BUDGET DEFICITS: HALF FULL OR HALF EMPTY?
October 12, 2004
Some economists have argued that deficits will raise interest rates, reduce economic growth, increase trade deficits, and possibly create a financial crisis. Alan Reynolds of the Cato Institute examines those claims and finds that they are not supported by the evidence.
In particular, the arguments of a recent study by former Treasury secretary Robert Rubin and others, proposed four hypotheses about the effects of sustained budget deficits:
- Projected future deficits affect current interest rates.
- Smaller budget deficits produce more domestic private investment.
- Budget deficits cause trade deficits.
- Budget deficits cause fiscal disarray and require tax increases to maintain confidence.
However, according to Reynolds:
- Real interest rate changes are determined by real return on capital investments, not budget deficits. Real interest rates are highest during economic boom times, indeed, the 1990s experienced a rising real 10-year interest rate in spite of a steadily increasing budget surplus.
- National savings rates are not negatively associated with budget deficits. From 1981 to 1989, the budget deficit was 3.8 percent of gross domestic product (GDP), while the national savings rate was 18.2 percent; between 1998 and 2002; however, the budget was in a surplus and the national savings rate declined.
- Trade deficits have resulted when the U.S. economy grows faster than other economies (consumers buy more imports). Foreign exporters use their American dollars for U.S. investments rather than the immediate purchase of U.S. goods and services.
- Tax increases imposed by Congress in 1990 and 1993 for the highest-income earners did not increase revenues as a proportion of GDP. In fact, the first two quarters of 1991 experienced a recession, and income tax revenues as a percentage of GDP have remained constant since 1952.
Source: Alan Reynolds, "Deficits, Interest Rates, and Taxes: Myths and Realities," Policy Analysis 517, Cato Institute, June 29, 2004; and Robert E. Rubin, Peter R. Orszag and Allan Sinai, "Sustained Budget Deficits: Longer-Run U.S. Economic Performance and the Risk of Financial and Fiscal Disarray," Brookings Institution, January 2004.
For Cato study: http://www.cato.org/pubs/pas/pa517.pdf
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