Do Deficits Matter? Posner

Vice President Cheney is reported (I don't know whether accurately or not) to have said that "deficits don't matter." Certainly the Bush Administration ran big ones, as a result of which the public debt (which is the national debt less federal liabilities to Americans created by the social security and other entitlement programs) doubled. It has continued mounting as the deficit continues growing, and has now reached $7.5 trillion, which is more than half the (annual) Gross Domestic Product. It will continue to grow rapidly, because of the fall in federal tax revenues as a result of the economic downturn, because of the aging of the population which along with the continued acquisition of advanced medical technology is causing a continuing rapid increase in Medicare costs, because of the reluctance of Congress to raise taxes or cut any spending programs, and because of the likely cost of the ambitious new programs of the Obama Administration. How much money will actually be appropriated for the programs, such as health-care reform and climate control, is, at this writing, unclear. The public debt is funded by Treasury borrowing (actually a bit of it is being funded as an emergency measure by the Federal Reserve, but I will ignore that), of which more than 40 percent comes from foreign governments and other foreign entities and the rest from Americans, including banks and other financial institutions. Much of this borrowing is in the form of 10-year Treasury bonds, which are now commanding an interest rate of about three and a third percent. The government is having no difficulty at present in borrowing at moderate interest rates to fund the public debt, large as it is. The reason is partly that Treasury securities are safe in the sense that there is no risk of default and the current global economic downturn has increased the demand for safe investments, and partly that the world is awash in dollars because of the policy of a number of major nations, such as China (but not only China--others include Germany, Japan, and the oil-exporting small nations of the Middle East), of running very large current-account surpluses (i.e., trade surpluses). These surpluses are largely in dollars because the dollar is the principal international reserve currency, which is to say a currency used in international transactions in preference to using local currencies that fluctuate more than the dollar does. As the world's principal sourcce of international reserve currency, the United States in effect sells dollars to the rest of the world to provide liquidity in international trade, and many of the dollars come back to the United States in the form of investments in Treasury securities, especially from countries that have large dollar reserves because they export much more than they import. A country that supplies a major international reserve currency must run a current-account deficit because otherwise the rest of the world wouldn't have enough of the currency for their transactions. The fact that foreign countries need large dollar reserves for this purpose means that there are a lot of foreign dollars available for the purchase of U.S. securities, quite apart from current-account surpluses. This makes it easy for the United States to borrow at reasonable interest rates to fund its public debt, even if Americans, unlike Japanese, are not big savers. (The fact that Japanese are big savers enables Japan to fund a public debt that is proportionately much greater than ours, without much difficulty.) Americans are saving much more nowadays than they were a year ago, but this may change as the economy recovers. As long as Americans are saving a lot, and wanting their savings to be safe, and foreigners as well, and as long as nations like China are running huge current-account surpluses, we can fund our public debt at reasonable interest rates. But that is provided it doesn't grow too fast, and it is growing very fast and there are no signs of its slowing. As the economy recovers, federal tax revenues will rise, but federal expenditures will be rising too, and rising all the faster if a significant part of the Administration's ambitious program is authorized by Congress, because there don't seem to be any serious efforts at either increasing any taxes (even by reducing deductions) or cutting any spending programs. The perfection of interest-group politics seems to have created a situation in which taxes can't be increased, spending programs can't be cut, and new spending is irresistible. Judging by the Bush Administration's profligacy and its impact on the public debt, the situation is bipartisan. At some point the wheels may start coming off the chassis. Assume that the public debt continues its rapid growth because government spending increases rapidly but Congress refuses to authorize significant increases in taxation. The Treasury will have to borrow more and more, yet at a time when recovering economies need investment capital, forcing interest rates up and hence deepening our deficits. We already pay more than $400 billion a year in interest on the public debt, and that amount will rise rapidly as both the size of the public debt and interest rates rise. Assume further that political pressures prevent the Federal Reserve from raising interest rates in order to head off inflation caused by the banks' finally deciding to lend (as the economy recovers) the huge excess reserves that they have accumulated as a result of the Fed's open-market operations during the current economic crisis. Fear of inflation will push up long-term interest rates, including rates paid by the Treasury to fund the growing public debt. Fear of inflation will also make foreign countries worry about the value of their dollar reserves, and wonder whether the dollar should continue to be the predominant international reserve currency. As the dollar falls in value, however, the public debt will become cheaper to repay, the demand for U.S. exports will grow, and our demand for imports will fall. The increase in the ratio of exports to imports will reduce the current-account deficit and thus reduce the rate of increase of the public debt. But increasing exports relative to imports, by tending to reverse the long-term decline in U.S. manufacturing relative to services, may be a painful and protracted one. We have grown accustomed to financing our consumption by borrowing heavily abroad to pay for manufactured imports and for our elaborate systems for distributing goods and providing other services. Our economic productivity has become heavily dependent on the immigration of high-IQ professionals, but one casualty of the current economic crisis has been restrictions on immigration that are designed to protect Americans' jobs. Moreover, even with a reduced current-account deficit, U.S. public debt will be rising because of increasing unfunded expenditures on medical care and other social programs, and for all one knows on military activity as well since the United States remains the world's policeman. And lenders will charge higher interest rates to continue to fund our public debt if they think the dollar is losing value because of inflation. If inflation persists, then given that there are other international reserve currencies, namely the euro and the yen, and in time the renminbi (the Chinese currency), the dollar will decline as an international reserve currency, and, with the demand for dollars thus reduced, its value will fall further. As real interest rates rise as a consequence of the growing public debt and decline in demand for the U.S. dollar as an international reserve currency, U.S. savings rates will rise, and by reducing consumption expenditures this will slow economic activity. Economic growth may also fall as more and more resources are poured into keeping elderly people, most of whom are not highly productive members of society from an economic standpoint, alive. The United States may find itself in the kind of downward economic spiral in which "developing" countries often find themselves. As an economic power we may go the way of the British Empire, which occupied approximately the same position in the world economy in the early twentieth century as the United States does today.

Comments

[Anonymous]

This is a masterful analysis of our situation and what consequences it is likely to produce. But, oddly, it ignores any economic explanation of the "perfection of interest group politics" that produces (and perpetuates) the stalemate that is at the root of our inability to get control of spending and the debt.

This, I believe, is because there is no economic, or even political, explanation of that dilemma. The root of the problem has more to do with political culture than economics. Your evasion of that issue becomes ever more clear with each posting on this topic.

[Anonymous]

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[Anonymous]

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[Anonymous]

Yes, very truth. Obviously, "The root of the problem has more to do with political culture than economics.", but the status of US in the world is at risk.
I´m Spaniard. As Spaniard, I see increasingly worried your growing Debt.
But it is also true that the main countries are in the same way, so I hope at the end you´ll conserve the advantage.

[Anonymous]

THE DOLLAR

Dean Baker wrote: Pleased by the prospect of the dollar declining. If foreign investors stop buying US bonds, that would be just great. The only mechanism for getting the trade deficit down is a lower dollar. Simon Johnson wrote similar comments in his blog. It makes me sad to hear such views by prominent US economists.

Well, even Botswana can lower its deficit in this way. It is not an "accounting identity", it is an accounting gimmick and a beggar-thy-neighbor policy. What if every nation was going to follow retaliatory competitive devaluations of their currency? According to the economics I know and have been teaching my students, this is a short-term "solution" which will backfire. Is it by accident that the world's least competitive countries are the ones that are constantly devaluing their currencies? The trade deficit can only be reduced by increasing competitiveness and productivity, technological superiority, innovation, entrepreneurship etc. A constantly declining dollar will bring about inflation and higher interest rates for obvious reasons. US consumers' purchasing power will drop. This will hurt manufacturing through a drop in consumption and demand for their products, and through an increase in their financing costs and imported raw material costs. They will become less competitive. This will increase the trade deficit. The decline of the dollar and its consequences will be exacerbated by the foreigners dumping the dollar and the dollar-denominated assets. I don't know who will then finance the US debt. Americans will also try to protect their life's dollar savings by converting them to stronger currencies, investing them in foreign-currency assets and perhaps moving them offshore. This capital exodus will further negatively impact the US current account deficit. Wall Street will plummet, and it will be very difficult for US companies to raise capital. A long-term Depression will hit the country. It's a vicious circle. And gradually but surely the world will move to other reserve currencies. America's economic and political standing in the world will erode.

[Anonymous]

Judge Posner's observations are consistent with the very insightful analysis published around 1983 by Mancur Olson in his book "The Rise and Decline of Nations". Unfortunately, unless the general public wakes up to the corrosive impact of "distributional coalitions" and special interest groups on our economy, the future does not look particularly bright. Anyone care to wager on the liklihood of the public coming to its senses any time soon?

[Anonymous]

Some sage comments on a sage analysis. However the little ball in which all of this mechanics is working is bouncing around in a social and political system which is based on a larger and larger part is parasitizing a smaller and smaller part. Oh, I forgot to mention that the ball is made of glass.

[Anonymous]

"The perfection of interest-group politics seems to have created a situation in which taxes can't be increased, spending programs can't be cut, and new spending is irresistible. Judging by the Bush Administration's profligacy and its impact on the public debt, the situation is bipartisan."

That's why I advocate a Negative Income Tax and Milton Friedman's Health Plan: Namely, fulfill the basic goals in a less expensive and intrusive manner. We should aim to aid the poor and cover everybody with health care. But, in doing so, we should attempt to confine the aid to people who really need it, relative to others. Otherwise, you have an irresolvable conflict between goals ( which raise taxes ) and the unwillingness to pay for them ( which keeps taxes from being raised to pay for the goals ).

Don the libertarian Democrat

[Anonymous]

Why is it worth remebering that the British decline as an economic power since the early 20th century is purely relative decline? Britain is a much richer place than it was then. It is worth remebering that because the relative decline of the USA from being the world's dominant economic power has been a clear prospect for more than a quarter of a century. Europe already is in the same economic league as the US. Japan is close, China and India will join that league. Thev USA will go on getting richer.

But the resons for British and American relative decline may be different. In the early 20th century, Britain was the world's leading creditor nation; the USA is now the world's leading debtor. The British political process before 1914 was challenging the country's vested interests, with some success. In the USA today the vested interests seem to be getting steadily more entrenched.

I doubt if deficits and national debt are the basic problem. As Samuel Johnson noted when faced with a lament about public spending in 18th century Britain, "There is a lot of ruim im a nation". But if vested interests prevent the debt burden being handled properly (as they did in pre-revolutionary France), deficits can become lethal for a society and a political order.

[Anonymous]

Medicare tax rates, versus Medicare expenditures

Hello people,

Medicare is a typical example of an unfunded government entitlement program. The program began in 1966, with a tax on wages up to $6600 of 0.7%, resulting in a maximum contribution of $46 per year. In 1976, the employee and employer contribution amounted to 1.8% of wages, not to exceed $275. In 1986, the contribution was 2.9% of wages, capped at salaries of $42,000 per year, for a maximum contribution of $1305. In 1996 the rate was 2.9% and max contribution was $1818, and in 2009, the combined employer and employee contribution is 2.9%, on maximum taxable earnings of $106,800, and maximum tax is $3,097 annually.

In return for these annual payments, which were as small as $46 in 1966, the retired citizen receives insurance at age 65 which pays 80% of medical expenses, for a small, monthly, fee.

A comparable policy from Blue Cross of Illinois, the I-Chip insurance policy, for a 65 year-old man, costs $20,028 per year, according to the Blue Cross web site.

How can a person pay $3,097 annually from his wages (in 2009), and receive an insurance policy for life valued at $20,028 per year? Only by borrowing from future generations.

This is a tax on the unborne and on our children. I raised the issue at one of my adult education classes (among seniors, like myself) at Northwestern University, and nobody seems to think it was unfair, nor a generational time bomb.

Big problem.

Jim

[Anonymous]

In addition, if a health insurance policy costs $20,000 at age 65, and $25,00 at age 75, it probably costs $35,000 at age 85, and $45,000 at age 95, if any such health insurance were available. In actuality, health insurers take pains to deny insurance coverage to people older than age 40, for fear they will be forced to pay a large claim, so the issue is moot.

Jim

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[Anonymous]

" Certainly the Bush Administration ran big ones..."

The Administration can only spend what Congress appropriates, not a penny more and, thanks to the Budget Impoundment Control Act, not a penny less. The Administration has no control over taxes, other than persuasiveness and a veto.

So, how is it that you can blame any Administration, past (post 1974) or present, for budget deficits?

[Anonymous]

" Certainly the Bush Administration ran big ones..."

The Administration can only spend what Congress appropriates, not a penny more and, thanks to the Budget Impoundment Control Act, not a penny less. The Administration has no control over taxes, other than persuasiveness and a veto.

So, how is it that you can blame any Administration, past (post 1974) or present, for budget deficits?

[Anonymous]

" Certainly the Bush Administration ran big ones..."

The Administration can only spend what Congress appropriates, not a penny more and, thanks to the Budget Impoundment Control Act, not a penny less. The Administration has no control over taxes, other than persuasiveness and a veto.

So, how is it that you can blame any Administration, past (post 1974) or present, for budget deficits?

[sesli chat]

Why is it worth remebering that the British decline as an economic power since the early 20th century is purely relative decline? Britain is a much richer place than it was then. It is worth remebering that because the relative decline of the USA from being the world's dominant economic power has been a clear prospect for more than a quarter of a century. sesli sohbet Europe already is in the same economic league as the US. Japan is close, China and India will join that league. Thev USA will go on getting richer.

[seslis ohbet]

Why is it worth remebering that the British decline as an economic power since the early 20th century is purely relative decline? Britain is a much richer place than it was then. It is worth remebering that because the relative decline of the USA from being the world's dominant economic power has been a clear prospect for more than a quarter of a century. Europe already is in the same economic league as the US. Japan is close, China and India will join that league. Thev USA will go on getting richer.

[sesli sohbet]

Why is it worth remebering that the British decline as an economic power since the early 20th century is purely relative decline? Britain is a much richer place than it was then. It is worth remebering that because the relative decline of the USA from being the world's dominant economic power has been a clear prospect for more than a quarter of a century. Europe already is in the same economic league as the US. Japan is close, China and India will join that league. Thev USA will go on getting richer.

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