Cato Institute
1000 Massachusetts Ave, NW
Washington, DC 20001-5403

Phone (202) 842 0200
Fax (202) 842 3490
Contact Us

Budget Deficits: Old Theories v. New Facts

by Alan Reynolds

This article was published in Apple Daily, September 22, 2004.

PRINT PAGE
CITE THIS
  Sans Serif
  Serif

Share with your friends:

The Economist (11 September) repeats the editors' habitual lecturing about a "reckless" U.S. budget deficit, which amounts to 3.6 percent of GDP. In a related essay, C. Fred Bergsten recycles his ill-fated "hard landing" scares of the 1980s, based on a metaphysical assertion that "larger budget deficits will produce larger American trade deficits . . .. [and] higher interest rates."

The statistical tables at the back of The Economist, by contrast, tell a different tale. Budget deficits in France and Germany are just as large as in the U.S., and the budget gap in Japan is twice as large. Yet all three countries have a current account surplus, not "twin deficits." And the interest rate on 10-year government bonds is only 1.6 percent in Japan.

Australia, by contrast, has maintained budget surpluses since 1998. Yet Australia's current account deficit is larger than that of the United States, as it was in all but one of the past six years. Australia's 10-year interest rate is 5.6 percent -- substantially higher than the U.S. rate of 4.2 percent. Canada, with a budget surplus since 1997, also has a higher interest rate than the U.S, 4.7 percent. These are regular patterns, not anomalies.

Alan Reynolds is a senior fellow with the Cato Institute and a nationally syndicated columnist.

More by Alan Reynolds

From 1994 through 2003, annual budget deficits averaged 5.8 percent of GDP in Japan, compared with 1.6 percent in the U.S. If budget deficits really increased interest rates and current account deficits, then Japan should be experiencing high interest rates and a large current account deficit by now. Countries with budget surpluses, like Australia, should be experiencing much lower interest rates and current account surpluses. The facts obviously don't fit the conventional theory.

The same stubborn theory also claims budget deficits reduce national savings and that tax increases can magically add to savings. On the contrary, the U.S., U.K. and Australia moved chronic from budget deficits to surpluses in the late 1990s, but the ratio of savings to GDP did not increase at all. The U.S. savings rate was 18.2 percent from 1983 to 1989, when deficits were relatively large, and 17.5 percent from 1998 to 2001 when the U.S. budget was in surplus. Hong Kong moved secular surpluses to cyclical deficits in recent years, but the national savings rate remained at 31-33 percent of GDP.

A paper of mine on these topics was originally presented at the U.S. Treasury and later published by the Cato Institute. I concluded: "In reality, neither actual nor projected budget deficits raise real or nominal interest rates, steepen the yield curve, reduce national savings, cause `twin deficits,' or make the dollar go up or down. The logic behind such speculations is flawed and contradictory and the evidence is nonexistent".

Two studies have appeared since mine. One by Eric Engen and Glenn Hubbard estimated that budget deficits might have a trivial effect on interest rates, with each 1 percent of GDP lifting interest rates an imperceptible 2-3 basis points. Another by Roger Kormendi & Aris Protopapadakis found "no evidence of any positive effects of either current or expected future budget deficits on either real interest rates or current account deficits."

It is not that budget deficits "don't matter." The extra debt service is a burden on future taxpayers, like any other spending. Yet it makes sense for governments, as it does for families and firms, to borrow in hard times or for investment or when the alternatives are worse.

What is done about budget deficits usually matters a great deal more than the deficits themselves. Alberto Alesina of Harvard University and three co-authors unveiled a major long-term study of fiscal policy changes in 18 economies for The American Economic Review, September 2002. What they found was that "fiscal stabilizations that have led to an increase in growth consist mainly of spending cuts, particularly in government wages and transfers, while those associated with a downturn in the economy are characterized by tax increases." Ireland prospered after cutting spending by an amount equal to 7 percent of GDP (equivalent to two U.S. defense departments), then slashing marginal tax rates on profits, capital gains and salaries.

To use any cyclical fiscal shortfall as an excuse for adding a permanent new tax is very risky. Such taxes cannot be justified by theoretical conjectures that budget deficits increase interest rates, because those theories have zero predictive value. What world experience demonstrates is that allowing government spending to grow faster than the private economy is a grave threat to prosperity -- particularly when such spending is financed by permanent tax increases rather than temporary government borrowing.

Share with your friends: