Do Deficits Matter?

Way back in what seems like another era–2004–the Washington Post published a retrospective article on fiscal policy under Reagan that did not utterly reject the Cheneyesque view that “Deficits don’t matter.” Now, of course, no one is saying that, and the Party of Reagan views deficit reduction as the primary task facing the federal government today. It is understandable that liberals would view their opponents’ about-face as motivated by partisanship rather than principle, and perhaps there is an element of that. But why did the WaPo view things so differently then, as well? Because when it comes to the impact of federal deficits, context is everything.

The key point is this: Deficits don’t matter, but debt does. Since the debt is built through the accumulation of deficits, this is of course an absurd statement taken literally. What, then, does it mean?

One of the essential building blocks of portfolio management is what’s referred to as the “risk-free asset.” Portfolio choice boils down to a matter of picking the right balance between safety and higher returns. And the definitive “risk-free asset” has long been U.S. Treasury securities. This means that there are lots of investors who want to hold the stuff that Tim Geithner is selling every week. But, as is true of every other market, there’s only so much demand at any particular price. At any moment, the Treasury should, ideally, have a sensible target value for the total debt outstanding that is based on its estimate of the public’s demand for it. The deficit (or surplus) would simply be the means by which the target level of total debt was reached or maintained.

When the stock of US debt is below its proper target value, it really is true that deficits “don’t matter.” In fact, they’re a pretty good idea. OTOH, if the debt is above the appropriate target, then deficits are not such a good idea. And if the debt is well above any sensible level, then deficits are recklessly bad policy.

What determines the appropriate amount of federal debt? Very simply, the world’s demand to hold it. If nobody wanted the stuff except US investors, then the target level of debt would be the historical fraction of private domestic wealth that investors want to hold as government bonds. Since US bonds have been viewed throughout the world as a safe haven, we’ve been able to sell lots more of the stuff than would be justified as a fraction of our own wealth. (I’m thinking of China right now, as you probably are, too.)

Lately many liberals have taken to pointing out that the ratio of our debt to GDP (which is not the same thing as wealth) was higher during WWII than it is today, with the implication that there is nothing to worry about now. That’s a silly comparison, though, because it was understood back then that the ballooning of the debt during mobilization for total war was a temporary deviation from the long-term level. Today, our great fear is that our huge debt is never coming down, and in fact is foreordained to keep rising indefinitely.

In this context, deficits do matter–and they matter a lot. Pushing beyond the right target level of debt is like skating on thin ice. There’s no clear point where we’ll fall through for sure, but we also know that by the time we start to hear the ice crack it’s too late. The bond market will keep soaking up our deficits for a while, but with an increasingly vigilant eye cast toward that critical moment when people start to worry about ability to service that debt. And by “ability” I mean “political will.”

Everybody who comprehends reality knows that the US is on an unsustainable growth path for entitlement spending. It was unsustainable before Obama, and thanks to “health care reform” it’s even worse.

This is all really bad news for Keynesians, whose analysis–such as it is–presumes that policymakers are able to choose any level of deficit spending they believe is necessary to boost the economy. That model is OK as far as it goes in a world where the government’s budget is kept in balance in the long run, because then the level of debt is nothing to worry about. However, we are not in that world. Even tax cuts are out, because it’s wishful thinking to believe that we’re on the “wrong” side of the Laffer curve. And monetary policy isn’t going to help us do anything but inflate our debt away.

The only weapon left in our policy arsenal is to lighten the regulatory burden on business, but Obama’s pointing it the wrong way.

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