Why do the deficits matter?
Under realistic assumptions, the U.S. faces large budget deficits as far as the eye can see.
William Gale and Peter Orszag, both of the Brookings Institution, explain why the deficits matter in their article, "The US Budget Deficit: On an Unsustainable Path", from the December issue of New Economy.
First, let's characterize the problem (linger on, and reread, the last sentence):
- "To get some sense of the long-term budget imbalance facing the nation, we rely on the ‘fiscal gap.’ The fiscal gap measures the immediate and permanent increase in taxes and/or reductions in non-interest expenditures that would be required to establish the same debt-GDP ratio in the long run as holds currently. Along with Alan Auerbach of Berkeley, we have estimated that the US faces a fiscal gap through 2080 of 7.1 per cent of GDP. To close the gap would require an immediate, permanent 40 per cent increase in revenues or 35 per cent reduction in outlays"
- "Several factors contribute to this fiscal gap. The most important is projected increases in Medicare and Federal Medicaid costs... Federal expenditures on these two programs are projected to increase by more than ten per cent of GDP by 2070. By comparison, the increase in Social Security costs over the same period is only 2.5 per cent of GDP. Unfortunately, the health-related programs are much more difficult to reform than Social Security.
The recent tax cuts also play a major role in the long-term fiscal gap. If extended and not eroded over time by the AMT, the tax cuts would cost roughly two per cent of GDP over the long term. Even though projected increases in Social Security costs eventually exceed the size of the tax cuts, do not conclude from this that the tax cuts are less expensive than the Social Security increases. The increase in Social Security costs mounts gradually as America ages. The cost of the tax cuts starts immediately, and changes little as a share of GDP over time. In present value, the actuarial deficit in Social Security is only one-fifth to one-third the cost of the tax cuts over the next 75 years. The tax cuts account for more than a quarter of the fiscal gap over the next 75 years."
- "...budget deficits matter because they reduce national saving and thus reduce future national income. That reduction in future income can occur either because interest ratesrise and domestic investment falls, or because we borrow more from foreigners and therefore owe more to them in the future. Or it could occur through some combination of these two effects."
- "...The reason is that they reduce national saving. National saving is equal to private saving minus the budget deficit; so when the budget deficit goes up, national saving goes down.
The federal deficit increased by more than six per cent of national income between 2000 and 2003, which triggered a substantial decline in national saving over that period. Indeed, in 2003, the net saving rate for the US amounted to less than two per cent of income. This level of national saving was the lowest since 1934.
But why does national saving matter? The reason is that it determines how rapidly Americans accumulate financial and real assets. The returns to those assets have a substantial effect on future income. The bottom line is that a larger budget deficit and lower national saving today reduce income in the future.
Another way of making the same point is that with a saving rate of two per cent of income, there are necessarily only two options.
The first option is that we reduce the amount that is invested in the US to two per cent of income, which would starve future American workers of computers, buildings, and other productive capital. This crowding out of private investment is brought about through higher interest rates. The budget deficit soaks up available private saving, leaving a smaller pool of national saving to finance domestic investment. Firms that want to borrow for investment projects compete for that smaller pool of available funds. In the process, they bid up the interest rate that they’re willing to pay. The higher interest rate dissuades some firms from undertaking their investment projects, with the net result that investment declines. A reasonable rule of thumb for the US is that each per cent-of-GDP in anticipated future permanent unified deficits raises forward long-term interest rates by 25 to 35 basis points.
The second option is that if we do invest more than two per cent of our income, we must borrow the difference from foreigners – which would leave future generations of Americans increasingly indebted to other nations. Indeed, as national saving has plummeted over the past few years, US domestic investment has increasingly been financed by foreign borrowing. The increase in such borrowing is reflected in our growing current account deficit, which has expanded from about 2.5 per cent of national income in 1998 to more than five per cent in 2003. This borrowing from abroad, however, mortgages the future returns from domestic investment in the US. Foreigners understandably do not lend us money for free, so we must share at least part of the future returns from our domestic capital stock with them. As a first approximation, borrowing more from foreigners has the same adverse implications for the future national income of Americans as reduced domestic investment does. Furthermore, the associated current account deficit likely stokes protectionist pressures in the US, potentially causing harm for the world trading system."