact on growth in the near term vs. the long term. In the near term given current conditions here and in most of Europe, deficit reduction is contractionary; in the longer term, lower deficits lead to lower interest rates, and are thus positive for growth.
My first thought was “sure” re the near term but “hmmm” re the long term. The evidence for lower deficits leading to lower interest rates is surprisingly weak. It’s largely predicated on the “crowding out” hypothesis, where the government competes with private investors for scarce capital, putting upward pressure on rates. That’s baked into all the major macro models, it’s definitely plausible, and the evidence shows at least weak correlations. But perhaps the fact of increasingly mobile, global capital or more interventionist central banks at work, you don’t see much of this in the data.
So, why not just go the Dick Cheney place and not worry about budget deficits at all? Well, a) because who’d want go to Dick Cheney’s place, b) rising debt/GDP levels (meaning primary deficits, i.e., deficits>~3% of GDP) makes us more vulnerable to interest rate spikes, wherever they come from, c) rising debt/GDP politically means we’ll be less able to add to the debt when we hit the next downturn, and d) structurally, you want you debt ratio growing in weak times and falling in bona-fide expansions–the definition of a sustainable fiscal path.
Source: CBO, Wonkblog.
[PS: Why do CBO graphs all look like they were made by Darth Vader these days?]