A Short Note on Deficits and Growth

March 6th, 2013 at 2:53 pm

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?]

Print Friendly

5 comments in reply to "A Short Note on Deficits and Growth"

  1. Figs says:

    Since we’re already below potential GDP, I’d be interested to see how these different scenarios play out over the course of the whole 10 years. That is, in the case where deficit reduction of $4 trillion is achieved, is the gain in 2023 (and presumably earlier) enough to offset the loss in 2014? Is the assumption that all of this deficit reduction is applied uniformly over the 10 years? What if it’s backloaded?


  2. rjs says:

    Laurence Ball, Douglas W. Elmendorf, N. Gregory Mankiw:

    “The historical behavior of interest rates and growth rates in U.S. data suggests that the government can, with a high probability, run temporary budget deficits and then roll over the resulting government debt forever. …whenever a perpetual rollover of debt succeeds, policy can make every generation better off. … the adverse effects of deficits, rather than being inevitable, occur with only a small probability.”

    http://www.nber.org/papers/w5015


  3. Kevin Rica says:

    The whole debate on the deficit and growth in this country is remarkably uninformed because it completely decoupled from the issue of the issue of international rebalancing, global oversavings (Benanke’s Saving’s Glut), and America’s misguided role of reserve currency issuer.

    If you want to understand the problem, it is is very-well explained by Michael Pettis’ book “The Great Rebalancing: Trade, Conflict, and the Perilous Road Ahead for the World Economy” from Princeton University Press.

    http://press.princeton.edu/titles/9936.html

    It’s time the Democratic Party (and Larry Summers) realized that the world has changed and it’s no longer 1996. Reliving (reviving) the old formulas from Bob Rubin (or Paul Samuelson) is akin to Captain Queeg’s search for the strawberries.


  4. Smith says:

    Re: “Macroeconomic Effects of Alternative Budgetary Paths”

    This report does not merit serious attention if you look closely at the assumptions made in the document:

    “Productive investments by the government can also increase output by raising productivity in the private sector. However, the unspecified changes in deficits that differentiate the three paths were assumed to leave government investment unchanged.”

    So the $2 trillion dollars is spent how? Thrown on a fire to heat the Capital building? I guess it doesn’t matter since we wouldn’t want to deprive investors the opportunity to finance the next Facebook or Foursquare, which is obviously way more important than increasing money for cancer research or bridge repairs.

    http://www.cbo.gov/sites/default/files/cbofiles/attachments/43769_AlternativePaths_2012-2-5_0.pdf

    The paper specifically cites concern over deficit spending crowding out private investment explaining:

    “That reduction in capital investment would, in turn, lower pretax wage rates.”

    As an aside, Europe is finding out sticky wages don’t drop. But moreover, private enterprise has failed to raise wages with investment.

    Finally, the numbers used are silly (correct me if I’m wrong). An average post WWII 10 year increase would be closer to $3 trillion accompanied by 2.5% to 3% GDP growth. Decreasing $4 trillion instead of historical increase trend of $3 trillion, a swing of $7 trillion doesn’t sound like a recipe for success. Note: neither the paper nor this comment address present emergency recovery expenditures and revenue loss from under performance.

    (eek, left this under wrong blog entry “Some thoughts … slog” by mistake, belongs here)


  5. Mike says:

    CBO has been saying that real economic growth is 4 years in the future — for the last four years. There’s no reason to believe their “model” is any good in the current environment. The quality of the model is highlighted in Smith’s comment where he notes that the 2 Trillion dollars of extra federal debt is assumed to never make it into the economy either as government investments nor as crowding-in to increase private investments.

    Elmendorf ought to be ashamed.


Leave a Reply

Your email address will not be published.

Current month ye@r day *