Sense and Nonsense About Budget Deficits

Almost everybody talks about federal budget deficits. Almost everybody is against them in principle. And almost no one knows what he or she is talking about. Maybe it goes back to something deep in our Calvinist heritage, that we must suffer rather than borrow. “No gain without pain,” goes the modern version. We must raise taxes or cut useful govern-for a better future. Or perhaps it has more recent political roots. Franklin D. Roosevelt pledged but never managed to “balance the budget,” and Republicans attacked Democrats over budget deficits for the next 50 years. Then, with the huge Reagan-era deficits, Democrats thought they had their chance and turned the tables on the issue. In charting his independent course, Ross Perot has made the deficit his principal issue and has advanced a number of extreme “solutions” to the problem, including a balanced-budget amendment to the Constitution. President Clinton, in his initial State of the Union address on the economy, was constrained to present a comprehensive deficit reduction package. The public has always agreed in wide proportions that the deficit should be eliminated. But it is far from clear that any candidate—Republican, Democrat, or Independent—has ever won an election with this position. In fact, many have lost by opposing popular deficit-increasing measures or by supporting tax increases to reduce it. With all the hoopla about deficit reduction, a Gallup poll reported at the time of Clinton’s first State of the Union address is significant. Asked, “Which is more important, creating jobs or reducing the deficit?,” 65 % of respondents chose “creating jobs” and only 28 % “reducing the deficit.” The public may well not understand the choice, but, as we shall confirm, deficits can indeed create jobs. Deficits can be good for us, as well as bad. And deficits can be too small as well as too large. To know which, you at least have to measure them right. What Is the Deficit and How Is It Measured? Few people have any notion how the federal budget deficit is measured. Many, including the major TV news anchors, editorialists in leading newspapers such as The New York Times, and countless politicians, do not even seem to know the difference between deficit and debt. The deficit is the amount by which expenditures exceed tax revenues in a given period or, in the more comprehensive official jargon, “outlays” exceed “receipts,” and hence the amount that must be borrowed or added to the debt over that period. The debt is the amount owed at any point in time—what has been borrowed and not paid back. President Clinton himself, in his Inaugural Address, succumbed to the public looseness of phrase, if not general confusion, in saying that we must “cut our massive debt.” If he meant the federal debt, that in fact is quite beyond reasonable possibility in the foreseeable future. Clinton has more realistically talked of cutting the deficit by $ 140 billion as against forecasts of what it will be in 1997. But that would still leave a deficit of some $ 206 billion and the debt hence growing by that amount annually. Only a budget surplus would reduce the debt. Yet we still hear the President and others talking about reducing the debt. Witness the pious Mobil advertisement that argues, “Clearly, one of President Clinton’s and the 103rd Congress’s primary tasks must be to reduce the federal debt to the extent practical as soon as possible,” adding inexplicably the internally redundant clause, “and to balance the budget to prevent further deficits.” Many do not understand the measures of the debt about which they speak so much. The most frequently cited figure, something over $ 4 trillion now, is a gross “total,” which includes over $ 1 trillion of “debt” held within the government, largely by trust funds such as those for Social Security for old age and retirement. But a more meaningful figure, relevant to household spending, financial markets, and business decisions, and excluding accounting transactions between one arm of government and another, is for what is called the “gross federal debt held by the public.” This came, at the end of the 1992 fiscal year, to almost exactly $ 3 trillion. We have a vast number of measures of the federal deficit, most of which would horrify any private or public accountants worth their salt. Aside from differences between the Bureau of Economic Analysis national income accounts and the Office of Management and Budget and Congressional budgets, budgets with and without “deposit insurance” outlays (chiefly for the Savings and Loan bailout), our federal accounting violates a basic principle of accounting for private business, most state and local governments in the United States, and national governments across the globe: it does not distinguish between current or operating outlays and capital expenditures. Most of our vast number of measures of the federal deficit would horrify any accountants worth their salt. If there were no separate capital accounts, almost every large corporation in the United States would be reporting “deficits” or losses. Of course, this is not so. Private businesses exclude capital outlays from their current accounts and charge only depreciation when presenting their income (or profit) and loss statements. In a growing company, current investment is virtually always greater than depreciation, which is an average of past investment. Including depreciation rather than current investment thus permits profitable companies to keep their bottom line in the black. And many state and local governments in the United States, required by their constitutions to balance their current or operating budgets, finance capital outlays (like roads and bridges and new water systems or school buildings) separately, by borrowing. Even this, however, would not now do much for the federal government deficit. Assume, counter-factually, that federal accounting conformed to private business practice and included in the budget only the depreciation on past tangible investment, not current tangible capital investment. The resulting U.S. federal budget deficit would be virtually the same as the overall deficits generally reported. This is a manifestation of something of which we should be much more aware—virtually zero net public investment in physical infrastructure. Our public physical plant is wearing out at least as fast as it is being replaced. A more comprehensive measure of investment, though, would include the OMB’s estimates of “Major Federal Capital Outlays” for research and development and education and training as well as physical capital. If we used this measure, net investment, reflecting (however inadequately) the needs of our growing population, would be positive. Its exclusion would reduce the measure of the deficit by perhaps $ 80 billion of the $ 290 billion reported for our last fiscal year. Given some $ 175 billion per year of federal grants to state and local governments, it might make some sense to present a consolidated account for all of government, as the U.S. Bureau of Economic Analysis does in its national income and product accounts. If we do that and then separate out all capital expenditures, for both tangible and intangible investment, we find that while the total consolidated 1991 budget retains a deficit of $ 193 billion, the current account portion of that deficit is only $ 24 billion. A large part of the deficit is accountable directly to our slow economy and high unemployment. The U.S. Congressional Budget Office indeed estimates that each percentage point of unemployment adds, in the short term, $ 50 billion to the deficit, with the amount growing over time as additional deficit adds more to debt and subsequent interest payments. If national unemployment in 1993 were merely back at its 5.3 % average of the years 1988 to 1990—instead of hovering at nearly 7 % —the deficit would be $ 100 billion less; by 1996, as a consequence of interest payment savings on a lesser accumulated debt, it would be some $ 130 billion less. Virtually all of the Clinton-Gore Administration’s commitment to deficit reduction could be realized by that minimal reduction in unemployment. Achieving a 4 % unemployment rate, which has long been a target, or a 3 % rate such as during the Vietnam War, could bring about an even greater reduction in the deficit. The Office of Management and Budget, in its final document released by President Bush, offered “baseline” deficit estimates grounded on the relatively pessimistic economic outlook of 51 private “blue chip” forecasters. They foresaw real GDP growth of only 3 % in 1993, 2.9 % in 1994, and then down to 2.5 % from 1995 to 1998; unemployment was still projected at 5.7 % for 1998. The OMB also presented deficit estimates on the basis of “high-growth” projections, which had the GDP increasing in successive years at 3.5 % , 4.0 % , 3.7 % , 3.4 % , 3.2 % , and 3.0 % , with unemployment down to 5.0 % in 1998, its level in March, 1989 at the beginning of the Bush Administration. I have added estimates of what the deficit would have been in any year over which unemployment had averaged 5 % . These were calculated on the assumption, consistent with Congressional Budget Office calculations, that each percentage point reduction in unemployment is associated in the short run, without including eventual interest savings, with a reduction in the deficit equal to 0.8 % of the GDP. I have compared deficit projections under the different assumptions as to growth and employment, and the results are striking. With no additional spending cuts or tax increases, the deficit would have fallen, in the high-growth scenario, from 4.9 % of the GDP in 1992 to 2.1 % in 1998, more than meeting the Clinton Administration’s goals. If unemployment had been down to 5 % throughout the period, instead of just in any given year, there would have been growing interest savings on a lower debt, and the deficit would have shrunk even more than shown in my short-run 5 % unemployment curves. The Deficit in a Growing Economy In an expanding economy with an increasing population, almost everything grows: births and deaths, marriages and divorces, borrowing and repayment, income and wealth, and assets and debt. The criterion for increasing debt—how much borrowing there should be—is directly related to income. This is true for the government as well as for prudent private borrowers, banks, and businesses. Governments, as well as people, should not indefinitely allow their debt to grow faster than their income. One may well argue that a responsible deficit target, similar to responsible targets for private business and households, is that debt over the long run grow no faster than income or, for the nation, gross domestic product (GDP). At the end of the 1939 fiscal year, as the New Deal was giving way to World War II, the gross federal debt held by the public came to $ 41 billion, 47 % of GDP. In 1946, after World War II, it reached $ 242 billion, or 114 % of GDP. By 1980, with federal budget deficits in all of the years from 1961 on, the debt had grown to $ 709 billion, but had fallen, relatively, to 27 % of GDP. At the end of the 1992 fiscal year, the debt held by the public was $ 2,999 billion, up to 51 % of GDP, but still only a little more than it was in 1939 and less than half of its proportion just after World War II. We may note both the short-period changes and the secular swings of the debt-GDP ratio in the graph “Some Say to Watch the Debt-GDP Ratio.” Some Say to Watch the Debt-GDP Ratio There is nothing sacrosanct about any particular debt-GDP ratio. In periods of recession we may expect deficits to rise and the debt to grow more rapidly than GDP, which will itself be growing much less rapidly, if at all. If there is need for major investment, debt may again grow faster than GDP. But suppose we were to keep the debt-GDP ratio constant. It is instructive to note what this “equilibrium” target would imply for our current situation. If we maintained the approximate 1992 debt-GDP ratio of 0.5 and assumed an estimated 7 % growth, then the projected 1993 deficit would be $ 210 billion. Compare this with the final Bush OMB projected 1993 deficit of $ 327 billion as well as with the $ 227 billion that deficit would be if unemployment were two percentage points less. The Bush OMB’s final deficit projections are based on the “blue chip” private forecasters’ anticipation of an unemployment rate averaging 7.2 % for all of calendar 1993! Greeted with much expression of concern, the OMB had its mismeasured deficit declining from $ 327 billion in 1993 to $ 270 billion in 1994 and $ 230 billion in 1995 before beginning to rise again to $ 266 billion in 1996, $ 305 billion in 1997, and $ 320 billion in 1998. They assumed unemployment above 6 % through 1995 and at 5.7 % in 1998. The OMB also assumed interest rates on 91-day Treasury bills would rise, unaccountably, from their current rate of less than 3 % to over 5 % , thus adding perhaps another $ 50 billion to the annual deficit. Those projections, though, even if correct, would still have the deficit-to-GDP ratio below 3.9 % , with the debt-GDP ratio virtually stable, at 57 % , by 1998. The debt would then be growing at a 6.67 % per annum rate with a projected nominal GDP growth of 5.93 % . If the rate of growth of GDP were over 6.67 % , the debt-GDP ratio would be declining. If unemployment were down only to its 5.2 % rate of 1989 and Treasury bill rates were still around 3 % , the resulting 1997 deficit would be not $ 305 billion but on the order of $ 200 billion, or 2.5 % of GDP. With a slightly more ambitious 7 % rate of growth of GDP, the debt-GDP ratio would then be headed for an equilibrium ratio of 36 % , well below its current figure of about 51 % . In a meaningful, relative sense, President Clinton would have reduced “our massive debt.” How Do Deficits Hurt? Or Do They? Much of what is written and said about the damage done by federal budget deficits is sheer nonsense, no matter how often repeated. First, of course, the notion that the federal government will go bankrupt because it is unable to pay off or service its debt is absurd. A sovereign government need never overtly repudiate a debt in its own currency. It can always tax those subject to its laws, including bondholders, to get the necessary proceeds. Or it can simply print the money needed—in the case of the United States, have the Federal Reserve buy Treasury securities. That may have other consequences, which we will consider. But in any event, there is no issue of bankruptcy for debt in dollars. (Debt denominated in a foreign currency, which is not the case for the United States, is quite another matter.) The debt may be repaid in cheaper dollars, but there is no reason why it cannot be repaid. Ross Perot warned repeatedly that we are “spending our children’s money.” But our children’s money has not yet been printed and will of course be printed or supplied when our children need it, in whatever quantities the interaction of the monetary authorities and our banking and financial system then determine. Alan Greenspan’s successors in the Federal Reserve will always be able to supply money for our children. What they cannot supply and, we shall see, what may be lacking are the real resources of capital—public and private, tangible and intangible, human and nonhuman—with which we are failing now to endow our children. Was Perot’s talk of “spending our children’s money ” nonsense? We are also told that our continuing deficits mean we are passing ever greater debt on to our children. This is literally true. Our children will be the owners of all those Treasury bills, notes and bonds that constitute the debt. That will give them a nice cushion of accumulated savings. Is that necessarily so bad? The growing debt will give our children a nice cushion of accumulated savings. Is that necessarily so bad? We are further told that the interest burden of the debt, currently about $ 185 billion per year, is a heavy drag on the economy. In fact it comes to only about 3 % of GDP. But, more fundamentally, the interest payments of the Treasury are, after all, income to their recipients. Any taxes that may be levied to finance the payments are then matched by added income. There are those who call this a regressive redistribution of income, on the assumption that the rich receive interest income financed by taxes paid by the poor. A moment’s reflection casts major doubt on that assumption. The ultimate beneficiaries of the interest receipts—via pension funds, insurance, and banking services, as well as savings bonds—must for the most part be in the large middle class. And relatively little is paid in taxes by the very poor. The social cost of debt and deficits will have to be found elsewhere. On a more sophisticated level, some might argue that if marginal tax rates are three percentage points higher to finance interest payments, work-effort may be discouraged. People receiving large proportions of their income in the form of interest would not wish to work to earn more with Uncle Sam taking still another three cents out of every additional dollar. But with interest income only 3 % of GDP (a bit higher as a percentage of national income), we are a long way from having to worry about that. It is also said that large deficits will cause inflation. The first answer to this is that we have had some large deficits in the last decade, and inflation has declined sharply. It is running currently at no more than 3 % by official measure and is probably less, perhaps zero with full adjustment for product improvement. Indeed, the times series relation between deficits and inflation in the United States has generally been negative; bigger deficits have come with less inflation and smaller deficits with more inflation. To be fair, however, this reflects primarily the effect of the economy on the deficit, rather than the deficit on the economy. In recessions, inflation tends to be less, and, with lesser tax revenues and greater outlays for unemployment benefits, deficits are larger. In booms, inflation may be more while tax revenues are greater and unemployment benefits less, so that deficits are less. From Deficit Delusion to Generational Accounting by: Laurence J. Kotlikoff Robert Eisner is right. Everyone is obsessed with the federal deficit. And yes, no one can agree how to measure it. But Eisner wants us to use his measure, which corrects the official estimate for inflation, the state of the economy, government investment, and economic growth. And without doubt, Eisner’s deficit has as much claim as any other to being a true calibration of our fiscal posture, but this is really no claim at all. Once we depart from the ad hoc Keynesian economics of Eisner and others and consider what mathematically rigorous, mainstream neoclassical economics tells us about the deficit, we learn that the deficit is inherently arbitrary—that it reflects how one labels the government’s receipts and payments, rather than some fundamental facet of its fiscal policy. Take Social Security contributions and benefit payments. The government labels our contributions “taxes” and our security benefits “transfer payments.” Were the government instead to label our contributions “borrowing” and our benefits “return of principal plus interest” on this borrowing, the official federal debt would be about $ 8 trillion larger than the current $ 4 trillion. While the Feds, like Eisner, leave Social Security debt off their books, the government’s obligation to make benefit payments to current and near-term Social Security recipients is certainly no less real than its obligation to pay interest on its Treasury bonds. Were Social Security the only debt the government ignores by its choice of words, we could correct for it and face no further linguistic troubles. But since literally every dollar the government takes in and pays out could be labeled differently, there is no end to the different ways we can define the federal debt. With the right set of words the government could add to its official debt its obligation to pay military and civil service pensions, its obligation to make benefit payments to current and future welfare recipients, its obligation to pay current and future Medicare benefits, its obligation to care now and in the future for the national parks, and on and on, producing in the process any size debt it wants. That’s why Eisner is right. No one can agree how to measure the deficit, but for a good reason. There is no right way. Rather than continue to focus on what is simply a figment of the government’s vocabulary, we should instead ask ourselves what really concerns us when we decry the debt? Our real concern appears to be that we are passing too big a fiscal burden onto our children, grandchildren, and subsequent issue. To address this we need to stop trying to find the perfect measure of the government’s debt and start measuring directly how the government is treating current generations and how it is likely to treat future generations. Generational accounting does just that. Generational accounting calculates, as a present value, how much generations now alive will pay in net taxes (taxes paid less transfer payments received) over the rest of their lives. It also calculates the present value of the government’s bills—the sum of the federal debt plus the present value of its current and future spending on goods and services, excluding transfer payments. Subtracting the size of the government’s bills from the present value net tax contribution of current generations produces, in present value, the net tax liability of future generations. The logic is simple: the less current generations pay for the government’s bills, the more future generations will have to pay. Unlike the federal deficit, generational accounting is impervious to changes in fiscal labels, it considers the operations of all governments (federal, state, and local), and it incorporates all of the government’s long-term tax, spending, and demographic forecasts. What does generational accounting show for the United States? The answer, I’m sorry to say, is very disturbing: if there is no change in the net taxes paid by current generations, future generations will have to pay net taxes equal to 71 % of their lifetime incomes. This projected 71 % lifetime tax rate may be compared with the 21 % rate faced by the generation born in 1900, the 28 % rate faced, so far, by the generation born in 1930, and the 32 % rate faced, so far, by the generation born in 1960. Why is the projected net tax rate on future generations so high? The answer primarily involves things that are not affecting the “official” federal debt. They include our out-of-control spending on Medicare and Medicaid, as well as Social Security. The calculated rate is also high because it assumes that even our children will bear no higher net taxes than we do. The alternative scenario, leaving the burden to our children as well as our grandchildren, is hardly a solution. Will President Clinton’s program help future generations? Indeed, it will. The fiscal plan recently announced will lower the net tax rate on future generations from 71 % to 59 % . While this reduction may seem inadequate, an effective health care reform plan could produce an even larger net tax rate reduction. The President’s program will also help today’s children. If nothing is done now, today’s children could well end up facing lifetime net tax rates of 50 % to 60 % in order to limit tax increases on future generations. Under the President’s program, today’s children are likely to face lifetime tax rates of 35 % to 40 % . While even that may be viewed as too high, it is the unavoidable consequence of the off-the-books game of “pass the generational buck” that we’ve been playing for a long time. The would-be heroes in the President’s program are we adults. Our financial sacrifice will provide the means to keep tax rates on our children and grandchildren from soaring. It’s high time we started focusing on the size of the tax bill facing our kids instead of worrying about different people’s favorite definition of the federal deficit. An appropriate test of the effect of deficits on inflation, or on any other economic variables, would have then to abstract from the reverse effect of those variables on the deficit. One way to get at this is to work with a measure of the deficit that is not affected by the fluctuations of the economy. For this purpose we may use what has variously been called the structural, the cyclically-adjusted, or the “high-employment” budget. This indicates what tax revenues, outlays, and the deficit would be if the economy were on some fixed path as, say, a 6 % unemployment path for a measure that has been published periodically by the Bureau of Economic Analysis. The size of the high-employment deficit may then be a measure of fiscal stimulus. But larger high-employment deficits have also not been associated with more inflation. The reason for this negative finding brings us closer to the fundamental relation of government deficits and government debt to the economy. That depends very considerably on the state of the economy, whether it is zooming along at top speed or is in a sluggish, slack-resources, unemployment mode. Recognizing this will lead us to the conclusion, however shocking to some, that deficits can be good for us. This is not to say that they are always beneficial, but they will be good if they generate otherwise lacking purchasing power for the products of American business. In general, deficits can be too small as well as too large. And for most of the past half-century, including right now, contrary to the conventional wisdom, we will find that deficits have been too small. Far from struggling to reduce the deficit, as President Clinton has constrained himself, or offering demagogic appeals for zero deficits (or even surpluses to “pay off” the debt), as has Mr. Perot, we should be looking for the most productive ways to increase it. Are Deficits Irrelevant? There is a school of thought, led by Harvard’s Robert Barro, which argues that deficits essentially do not matter. This is not my argument. What Barro and his many followers (still a minority among economists) claim is that financing government expenditures by borrowing and by taxes (at least nondistortionary “lump-sum” ones) are equivalent in their effects on the economy. This proposition is called “Ricardian equivalence,” after the great classical economist, David Ricardo, who first suggested the possibility before later rejecting it. It reasons that if taxpayers have greater aftertax incomes because government expenditures are financed by borrowing instead of by taxes, they will not spend their extra income. Instead, they will save it to pay the future taxes necessary to service the resulting debt, or else leave the money to their children, who will pay those taxes. The arguments against Ricardian equivalence are myriad: the difference between borrowing and lending costs of government and private agents who frequently have liquidity constraints; the lack of certainty or even knowledge by any of us that taxes will in fact be higher in the foreseeable future or that others, including the parents of our children’s spouses or the other grandparents of our grandchildren, will not pay those taxes; and finally the case where we have no children or else consider them worthless and not worth providing for. But I leave that debate to the economics journals, which have filled many pages with it. How Deficits Do Matter We return then to the mainstream argument that deficits do matter; the question is how. Simply enough, deficits, as opposed to government outlays financed by taxes, matter because they add to the purchasing power and aggregate demand of the private sector. A person or business is likely to spend more when holding a government security than a receipt for payment of taxes. The former, after all, is part of the person’s or business’s wealth. All of our economic theory and empirical evidence indicate that people with more wealth, other things being equal, will spend more. That increases in the real value of the government debt to the private sector increase consumption and aggregate demand is old neoclassical economics, a line of reasoning to be found in the works of Gottfried Haberler and A.C. Pigou. The Keynesian argument is parallel, that real deficits increase consumption by adding to current real disposable income. Keynes also included changes in the value of wealth as an argument of his consumption function, warning that ignoring them would be perilous in times in which they changed. Failure to take into account the huge increase in debt held by the public during World War II—the debt-GDP ratio was well over 100 % in 1946—was a major factor in the alarmist, erroneous predictions that the end of the war would bring on a major recession. And that failure was part of the background and motivation for the path-breaking work of Nobel Laureates Milton Friedman and Franco Modigliani in developing our modern theory of the consumption function. Wealth, or the permanent income to be expected from that wealth, are critical determinants of consumption expenditures. If we doubt that theory, we can try a quick mental experiment. Suppose I could arrange with Lloyd Bentsen, our new Secretary of the Treasury, for each reader of this article to be given $ 100,000 in new Treasury bills. How many would feel poorer? How many would spend none of their new holdings? And how many might just buy a new car or take a more expensive vacation trip? If even some fall into that last category, the result is higher consumption expenditures and more business to those producing the additional goods or services purchased. But this additional holding of Treasury bills—or other Treasury securities, or cash to the extent that the Federal Reserve buys some of the additional debt—is exactly what happens when the government runs a deficit. There is one important qualification, however, too often overlooked: inflation. If prices today are 3 % higher than a year ago, then today’s $ 100,000 are the equivalent, roughly, of $ 97,000 in last year’s purchasing power. We may be expected to feel richer and spend more only to the extent that the deficit raised our wealth in government securities by more than enough to keep up with inflation. A deficit is a real deficit only to the extent that it adds to the real value, that is the value in constant dollars, of our holdings of government debt. We may view the loss in real value of outstanding debt due to inflation as an “inflation tax” levied by the government on debt holders, thus reducing that real deficit. Another way of looking at this is to see that of the $ 185 billion of interest payments swelling the nominal deficit, some $ 90 billion represents the amount the government finds it necessary to pay, because of higher nominal interest rates, to compensate bondholders for their inflation losses. The Short Run: Consumption, Output, and Employment While the greater wealth the public holds in government debt as a result of deficits will induce more consumption, greater deficits are actually often accompanied by less consumption. This is because recessions and associated unemployment reduce consumption and also, as we have noted, increase deficits. As warned before, we have to avoid confusing cause and effect, the effect of deficits on the economy and the effect of the economy on deficits. To ascertain the effect of an independent increase in the deficit, one not brought on by the decline of the economy, we need again to consider the high-employment budget, which indicates what the deficit would be, aside from fluctuations of the economy, if unemployment were fixed. And further, since we can expect that it is only real increases in the wealth in the form of government debt held by the public that can be expected to affect consumption, we should also adjust the deficit for the loss in the real value of the debt due to changes in the price level. The impact of deficits on the economy should then be found in the relation between an inflation-adjusted and cyclically adjusted deficit and the economic variables with which we are concerned. I have accordingly constructed (along with Paul J. Pieper of the University of Illinois at Chicago, my collaborator in many of these investigations) time series of what I call the price-adjusted, high-employment deficit. And I have worked these into simple charts and tables and more rigorous least-squares regressions as well as, more recently, VARs (vector autoregressions). These latter put together past and current values of the presumably underlying variables and try to estimate their relations and interrelations without preconditions or confining specifications as to lags or what determines what. The results have confirmed, over and over as I have tested the relations for robustness over time as well as for variations in formulations, that deficits, over the past three decades at least, have been good for us. Our investigations have confirmed over and over that deficits, for the past three decades at least, have been good for us. Specifically, we have found that higher values of the price-adjusted, high-employment deficit, taken as a percent of GNP or GDP, have been associated with more rapid subsequent growth in real product, as may be seen in the graph “As Goes Deficit, So Goes Product,” sparing readers of this article more sophisticated statistical presentation. (This may be found in my 1986 book, How Real is the Federal Deficit?, and in numerous periodical articles.) And since more rapid growth in real product is associated with alleviated unemployment, it comes as no surprise that we have also found that larger deficits have been associated with less subsequent unemployment. As Goes Deficit, So Goes Product Changes in Price-Adjusted High-employment Deficit and Real Gross Domestic Product as Percentages of GDP, 1961–91 There is one condition that must have been necessary for this result. There must have been slack resources for most of the last 30 years over which I have estimated these relations. Unemployment could not have been reduced by bigger deficits if it were already at its rock-bottom, full-employment level. And output could not have increased faster if there were no additional workers and no additional capacity for increased production. Sadly, this slack-resource condition was met. It must be recognized that, except for wartime—unemployment reached the 3 % level during the Vietnam War—we have rarely if ever had truly full employment. Herein is a vital caution to President Clinton and the Congress as they put into place a program for economic recovery and sustained, high-investment growth. We entered 1993 with unemployment still over 7 % and most forecasts, including those used by the OMB, the Congressional Budget Office, and the Clinton Administration itself, indicating that this unemployment rate would subside only very slowly. Yet the economics program the president presented in his February 17 address to Congress included a reduction of the structural deficit by $ 55 billion from 1993 to 1994. Is this a time for the restraint of deficit reduction or for the stimulus of more government spending—preferably for public investment—and lower taxes? This fundamental fact of excess unemployment may be challenged by devotees of the pernicious “natural rate” of unemployment or “non-accelerating-inflation-rate of unemployment (NAIRU).” They may find 6 % or 6½ % or even the 7+ % of the past year to be natural. They may think that in our perfect market economy whatever is must be optimal and natural. I recall the joke about the graduate student who in January, 1983 wrote on the board the flash, depth-of-recession news from the Bureau of Labor Statistics: “The natural rate of unemployment has just reached 10.7 % .” The fact of unemployment invalidates arguments for reducing the deficit. But I will maintain that involuntary unemployment due to a lack of aggregate demand or purchasing power is a fundamental fact of our economy, as confirmed by these effects of deficits. And this fundamental fact makes all the difference, making a mockery of most arguments for reducing the deficit at this time, and exposes the error of the conventional wisdom of too many, although not all, macroeconomic theorists. The Long Run: National Saving The fact that increases in the real, structural deficit have usually ushered in growth or greater growth in output and reductions in unemployment becomes central to the one legitimate possible argument that deficits may be too large. It relates to the future, not to their current effect. As long as there is some slack in the economy, fiscal stimulus in the form of bigger deficits will in the short-term raise output and employment. But, some insist, these deficits reduce “national saving.” In so doing they reduce the capital we will have in the future and hence reduce future product. That is—or would be, if it were true—the real burden that deficits place on our children and grandchildren and indeed, except for those near the end of their lives, on all of us. Is it true, though? Do our deficits reduce national saving and investment or capital accumulation? There is one argument that gives the false impression that this is inevitable. Conventional gross national saving, GS, is defined as the sum of private saving—personal saving, PS, and business saving, BS—and public saving, or the consolidated federal, state, and local budget surpluses, FS plus SLS. And the total of gross national saving (except for a statistical discrepancy) is identically equal to the total of gross investment, GI: GS ≡ PS + BS + FS + SLS ≡ GI Deficits are then seen as negative surpluses, or negative public saving that offsets positive private saving. Bigger federal deficits constitute a still greater negative value to FS and hence mean less total or national saving, GS, and less gross investment, GI, or less accumulation of capital for the future. Reducing the deficit would raise national saving and investment. All this may seem apparent from the identity above. This argument is alas just too simplistic. It entails the elementary fallacy of assuming ceteris paribus: other things being the same. But imagine more realistically, for example, that the federal deficit is reduced—FS is made less negative—by cutting grants to state and local governments, which have been running about $ 175 billion per year. Would this not immediately reduce state and local government surpluses, SLS, and thus offset the reduction in the federal deficit or algebraically higher value of FS? Or suppose the federal deficit is reduced by raising income taxes. This would reduce disposable personal income and surely reduce personal saving, PS, the difference between disposable personal income and consumption, even if, as is likely, consumption were also reduced. So here we would have another offset to the increase in public saving or reduction in public spending. Similarly, an increase in corporate profits taxes would reduce undistributed corporate profits and thus reduce business saving, BS. And a like consequence, it should be noted, would flow from a reduction in government expenditures, either in transfer payments like Social Security benefits or in government outlays for goods and services. In both events, disposable income and private saving would be reduced. A decline in business saving and private saving would at least partly offset the algebraic increase in the negative federal surplus. Looking at Investment A nation invests either by accumulating real assets on its own soil or by acquiring claims to assets in the rest of the world. Gross investment is the sum of gross private domestic investment and net foreign investment. GI ≡ GPDI + NFI And gross national saving, GS, we have noted, is identically equal to gross investment. We can thus better consider how reduced federal deficits would affect national saving by finding its effects on the components of gross investment. By far the larger element here is gross private domestic investment, the sum of business and nonprofit institution expenditures on new equipment and structures, construction of new housing, and increases in business inventories. Would the cuts in consumption and government expenditures for goods and services result in more or less private domestic investment? If we cut our purchases of new cars, is that going to lead the automobile industry to spend more or less on new facilities? If our disposable income is cut, will we buy more or fewer new houses? I may seem to be loading the questions, but the answer is not that obvious. Classical economists and the conventional wisdom would argue that if the government is borrowing less, interest rates will be lower, and this will stimulate more business investment and purchases of new houses. But will this positive effect outweigh the negative effect of lower sales to ultimate consumers and of lower incomes? A half-century ago Oscar Lange examined this issue in a seminal review of Keynes’s General Theory. He pointed out that there was an “optimal propensity to consume” that would maximize investment. This would be reached when the stimulative effect on investment of more consumption was eventually just balanced by the increasing negative effects of higher interest rates. What happens is that as consumption increases from low levels the developing pressure on capacity stimulates investment, and there is little rise in recession interest rates and little negative effect on investment. As full employment is approached, more consumption begins to crowd out investment simply because there is no more capacity to increase both consumption and investment. In a free market, interest rates rise as business struggles to get the funds to finance additional capital to increase capacity. But these higher interest rates increasingly choke off investment. Thus, whether more consumption or more government expenditures crowd out domestic private investment may again depend on how close the economy is to full employment. If we are at full employment—or some people’s “natural rate”—so that output cannot be increased, then it is clear that, aside from getting goods from the rest of the world, more output going to consumption or government must mean less output to private investment. If we are not at full employment, then the outcome of changes in budget deficits and changing consumption and/or government spending is not clear. We can get a pretty good idea, however, by looking at the historical facts. Here again, my charts, tables, and regressions provide clear results. As shown in “Deficits May Spur Investment…,” larger inflation-adjusted, structural deficits have been associated with more subsequent gross private domestic investment, and smaller deficits have been associated with less investment. My multiple regression results add the information that easier money, as measured by increases in the real monetary base, has also been associated with increases in real output and domestic investment. The remedy to any increases in interest rates would thus appear to be supportive, stimulatory monetary policy by the Federal Reserve. Deficits May Spur Investment… Price-Adjusted High-Employment Deficit and Gross Private Domestic Investment as Percentages of GDP, 1959–91 This, however, still does not tell the whole story. Gross investment, which is equal to gross saving, is the sum of gross private domestic investment and net foreign investment. And net foreign investment is largely net exports or, a bit more generally, the current account surplus in our balance of international payments. If we export more than we import, to the extent that we do not give foreigners’ payments back to them, we acquire foreign assets. We thus have net foreign investment. But if we import more than we export, we pay for this excess by giving foreigners net additional claims, in debt or equity, on us. We have negative net foreign investment, reducing total gross investment. Will not increased deficits stimulate the demand for all goods, foreign as well as domestic, and thus increase imports and reduce net foreign investment? Indeed they will. And reductions in the deficit would reduce imports—perhaps by causing a recession—and raise net foreign investment! Whether the cutting of deficits raises or reduces national saving then depends on the balance of the two effects, the increase in net foreign investment and the reduction in gross private domestic investment. Larger, real structural deficits have been associated with more saving and smaller deficits with less saving. Once more, we can turn to the data. The results of statistical analysis, while not as sharp as in the case of domestic investment alone, take the ground out from the argument that reducing deficits is likely to raise national saving. The historical record has shown the opposite. Larger, real structural deficits have been associated with more saving and smaller deficits with less saving. Deficits and Total National Saving The statistical relation involving the conventional, narrow measure of national saving, it must be acknowledged, is not that strong. It is strengthened in a major way, however, when we recognize that what is relevant for our future, and that of our children and grandchildren, is not merely the accumulation of capital in the form of gross private domestic investment and net investment in the rest of the world. Of vital significance is public investment in all of the tangible infrastructure on which private industry depends, as well as all investment, public and private, in education and training and research and the basic services of public security on which social living depends. Increased federal deficits may well go toward financing increased public investment. They have apparently done so already, if insufficiently. Inflation-adjusted, strategic deficits have been positively related to total government tangible investment. As shown in “Encourage Education Spending…,” they have also been positively related to total government expenditures on education. Encourage Education Spending… Changes in Price-Adjusted High-Employment Deficit and Real Total Government Expenditures on Education as Percentages of GNP, 1960–91 As a start to measuring this broader effect of deficits, I have related our real, structural deficits to expanded measures of national saving, and once again I find a sharp positive relation, as seen in the graph “…and Increase National Saving.” Larger price-adjusted, high-employment deficits have historically been associated with more, not less, national saving. …and Increase National Saving Changes in Price-Adjusted High-Employment Deficit and Real Total Tangible National Saving as Percentages of GNP, 1961–91 Providing for the Future Given the state of our economy, present deficits are not too large. They will naturally come down as we reduce unemployment, speed economic growth, and achieve a prosperous economy. Real, structural deficits have helped and not hurt current output, employment, consumption, and well-being. They also encourage more, not less, investment in our future. President Clinton, in advancing a broad-based program for investment and economic growth, has stated explicitly, “Deficit reduction is not an end in itself.” The purpose of deficit reduction is rather to help provide for our future and our children’s future by increasing national saving and investment. But we must then be clearly aware of the danger that deficit-cutting measures will curtail or reduce conventionally measured gross private domestic or business investment, household investment, and the public investment in physical capital and in people that he sees, correctly I believe, as vital to that future.

Sense and Nonsense About Budget Deficits

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