Does focusing on deficit reduction reduce deficits?
The short answer to my question is no. I was thinking about this early today and here’s what I have come up with as a more fleshed out answer.
Budget deficits are the result of an ex-post accounting identity. In plain English this means that the deficits are the effect and not the cause. For example, if I told you that the unemployment was X%, savings rates Y%, and capital investment Z%, this would go a long toward telling you how much revenue the federal government would be able to collect under any given tax regime. The point is not that you could predict the budget deficit in advance with remarkable accuracy but that you could build a range for federal deficits based on these inputs and other factors. This is what the US Office of Management and Budget does every year with a reasonable track record. The deficit is an exogenous variable – it’s causal effect is limited.
Focusing on deficit reduction is akin to my going to my garden and mowing the grass way down when I see a bunch of weeds growing. Yes, I have temporarily reduced the weeds down but only temporarily; they will grow again because I have failed to kill the root. Meanwhile I have also killed the grass which I am trying to grow. This is what has happened in Ireland, by the way. Reducing government employee wage rates and cutting government expenditure only sucks demand out of the economy. It doesn’t actually do anything to address falling house prices and the private sector debt overhang which are the root causes of Ireland’s malaise. Predictably, this has led to a double dip in Ireland. Germany can (and should) reduce deficits because they are at a different point in the economic cycle and face different constraints.
So, government shouldn’t focus on the deficit per se. When you hear a politician saying, "we have to reduce the deficit because of A, B or C," you can bet they have no idea what they’re talking about. What government should focus on are structural and cyclical causes of deficits i.e. the endogenous variables that cause the deficit to begin with.
From a cyclical perspective, deficits are caused by a fall in aggregate demand due to unemployment and underemployment. This loss of labour causes an economy to operate below potential, reducing tax revenue and inducing deficits. Eventually an economy’s output gap will close as a recovery becomes well advanced. Now, there is a huge debate raging in the economics profession right now as to how much of this un- and underemployment is cyclical and how much is structural. I believe much of it is structural (see here). But from a framing perspective this only matters regarding what policies government should pursue in returning to full employment. Essentially, I am saying this is a political debate as much as an economic one (see here). The overall point is that eventually, the output gap will close and the cyclical causes of deficits will disappear. The political question goes to what government should do to help close that gap more quickly.
From a structural perspective, in the US, the deficit is caused almost exclusively by defense and non-discretionary spending i.e. military spending and entitlement spending (Medicare, Medicaid, and Social Security). Other discretionary spending is pitifully small compared to these items. In fact, if you were to eliminate all non-defense discretionary spending today, you would still have an enormous budget deficit. And I would add that it will kill aggregate demand in the short-to-medium term. No one wants to touch non-discretionary spending because its politically radioactive to do so. On this score, I agree with David Stockman.
So what about the Cult of Zero Imbalances – the notion that the deficit must be as close to zero over the business cycle as possible? I would agree with Marshall that this is an artificial political constraint. For example, if nominal GDP is growing at 6% and the budget deficit averages 4%, then the debt-to-GDP ratio is falling inexorably toward zero. Is there a need to move toward a zero balance in this situation?
I surmise Marshall sees little value in the cult of zero imbalances because he is focused on full employment only (an endogenous variable) and not on deficits per se (an exogenous variable). One reason you won’t hear him or other MMT’ers say that we need to reduce the long-term budget deficit (i.e. structural deficits) is because they feel government’s public purpose is full employment. Full stop. In this view, looking to ward off structural deficits 25 years down the line when we have nearly 17% un- and underemployment is madness. I reckon they would say it is also politically-motivated.
On the other hand, I take a more hawkish position. I do see value in restraining deficits because it prevents government from redirecting real resources on cronyism when the economy is in the up-cycle. In the bubble economies, this is most certainly what we have witnessed.
My conclusions are these:
- Cyclical deficits are just that cyclical. Focusing on deficit reduction as a cause is likely to increase these cyclical deficits.
- Debt-to-GDP constraints are artificial and are implicit indications of fears of cronyism and government waste.
- Deficits matter only to the degree they steal real resources from productive use. This can be surmised from a rapidly rising debt-to-GDP ratio.
My thinking on this is still a work in progress.