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:

  1. Cyclical deficits are just that cyclical. Focusing on deficit reduction as a cause is likely to increase these cyclical deficits.
  2. Debt-to-GDP constraints are artificial and are implicit indications of fears of cronyism and government waste.
  3. 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.

22 Comments
  1. Larry Walker Jr says

    And when GDP growth is 1.6%, Government Revenue drops by -14%, and Government Spending Increases by 78%, what do you call that? Cause that’s really what we’re dealing with in comparing the fiscal year 2008 and 2010 budgets. And there are many areas of discretionary spending such as Energy which have increased by more than 2,000% over the two years. What about that. See my post at: Obama’s Unfunded Consumption – http://larrymwalkerjr.blogspot.com/2010/09/obamas-unfunded-consumption.html

    1. Edward Harrison says

      You write: “And when GDP growth is 1.6%, Government Revenue drops by -14%, and Government Spending Increases by 78%, what do you call that? Cause”

      I don’t know where you’re getting your numbers but all objective estimates have shown that we were operating with a trillion dollar deficit as a baseline as soon as the crisis hit. The deficit in October 2008 was approx $450 billion for FY08 (almost all of this from non-discretionary spending). By 2009, the deficit estimates had increased to over $1 trillion without any stimulus. Now that the stimulus is gone, deficit estimates are still over $1 trillion. Again, we’re talking about a revenue shortfall and increase in non-discretionary spending.

      Also, that energy piece is small potatoes compared to non-discretionary spending, Larry. If you think the deficit is a problem, tinkering at the margins with energy spending is meaningless.

    2. Edward Harrison says

      If you want to look at the numbers, see the source document from the OMB for yourself:

      http://www.whitehouse.gov/sites/default/files/omb/assets/fy2010_new_era/A_New_Era_of_Responsibility2.pdf

      This was the picture in January 2009.

      The deficit spending for FY09 was projected at about $1 trillion. It was originally budgeted to be a shade over $400B in January 2008 before the crisis in the previous budget.

  2. Tom Hickey says

    Ed, I am not sure that you have properly characterized the MMT position on budgetary deficits. As I understand it from Bill Mitchell, budgetary deficits make space for the public’s desire to save to the extent that the current account balance does not. This is the positive role of a budgetary deficit according to MMT, which Bill calls a “good deficit.”

    Should government policy not address the propensity to save sufficiently, then the public’s desire to save will mean that output at optimal capacity utilization and full employment will not be purchased, inventories will build up, and businesses will cut back, resulting in an output gap that entails rising unemployment and falling tax revenue. Automatic stabilizers will kick in, and the budget will go into deficit. This is a “bad deficit” that could have been headed off by a “good deficit.”

    Should the government run a budgetary surplus, then the nongovernment will be in deficit, and if there is a CAD, then the domestic private sector will either have to dig into savings, sell assets, or borrow to maintain lifestyle. The Clinton era surpluses resulted in the domestic private sector dissaving and going into debt, and Bush administration policy did not do enough to reverse this. In fact, low interest rates and loose credit encouraged borrowing to expand lifestyle. As a result, the buildup of private debt ultimately became unsustainable, which put us the hole we are trying to dig out of now. The antidote has to be either rising exports or an offsetting deficit, or the economy will remain in the tank until the debt is paid down or defaulted on, and if defaulted on, this could provoke debt deflation. It is clear that in the present environment exports will not be sufficient so deeper deficits are called for not only to stimulate recovery but also to prevent a worse situation from developing.

    The general MMT principle is that if the public desires to save, then budgetary deficits must make space for this. This is no problem because the national debt is simply the stock of cumulative deficits, which is by accounting identity the stock of cumulative saving of net financial assets by nongovernment. The special cases arise when the general principle is violated, and imbalance occur that force automatic stabilization and possibly require ad hoc response. It is just a matter of national accounting identities and sectoral balances operating.

    So MMT sees the present kerfuffle about public debt and budgetary deficits as much ado about nothing that distracts from the real issues and challenges, namely, the foregone opportunity resulting from the output gap and the mounting losses from unemployment and underemployment. These cannot be recouped once lost, and the deleterious effects persist over an extended period. Better not to get in such a position through understanding how the monetary system operates and designing policy accordingly.

    1. Edward Harrison says

      This post is not about MMT actually. These are my own thoughts about deficits. But I don’t see how I have mischaracterized MMT here. The only time I mentioned MMT specifically was when I said:

      “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.”

      The rest of what I have written does not apply to MMT.

      Here I was making a mental reference to a specific historical event:

      http://www.thedailybeast.com/blogs-and-stories/2010-07-19/save-the-economy-a-manifesto-by-harry-evans-joseph-stiglitz-alan-blinder-and-other-leaders/%5D

      Many leading (Keynesian) economists gathered to sign a document regarding their position on deficits. I know for a fact that the MMT’ers refused to sign this document because of this line in the text:

      “We recognize the necessity of a program to cut the mid- and long-term federal deficit but the imperative requirement now, and the surest course to balance the budget over time, is to restore a full measure of economic activity.”

      Krugman also did not sign. Galbraith has specifically said exactly what I did in this post on that score: “looking to ward off structural deficits 25 years down the line when we have nearly 17% un- and underemployment is madness.”

      1. Tom Hickey says

        Thanks for the clarification, Ed. Sorry to have misconstrued what you were saying.

        1. Edward Harrison says

          No worries. Since I’m not an MMT’er I can definitely get it wrong sometimes.

Comments are closed.

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