Deficits Matter

I believe deficits matter.  There are lots of studies showing no correlation between deficits and interest rates and deficits and inflation.  That's because deficits are usually small compared to the size of the economy and because deficits usually have short-run stimulative effects if there is slack in the economy.  If the economy is near full employment, interest rates and inflation rise, but full employment is rarely achieved, so deficits don't seem to matter.

If deficits rise too rapidly, and publicly held debt reaches levels, say 100% of GDP, then no one will buy government debt because inflation will rob debt holders of their interest income and their principal.  That effect can be mitigated if you're a large country with a reserve currency, like we are.  When Asians buy our debt, we can consume way beyond our means, and, again, deficits don't seem to matter.

Does this mean we don't have to worry about deficits?  No!  We will find out why soon enough.  Our public debt is poised to shoot from 40% of GDP to 70% over the next five years.  See Figure 10 in CBO Director Doug Elmendorf's testimony before the House Budget Committee on May 21.   That means future U.S. taxpayers are going to pay a lot more interest on the public debt and incur higher taxes.  If foreigners stop buying as much debt our interest rates and inflation will be higher than they otherwise would have been, even at the modest 2% of GDP growth rates.  It will be very difficult to prove this econometrically, but eventually our children will pay.

It's an old analogy, but a good one that deficits are like termites in the basement.  It takes a long time before the house falls down.

Stan's timing on urging deficit reduction was impeccable.

Fed Chair Ben Bernanke's testimony before the House Budget Committee yesterday stated very clearly our challenge:

"Despite the recent signs of stabilization in the economy, we policy makers should recognize that our most challenging period is going to be ahead of us as we try to right the ship and get back on the path of sustainable growth and job creation. That will clearly take a renewed sense of fiscal discipline to reign in spending and budget deficits. But it will also take a clear edged strategy on the part of the Fed and a firm commitment to price stability."