Today most of the world’s rich countries are running rather large budget deficits. In some cases, the deficits are unusually large and have led governments to engage in painful austerity in order to bring the deficits under control. In others, such as the United States and Japan, little is being done to rein in deficits, and such inaction appears not to have done any harm. Thus, the question arises as to whether we should worry about deficits, and, if so, why? In what follows, we examine why some people hate deficits, others love them, and many simply don’t care.
First, consider a little history. In the old days before the post-war era, deficits were generally seen as a bad thing. Certainly countries in recession ran deficits, but often, countries went to considerable lengths to avoid accumulating debt. Those that did not rein in deficits often were unable to service their debts, and defaults were not unusual. However, the experience of the Great Depression, in which fiscal tightening was seen to worsen an already onerous economic downturn, led to new thinking about deficits.
The Keynesian critique was that, when a country is producing below its capacity, a debt-financed expansion in government spending would be a suitable way to boost output. Moreover, when the private sector hoards cash, the government could borrow that cash, spend it, and boost output. This view took hold of economic thinking in the immediate post-war era and found favor with policy makers in the 1960s. By the end of the 1960s, Richard Nixon was quoted as saying “we’re all Keynesians now.” Yet, the Keynesians seemed to have taken their views too far, believing that deficits could permanently increase growth. They could not.
By the mid-1970s, support for Keynesian stimulus abated as inflation became a greater worry. There was talk of “stagflation,” in which the economy stagnated but inflation endured. OPEC oil price shocks contributed to the inflation, but attitudes toward deficits changed. At that time, the main criticism of deficits was that they “crowd out” investment and slow economic growth. That is, when the government borrows in competition with the private sector, it drives up interest rates, hurts investment, and ultimately slows the economy. There was debate about the degree of crowding out and whether it is a problem when the economy is operating below capacity. In any event, the theory of crowding out suggested that, in the long term, deficits could do much harm. Indeed, they were blamed by some for the stagnation of the 1970s.
In the 1980s, Ronald Reagan came to power in the United States by attacking deficits. Yet he adopted a theory popular among some Republicans that tax cuts would pay for themselves by boosting work effort and investment. His large tax cut in 1981, followed by large increases in defense spending, wound up resulting in very big deficits. Evidently, the tax cuts did not pay for themselves, but they did boost private sector spending in the way Keynes suggested. Yet, given that large deficits did not appear to be doing much harm, an old theory was revived, suggesting that deficits are not a problem. The old theory, known as “Ricardian equivalence,” was based on the work of 19th-century British economist David Ricardo, who said that when the government borrows, individuals will increase their savings in anticipation of higher future taxes needed to service the debt. The higher saving would enable continued funding of investment. As such, there would be no “crowding out.” At the same time, higher savings would mean that consumers would spend less. Consequently, there would be no Keynesian stimulus. In other words, the deficit would make no difference either way. Conservative Harvard economist Robert Barro adopted the Ricardian view and provided statistical evidence in support of this view. Even Reagan adopted the view, saying that it made no difference whether the government taxed or borrowed to fund spending.
Still, the world was not totally convinced. After Reagan, George H.W. Bush and Bill Clinton both implemented tighter fiscal policies (higher taxes, reduced spending) that ultimately led to budget surpluses. As Clinton’s Treasury Secretary Robert Rubin argued, fiscal probity would create a more stable financial market environment, boost business confidence, and allow for a strong economy. This turned out to be true in the late 1990s. On the other hand, under George W. Bush, the United States returned to structural deficits in the 2001–2008 period, and growth continued at a reasonable pace.
Where do things stand today? In Europe, governments adopted tighter fiscal policies, which are widely seen as having inhibited economic growth. The United States had a more neutral fiscal policy, and growth has been stronger. There has been no crowding out given that the private sector is hoarding cash. The government is clearly not competing with the private sector for scarce funds. This supports the Keynesian view. On the other hand, the fiscal stimulus in 2009–2010 was accompanied by a sizable increase in private sector savings and a less-than-expected boost to growth. This would seem to support the Ricardian view.
Where do we go from here?
Few pundits, and fewer politicians, will say that we should not worry about deficits. The reality may be, however, that deficits are, at the least, harmless when the economy is weak and should be avoided when the economy is strong. For the United States, that probably means not focusing on the current deficit but attempting to do something now about future deficits. For Europe, it probably means slowing the pace of austerity and focusing first on restoring economic growth. Of course, very large long-term deficits should always be avoided. When interest payments become too large, deficits grow out of control, the debt-to-GDP ratio grows out of control, and either default or ruinous inflation becomes much more likely. Finally, when countries don’t control their own money supply (as in the Eurozone) or borrow in foreign currencies, the risk associated with their accumulation of debt is far higher, leading to high interest costs if financial markets become worried. Thus, their ability to engage in fiscal stimulus is severely limited.