Arnold Kling  

The Deficit Argument

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Kevin Hassett believes that the U.S. budget deficit is a matter more of politics than economics. On the issue of deficits and interest rates, he writes

My own view is that there are many close substitutes for U.S. government bonds in the world today (Fannie Mae's, corporate bonds, foreign government bonds) and that the historical swings in U.S. deficits are so small relative to the stock of existing debt that it would be miraculous if debt did have much of an effect on interest rates

Brad DeLong would want to know what the meaning of "much" is. More important, DeLong worries that current fiscal policy is not a "swing" in the deficit but a large, permanent change.

The effect of the policy (and forecast) changes between 2003 and 2004 has been to widen future deficits (and eliminate future surpluses) by an amount that averages 2.7% of GDP--roughly $300 billion dollars a year--in each of the next seventeen years (and thereafter as well). The Bush Administration policy changes look much, much, much more like a permanent widening of the deficit than a transitory one-year fiscal stimulus that is then reversed.

All economists would agree that for the government to plan to incur an ever-increasing debt burden (cumulative deficit) as a percent of GDP is not a good thing. One can argue about the impact on interest rates, in part because interest rates and deficits are both endogenous variables that are affected by many factors. But in my view, the debate over how much deficits affect interest rates sheds more heat than light on the topic of fiscal policy. The real question is whether the debt burden is going to outgrow the economy, or vice-versa.

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CATEGORIES: Macroeconomics

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Matthew Zobian writes:

The real question is, indeed, "whether the debt burden is going to outgrow the economy, or vice-versa." If a public debt burden is outgrowing the country's ability to service it, this is called an 'unsustainable debt'. The usual government recourse is to shrink the public debt in real terms by inflating the economy. Thus, a public debt that is deemed unsustainable leads to, among other things, inflation expectations and higher long term interest rates.

This begs the question: how do we determine if a country's public debt is sustainable or not? That can be answered by simple partial equilibrium models or more complex temporal budget constraint analysis.

My URL points to a paper I wrote that explains a simple model for testing public debt sustainability.

Such models can remove most (alas, never all) of the political debate surrounding deficits and debt, and whether they are good or bad, small or excessive.

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