Is the government budget deficit a problem?
January 29, 2006
Debt isn’t a problem, as they say, until it’s a problem, and then it’s the only problem. This applies to government budget deficits and debt as well as an individual’s finances. Generally speaking, the problem with deficits is not that they are a problem, but that it brings the government one step closer to the point at which it is a problem. Along the way, as debt builds up, more and more tax revenues go toward financing the debt instead of paying for government services. This makes a budget deficit all the more likely, thus increasing the debt, and so on and so forth.
As the point at which debt is the only problem is approached, the interest rate the government must pay to refinance its debt rises. This puts a greater burden on finances, which means a bigger deficit, and more debt, and the problem approaches faster.
Nevertheless, it is hard to find a single example where a government simply collapsed from too much borrowing. Maybe Japan will be one such example in the future. Typically, the process by which a country defaults (Russia or Argentina in recent memory) involves some sort of currency or tax mishap, which damages the economy, leading to the final collapse. Thus, the problem with debt may be that it often inspires the government to do something stupid, hastening the decline.
Is it bad for an economy if the government defaults? This may seem like a stupid question: “of course!” comes the ringing reply. But why? Why should an economy suffer if the government stops making payments on the debt? Yes, the holders of the debt will be in trouble, but so what? I note, for example that the Argentine economy, which suffered badly through the 1997-2001 period, actually boomed soon after the government defaulted. After the Argentine government’s default, it began running a big surplus, and cut taxes!
One of the many stupid things a government may do, as it gets into trouble, is to raise tax rates. This is inevitably expected to produce more tax revenue, but the results are almost always disappointing, because the economy slows and tax avoidance increases. As the economy slows, the government is asked to spend more and more money in the form of welfare projects. Thus, the result of tax hikes is often lower revenues and higher expenditures! One of the smartest things a government can do, when it faces a large debt burden or deficits, is to cut tax rates. The result often is that the economy expands and tax revenues rise, and tax avoidance declines. Often, taxes as a percentage of GDP will actually rise after a major tax cut. As GDP increases, the debt/GDP ratio declines even if the debt is getting bigger. The government also finds it politically easier to cut expenditures, as welfare-related payments are low and employees in protected bureaucracies, rather than fighting to keep their government jobs with cushy benefits, are happily departing for higher-paying positions in the private sector. The heavily indebted Turkish government has been cutting taxes recently, especially corporate taxes, and is enjoying a booming economy and booming tax revenues. Russia instituted a revolutionary 13% flat income tax in 2001 and than reduced corporate and payroll taxes substantially. Aided by strong revenues from oil export taxes, the result has been that not only has the government paid off the debt that it defaulted on in 1998, it is running a budget surplus of 7% of GDP. Within a couple years, the Russian government may be one of a handful in the world with no debt at all.
John F. Kennedy wasn’t always a popular president. He barely beat Nixon in the 1960 election (some would argue that he didn’t). He became more popular when he began to propose tax cuts not only to deal with the recession and unemployment of the time, but also the budget deficit. Here’s how he described his strategy in 1962:
It is a paradoxical truth that tax rates are too high today and tax revenues are too low, and the soundest way to raise the revenue in the long run is to cut the rates now. The experience of a number of European countries and Japan has borne this out. This country’s own experience with tax reduction in 1954 has borne this out. And the reason is that only full employment can balance the budget, and tax reduction can pave the way to that employment. The purpose of cutting taxes now is not to incur a budget deficit, but to achieve the more prosperous, expanding economy which can bring about budget surplus.3
The Kennedy tax cut was implemented by Johnson in 1964. How long did it take the government’s accounts to swing from deficit to surplus as a result? It took exactly one year. In 1965, the government was on track to run a $3 billion surplus, until Vietnam-related expenditures caused the accounts to fall back into the red.
The other thing that may happen, as a government struggles for a solution to its debt problems, is the currency may do something unfortunate. This can be particularly burdensome for those governments that borrow in dollars or other foreign currencies, as they usually receive revenues in their local currencies. Often, it is a currency decline associated with the debt crisis that puts a government over the edge. However, there is no reason at all why a currency must decline because a government has a lot of debt, or even if it defaults on that debt. Take the eurozone for example: if Greece defaults, will that cause a decline in the euro’s value? Japan has one of the largest debt/GDP ratios on the planet (estimated as high at 200% of GDP), but the yen, if anything, has to be kept from rising. It is quite likely that demand for a currency would decline in the event of a debt crisis, but this can be easily remedied by reducing the supply of currency (base money) via open-market operations. Such currency declines are often “accidental”, i.e. the result of stupidity and negligence. In the bad old days, before World War II, governments occasionally hyperinflated their way out of debt, but this is essentially nonexistent today. (Maybe it will make a comeback?)
Another common criticism of government debt is that it causes interest rates to rise, thus slowing the economy and causing higher debt service costs for corporations and individuals. Once again, there is hardly any evidence for this. Japan’s debt continues to trade at yields below 2%, as it has for roughly a decade now. A wonderful new example has now been created in the eurozone, where debt of twelve (soon to be over twenty) countries trade using the same currency. The result? The difference in yields between the debt of the most trustworthy borrowers (Germany is the benchmark in this case) and the more marginal debts (Italy, with a debt/GDP ratio over 100%) is typically less than 0.50%. There is no particular reason why a corporation can’t borrow at rates lower than the local government, either: it is quite common in Latin America. However, this is usually the case for debt denominated in foreign currencies. For local currency-denominated debt, the risk of corporate debt increases because governments often end up doing something stupid with the currency as they go into their death throes, thus putting corporate debt at risk as well. The lowest yields on US government debt during the 20th century were in the late 1940s, when the US government had debt in excess of 120% of GDP as a result of World War II. (It was the US government’s highest debt/GDP ratio, actually, of the 20th century.)
Most of the time, deficits basically don’t matter. I am loathe to say this, because usually the government deficit spending goes to finance pure waste, or something worse than waste like the US’s government’s war in the Middle East. Not to mention a large portion of simple thievery. I don’t want to encourage more of such spending. Nor would I want to encourage the US government to get into the position where the debt is the only thing that matters. But, at this time, as unpleasant as it is, the US government’s debt and deficit has little economic effect.