Do Deficits Matter?

by | December 16, 2020

As a result of the 2009 financial crisis and now of the global pandemic, government budget deficits have exploded and levels of debt have soared. Yet the US, the UK, major European economies and Japan have all been able to borrow at ever lower interest rates—even negative rates in countries such as Germany.

Decades ago, economists worried about government deficits and debt. In the 1980s, mainstream thinking focused on ‘crowding out’, where government deficits would drive up real interest rates and sideline much-needed private sector investment. The Maastricht criteria, which guided the formation of the European Monetary Union, imposed strict fiscal rectitude on candidate members, motivated by fears that member countries might run up unsustainable deficits and debt inside of a common currency area.

In a recent paper, President Obama’s Chairman of the Council of Economic Advisors, Jason Furman, and former US Treasury Secretary, Larry Summers, made the case that conventional measures such as ‘Debt/GDP’ might signal potential risks where there may be none, or at least none for a significant period of time. Furman and Summers also contend that the near four-decade downward trend in real (i.e., inflation-adjusted) interest rates imply a debt load for the US that is not as high as perceived by the Debt/GDP ratio. They proceed to argue that ample room exists for fiscal expansion, and not just during times of stress, such as the ongoing recession.

Furman and Summers also argue that achieving a balanced budget is not necessary during the expansionary phase of a business cycle, particularly if fiscal rectitude results in slower growth. Instead, they suggest that in order to boost the economy’s long-term growth potential, government spending (investment) ought to be targeted to areas that have higher rates of return than their cost of financing.

All of this begs the fundamental question – do deficits and debt still matter?

They do, and here’s why.

First, deficit spending in times of stress and expansions is nothing new. With the exception of 1998-2001, the US federal budget has been in a deficit every single year since the late 1960’s. That has led to an inexorable rise in national indebtedness, however measured. At some point, the stock of national debt must stop growing as a share of income. That imperative becomes more pressing once the cost of servicing that debt rises.

Second, while a strong case can be made that targeted outlays on productivity-enhancing investments is worthwhile, can governments do so indefinitely and recoup significant multipliers? Even if investment is restricted to ‘public goods’—such as education, training or transportation, that free markets tend to shun—can economists be certain that governments will make the most optimal choices? Investing in highways or railroads, for instance, may be unwise and inefficient if new technologies usher in ‘smart modes’ of moving people and things about.

Third, while Furman and Summers correctly note that given excess global capacity and a very low cost of capital, ‘crowding out’ is less relevant today, theirs becomes an argument for short-term counter-cyclical fiscal policy, rather than long-term sustained deficit spending. After all, at full employment, increased borrowing by the government must raise the real rate of interest, implying that some private sector investment will be forgone.

Indeed, when full employment is restored, the relevant questions should change. For instance, can an economy sustain a dependency on deficit spending without the need for structural realignment of the private-public relationship? If not, what kind of realignment is necessary and appropriate? How will the financial markets respond to such a realignment?

Fourth is the issue of current low productivity. Is it coincidence, or causal, that slowing productivity growth – especially since the global financial crises – has been accompanied by exploding government spending?

Finally, it has not escaped notice that a key driver of low borrowing costs owes to highly expansionary monetary policies, underpinned by record-low policy rates and unprecedented asset purchases. Quite apart from their potential distortions to asset prices and the broader economy, how might fiscal policy have to adjust should inflation begin to accelerate, necessitating a tightening of monetary policy? At that point, fiscal dynamics might appear more precarious.

Is it time to jettison conventional economics when it comes to government deficits and debts? We agree that fiscal policy—appropriately designed—can be deployed to boost economy-wide productivity growth. Equally, fiscal expansion is warranted in recessions, particularly when monetary policy may have lost effectiveness. But reducing the share of output derived from fiscal deficits should still remain a target of policymaking, especially when momentum in the private sector favors greater investment.

Deficits and debt do matter. Although tax and spending policies can be put to good use to promote growth in both the short and the long run, the age-old wisdom of all things in moderation still holds. Even for fiscal policy.

Filed Under: Economics

About the Author

Larry Hatheway

Larry Hatheway has over 25 years experience as an economist and multi-asset investment professional. He is co-founder, with Alexander Friedman, of Jackson Hole Economics, LLC, which offers commentary and analysis on the global economy, policy & politics, and their broad implications for capital markets. Prior to co-founding Jackson Hole Economics, LLC Larry worked at GAM Investments from 2015-2019 as Group Chief Economist and Global Head of Investment Solutions, where he was responsible for a team of 50 investment professionals managing over $10bn in assets. While at GAM, Larry authored numerous articles on the world economy, policy-making and multi-asset investment strategy. Larry was also the lead investment manager for various mandates, funds and an actively managed multi-asset index. Larry also served on the GAM Group Management Board, was Chairman of the GAM London Limited Board and served as member of the GAM Investment Management Limited Board. Larry was also Chairman of the GAM Diversity & Inclusion Committee. During his tenure at GAM, Larry was based in London, UK and Zurich, Switzerland. From 1992 until 2015 Larry worked at UBS Investment Bank as UBS Chief Economist (2005-2015), Head of Global Asset Allocation (2001-2012), Global Head of Fixed Income and Currency Strategy (1998-2001), Chief Economist, Asia (1995-1998) and Senior International Economist (1992-1995). During his tenure at UBS, Larry was also a standing member of the UBS Wealth Management Investment Committee. While at UBS, Larry worked in Zurich, Switzerland, London, UK (various occasions), Singapore and Stamford, CT. At both GAM Investments and UBS Investment Bank Larry was widely recognised for his appearances on Bloomberg TV, CNBC, the BBC, CNN and other media outlets. He frequently published articles and opinion pieces for Bloomberg, CNBC, Project Syndicate, and The Financial Times, among others. Before joining UBS in 1992, Larry held roles at the Federal Reserve (Board of Governors), Citibank and Manufacturers Hanover Trust. Larry Hatheway holds a PhD in Economics from the University of Texas, an MA in International Studies from the Johns Hopkins University, and a BA in History and German from Whitman College. Larry is married with four grown children and a loving Cairn Terrier, and resides in Wilson, WY.

Alex Friedman

Alex Friedman is the co-founder of Jackson Hole Economics, LLC, a private research organization which provides commentary and analysis on economics, politics, the environment and finance, and develops actionable ideas for how sustainable growth can be achieved. Friedman is a senior business leader with two decades of experience growing and transforming businesses in the financial and non-profit industry. He was the CEO of GAM Investments in London and chairman of the firm’s executive board. Previously, he was the Global Chief Investment Officer of UBS Wealth Management in Zurich, chairman of the UBS global investment committee, and a member of the executive board of the private bank. Before moving to UBS, Alex Friedman served as the Chief Financial Officer of the Bill & Melinda Gates Foundation. He was a member of the foundation’s management committee, oversaw strategic planning, and managed a range of the day-to-day operating functions of the world’s largest philanthropic organization. Friedman also created the foundation’s program-related investments group, the largest impact investing philanthropic fund in the world. He started his career in corporate finance at Lazard. Friedman served as a White House Fellow in the Clinton administration and as an assistant to the Secretary of Defense. He is a member of the Council on Foreign Relations and the Chairman of the Advisory Board of Project Syndicate, the non-profit opinion page that provides world-class commentary to over 500 newspapers globally. In addition, he is a board member of the American Alpine Club and the Jackson Hole Community Housing Trust, and has served on the boards of the Gates-Cambridge Trust, the Seattle Art Museum, and a number of other non-profits. Friedman is a regular contributor to several newspapers and thought leadership groups and has published numerous opinion editorials on topics including economics, finance, philanthropy, and politics in Project Syndicate, Bloomberg, The Wall Street Journal, The Financial Times, The Guardian, CNBC, The South China Morning Post, The Chronicle of Philanthropy, and other news outlets. He is also the author of Babu’s Bindi, and The Big Thing, both children’s book. An avid mountaineer and rock climber for 30 years, Friedman has climbed some of the world’s highest mountains and led the first major climb to raise money for charity through an ascent of Mt. McKinley. He holds a JD from Columbia Law School, where he was a Harlan Fiske Stone Scholar, an MBA from Columbia Business School, and a BA from Princeton University.

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