Saturday, March 13, 2010
To be sure, the U.S. government deficit is shocking; but it's not anymore shocking than the recession through which we have all lived. Tax receipts plummeted (see the second chart from this post) and spending on cyclical social programs (like unemployment benefits) is surging. This adds up to an exponentially rising budget deficit, and thus an increasing debt burden.
The resulting hysteria leads to headlines like that from Reuters on March 11, 2010: "Fed's Dudley: Waiting to fix fiscal problems risky".
Be very careful when reading these articles, as the title implies that William Dudley, president of the New York Federal Reserve Bank, is advocating "fixing fiscal problems" right now - cutting spending and/or raising taxes now - while that is not the case at all. According to Reuters, Dudley says:
The issue, Dudley said, is not fiscal stimulus, which he noted had been necessary in the United States to stabilize the economy, even though it drove up the deficit. That spending is temporary, he added. The bigger long-term problem for the United States and other advanced economies is structural deficits -- those likely to persist absent changes in tax and spending policies.A link to Dudley's speech. He does refer to structural deficits that may result from recent countercyclical policy. However, these long-term structural deficits have essentially nothing to do with the current downturn, in my view. In fact the effects of the current deficits are simply a speed bump on the road to structural indebtedness.
Just look at the CBO's extended-baseline projection for the long-term budget published in June 2009.
This above scenario projects the spending share on social security, Medicare and Medicaid, and Other Federal Noninterest Spending through the medium and long term under current law. Notice the blip that is 2009 and 2010?
What is key to this outlook is the assumption on economic growth and productivity trends (among others, of course!). GDP is assumed to grow an average 2.2% per year. I didn't delve into this full report and conduct a full alternative scenario test. But it is pretty clear that GDP growth of anything less than 2.2% (on average) - holding all else equal, of course - would have a deleterious impact on the outlook for government financing.
Japan provides a perfect case study of what not to do when the economy is recovering from a financial crisis: raise taxes too soon. You do that, and the probability of a "lost decade" rises quickly. You suffer a lost decade, and the outlook on the structural budget looks a lot worse than that illustrated above.
Marshall Auerback has argued time and time again that the government should run deficits until private saving adjusts so that the economy can stand on its own two feet, i.e., grow. As long as the currency floats and is fully non-convertible, the government's debt burden will not become a solvency issue. Hence, his interview titled fighting deficit hysteria.
I would say, rather, that the deficit hysteria is appropriate, but very much misallocated intertemporally toward the short-term outlook.
Part II coming to a post near you!
This article is crossposted with Angry Bear