"Blessed are the young, for they will inherit the national debt"
The United States' budget deficit has been a contentious issue since the nation was founded. When President Bill Clinton left office, he bequeathed an almost unprecedented budget surplus. During the Bush Administration's first term, this record surplus was converted into a record deficit, prompting alarm in many quarters.
In order to examine the effects of the budget deficit, we must understand some of the unique features of the US economy. While I briefly examine short-run effects on consumer consumption and saving, I have focussed on the long-run. As of 2005, the majority of short-run effects have already been felt by the US economy, limiting the relevance of a discussion of hypothetical effects. However, the full impact of the continuing deficit on the exchange rate, the trade deficit and even the position of the US in the world economy are unlikely to have been felt. These second-order effects are open to ongoing analysis, and present some disturbing possibilities for the US economy in the coming years. It is these possibilities that I examine here.
In the conventional model, the immediate effect of a budget deficit is to reduce national saving. National saving is the sum of public and private saving, and a budget deficit means public saving is negative. This obviously reduces total national saving, all other things being equal. We can illustrate the effects of this with the following identities.
(1) S ≡ (Y - T - C) + (T - G) ≡ Y - C - G
By adding the public and private savings identities, we establish that national saving equals GDP less consumption and government expenditure (1).
(2) Y ≡ C + I + G + (X - M)
By substituting the GDP identity (2) into the national savings identity (1), we can show that savings equals investment plus net exports (3).
(3) S ≡ I + (X - M)
The implication of this is that as budget deficits have been shown to reduce national saving, they must also reduce investment and/or net exports.
Proponents of the Ricardian Equivalence model claim that consumers are forward-looking, and rather than increasing consumption they instead save the proceeds of a deficit-financed tax cut, anticipating the 'inevitable' future tax increases needed to repay the government debt. In this model, private saving increases to exactly offset the drop in public saving, leaving national saving unchanged. The strongest argument against this view is that it relies on perfectly rational behaviour by consumers, which is quite plainly an absurd assumption to make.
After the 2001 tax cuts and spending increases, national saving did fall sharply. As predicted by (3), this lead to a linked rise in the trade deficit (fall in net exports). This reached a record high of $187.9 billion in Q4 2004 . Thus it is shown that the budget deficit and trade deficit are closely linked, which has further implications for the US economy.
Conventional models show that large budget- and current account deficits cannot be sustained indefinitely. Eventually lenders lose their appetite for the government's debt. This may be triggered by a fear of actual default, or an effective default by devaluation of the currency and inflation.
The US, however, is in the unique position of having an almost unlimited line of credit with the rest of the world. This is due to the US Dollar's role as the international reserve currency: a position it has held since the first implementation of the Bretton Woods system. Not only is this line of credit virtually unlimited, it is also on exceptionally generous terms. Unlike other countries, the US can borrow in its own currency, passing the exchange rate risk onto the creditors.
While this may seem encouraging for the US economy's prospects, there is no guarantee that this situation will last indefinitely. A primary requirement for a reserve currency is that it must act as a store of value. Over recent decades, the dollar has steadily lost value, and this depreciation has accelerated since 2001.
Although there is a correlation between the fall in the dollar and the increased deficits, it is not immediately obvious as to how the exchange rate could be affected in this way. Models would predict that an increased budget deficit would lead to higher interest rates as the government competes in the market for debt (the crowding out effect). This in turn would be expected to lead to an appreciation of the currency. Instead, the opposite has occurred. Between Bush's inauguration in January 2001 and the end of February 2005, interest rates on 10 year T-Bonds fell from 5.16 to 4.17 percent . Short term real interest rates have remained negative for some time.
Meanwhile, the dollar has lost around one third of its value against many major currencies. There are a number of possible explanations as to why this has occurred. Alan Greenspan, chairman of the Federal Reserve, has justified the policy of low interest rates as necessary to stimulate growth. There is a case to be made that the rates are being held artificially low, and this is contributing to the fall in the dollar and low levels of private saving. Despite low yields, there is still a strong appetite for T-Bonds among purchasers, especially Asian central banks. The People's Bank of China has been a major purchaser of US debt as it maintains the peg of the yuan to the US Dollar, as has the Bank of Japan.
So long as it retains its reserve status, there is little chance of a run on the dollar, thanks to the actions of many central banks to maintain its value. The question is now whether the dollar might lose its reserve status. Until recently such an event would have been unthinkable, but a number of factors now make this a real possibility. In the euro, there is now an alternative for central banks looking to hold a strong, highly liquid currency backed by a major trading power. More significantly, many banks seem to have been quietly moving to diversify their holdings into a trade-weighted basket of currencies, so as to avoid facing similar problems in the future. If this process continues then the dollar will depreciate still further until a tipping point is inevitably reached and investors run for the exits.
The effects of a loss of reserve status and the resulting 'hard landing' on the US economy could be wide and damaging. As US debt and assets became less attractive to lenders, yields would rise and stocks would fall. Rising interest rates would risk a house price collapse: a particularly pertinent danger considering the current over-heated nature of the property market. The two quasi-independent re-mortgage lenders, Fannie Mae and Freddie Mac, would come under intense pressure from defaults in the event of a collapsing housing market and rising interest rates. The government would almost certainly have to step in to bail them out before they collapsed, or otherwise risk a cascade of bank failures. This would be a considerable expense for a government which had lost its easy line of credit. Bankruptcies would rise as businesses felt the strain of interest repayments and falling asset prices. This would in turn place their banks under further pressure. If banks started to fail, the government would once again come under pressure to bail them out in order to avoid a cascade effect. Faced with a sudden drop in tax receipts and a jump in expenditure requirements, the government and the Federal Reserve would be forced to resort to printing money. The increase in the money supply as the Fed adopted an accommodating monetary policy of purchasing government debt would cause high inflation, with the increased cost of imports adding to the effect. This 'inflation tax' would help reduce the value of the existing government debt at the expense of holders of dollars in both the US and worldwide. The combination of these effects could lead the economy into a depression. A decade after discussing the dangers of such a hard landing, N. Gregory Mankiw was appointed chairman of President Bush's Council of Economic Advisers, and has acknowledged the need to cut the budget deficit. This frank speaking led in part to Bush's decision to sack him in 2004.
There are risks attendant to any attempt to reduce the deficit. Any tax increases would lead to lower disposable income and would increase deadweight losses from distortion effects. This would risk returning the economy to recession. Increases in interest rates designed to encourage saving would hold similar risks. Consumers could be encouraged to behave in a more 'Ricardian' manner through tax breaks on savings and reform of inheritance tax.
The profligate policies pursued in the first term of the Bush administration have left the economy in a difficult situation. While there are risks associated with some of the austerity measures needed to cut the budget deficit, the dangers posed by a loss of reserve status or hard landing make them unavoidable. The US government needs to abandon its plans to make the tax cuts permanent, while engaging in cuts of discretionary spending.
- Ball, L., & Mankiw, N. G. (1995). "What do budget deficits do?" Symposium: Budget Deficits and Debt: Issues and Options, Jackson Hole, 2nd September. Kansas City: Federal Reserve Bank of Kansas City (pp. 95-149).
- Federal Reserve. (2005). "Statistical Release H.15 Historical Data." http://www.federalreserve.gov/releases/h15/data/m/tcm10y.txt
- Greenspan, A. (2003). "Monetary Policy Report to Congress, July 15, 2003." http://www.federalreserve.gov/boarddocs/hh/2003/july/testimony.htm
- Jaffee, D. (2003). "The Interest Rate Risk of Fannie Mae and Freddie Mac." Journal of Financial Services Research, 124(1), 5-29.
- Krugman, P. (1997). "Currency Crises." NBER Conference, October 1997.
- McKinnon, R. (2001). "The International Dollar Standard and Sustainability of the U.S. Current Account Deficit." Brookings Panel on Economic Activity: Symposium on the U.S. Current Account, Washington, DC, 29th March. Palo Alto: Stanford University, Department of Economics
- Mankiw, N. G. (2004). "Domestic Effects of Foreign Direct Investment." International Tax Policy Forum, Washington, DC, 2nd December. Washington, DC: American Enterprise Institute
- Mankiw, N. G. (2002). Macroeconomics. New York: Worth Publishers.
- NIPA. (2005). "National Income and Product Accounts Table 5.1." http://www.bea.gov/bea/dn/nipaweb/TableView.asp?SelectedTable=120&FirstYear=1990&LastYear=2004&Freq=Ann
- The Economist. (2005). "Buttonwood: 16/3/2005." http://www.economist.com/finance/displayStory.cfm?story_id=3761805
- The Economist. (2004). "The Future of the Dollar." http://economist.com/displaystory.cfm?story_id=3445928
Based on an essay that I wrote for my introductory macroeconomics course at the University of Bath. I've tried to make it less boringly technical than the original, but it obviously doesn't have the pretty graphs. It got me a 78: at the time my best grade ever.