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Monday, December 27, 2010

Economic Effects of a Budget Deficit Exceeding $1 Trillion

Marc Labonte
Specialist in Macroeconomic Policy

The budget deficit in FY2009 equaled $1.4 trillion, or 10% of gross domestic product (GDP). In 2010, it equaled $1.3 trillion, or 9% of GDP. Combined with a shrinking economy, this increased the publicly held federal debt by 12.8 percentage points of GDP in 2009 and 8.6 percentage points in 2010. Deficits of this size are not sustainable in the long run because the federal debt cannot indefinitely grow faster than output. Over time, a greater and greater share of national income would be devoted to servicing the debt, until eventually the government would be forced to monetize the debt (finance it through money creation) or default on it.

Although the debt cannot persistently rise relative to GDP, it can rise for a time, so it is hard to predict at what point investors would deem it to be unsustainable. A few other advanced economies have debt-to-GDP ratios higher than that of the United States. While some of those countries have seen their relative financing costs rise during the financial crisis, Japan has continued to be able to finance its debt at extremely low costs.

If investors as a whole currently deemed the debt to be unsustainable, the yields and the cost of credit default swaps on Treasury securities would be expected to rise. Instead, both are low. This may seem surprising, given that the debt is currently growing more rapidly than output, and it is projected to continue to do so under current policy. Over the next few years, the deficit is projected to fall somewhat, but if tax provisions scheduled by law to expire are extended and discretionary spending stays at recent levels, the deficit would not fall enough under current policy to stabilize the debt. Further, the debt is projected to begin rising more rapidly in the long term under current policy because of the rising costs of Social Security, Medicare, and Medicaid. The willingness of investors to finance the federal debt at low interest rates in light of these projections suggests that investors believe that policy changes will eventually be made that will place the federal debt on a sustainable path.

Standard macroeconomics predicts that the increase in the deficit will temporarily boost overall spending at a time when there is significant slack in the economy. Were the deficit to be harmful to the economy, it would likely occur in one of two ways. First, it could result in higher interest rates that would “crowd out” private investment. Because private investment has fallen so much as a result of the recession and interest rates are currently low, there is little evidence that crowding out is a significant factor at the moment. Second, the deficit could fail to boost GDP if it led to more borrowing from abroad. This factor also does not seem significant at present, as borrowing from abroad has fallen by about half during the recession.

Once private investment demand recovers, a large deficit would be expected to limit the resources that are available to finance investment. By accounting identity, domestic investment spending equals national saving plus net borrowing from abroad. The budget deficit is currently more than half the size of private saving. Even before the increase in the deficit, national saving was insufficient to finance domestic investment spending, and the United States was borrowing from abroad at unprecedented rates. (Borrowing from abroad has since fallen, but remains high.) To sustain large deficits, the economy will require some combination of higher private saving, lower investment, and higher borrowing from abroad. Some economists have argued that borrowing much more from abroad is unrealistic, and the already heavy U.S. reliance on borrowing from abroad makes the maintenance of a large deficit even less sustainable.

Date of Report: December 13, 2010
Number of Pages: 13
Order Number: R40770
Price: $29.95

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