Sustained Budget Deficits: Longer-Run U.S. Economic Performance and the Risk of Financial and Fiscal Disarray

Allen Sinai, Peter R. Orszag, and
Peter R. Orszag Vice Chairman of Investment Banking, Managing Director, and Global Co-Head of Healthcare - Lazard
Robert E. Rubin
Robert E. Rubin headshot
Robert E. Rubin Former U.S. Treasury Secretary, Co-Chair Emeritus - Council on Foreign Relations

January 5, 2004


The U.S. federal budget is on an unsustainable path. In the absence of significant policy changes, federal government deficits are expected to total around $5 trillion over the next decade. Such deficits will cause U.S. government debt, relative to GDP, to rise significantly. Thereafter, as the baby boomers increasingly reach retirement age and claim Social Security and Medicare benefits, government deficits and debt are likely to grow even more sharply. The scale of the nation’s projected budgetary imbalances is now so large that the risk of severe adverse consequences must be taken very seriously, although it is impossible to predict when such consequences may occur.

Conventional analyses of sustained budget deficits demonstrate the negative effects of deficits on long-term economic growth. Under the conventional view, ongoing budget deficits decrease national saving, which reduces domestic investment and increases borrowing from abroad.1 Interest rates play a key role in how the economy adjusts. The reduction in national saving raises domestic interest rates, which dampens investment and attracts capital from abroad.2 The external borrowing that helps to finance the budget deficit is reflected in a larger current account deficit, creating a linkage between the budget deficit and the current account deficit. The reduction in domestic investment (which lowers productivity growth) and the increase in the current account deficit (which requires that more of the returns from the domestic capital stock accrue to foreigners) both reduce future national income, with the loss in income steadily growing over time. Under the conventional view, the costs imposed by sustained deficits tend to build gradually over time, rather than occurring suddenly.

The adverse consequences of sustained large budget deficits may well be far larger and occur more suddenly than traditional analysis suggests, however. Substantial deficits projected far into the future can cause a fundamental shift in market expectations and a related loss of confidence both at home and abroad. The unfavorable dynamic effects that could ensue are largely if not entirely excluded from the conventional analysis of budget deficits. This omission is understandable and appropriate in the context of deficits that are small and temporary; it is increasingly untenable, however, in an environment with deficits that are large and permanent. Substantial ongoing deficits may severely and adversely affect expectations and confidence, which in turn can generate a self-reinforcing negative cycle among the underlying fiscal deficit, financial markets, and the real economy:

  • As traders, investors, and creditors become increasingly concerned that the government would resort to high inflation to reduce the real value of government debt or that a fiscal
    deadlock with unpredictable consequences would arise, investor confidence may be
    severely undermined;
  • The fiscal and current account imbalances may also cause a loss of confidence among
    participants in foreign exchange markets and in international credit markets, as participants in those markets become alarmed not only by the ongoing budget deficits but
    also by related large current account deficits;
  • The loss of investor and creditor confidence, both at home and abroad, may cause
    investors and creditors to reallocate funds away from dollar-based investments, causing a
    depreciation of the exchange rate, and to demand sharply higher interest rates on U.S.
    government debt;
  • The increase of interest rates, depreciation of the exchange rate, and decline in
    confidence can reduce stock prices and household wealth, raise the costs of financing to
    business, and reduce private-sector domestic spending;
  • The disruptions to financial markets may impede the intermediation between lenders and borrowers that is vital to modern economies, as long-maturity credit markets witness
    potentially substantial increases in interest rates and become relatively illiquid, and the reduction in asset prices adversely affects the balance sheets of banks and other financial
  • The inability of the federal government to restore fiscal balance may directly reduce
    business and consumer confidence, as the view of the ongoing deficits as a symbol of the
    nation’s inability to address its economic problems permeates society, and the reduction
    in confidence can discourage investment and real economic activity;
  • These various effects can feed on each other to create a mutually reinforcing cycle; for
    example, increased interest rates and diminished economic activity may further worsen
    the fiscal imbalance, which can then cause a further loss of confidence and potentially
    spark another round of negative feedback effects.

Although it is impossible to know at what point market expectations about the nation’s
large projected fiscal imbalance could trigger these types of dynamics, the harmful impacts on
the economy, once these effects were in motion, would substantially magnify the costs
associated with any given underlying budget deficit and depress economic activity much more
than the conventional analysis would suggest. Indeed, the potential costs and fallout from such
fiscal and financial disarray provide perhaps the strongest motivation for avoiding substantial,
ongoing budget deficits. 3

Conventional analyses of budget deficits also do not put enough emphasis on three other related factors: uncertainty; the asymmetries in the political difficulty of revenue increases and spending reductions relative to tax cuts and spending increases; and the loss of flexibility in the future from enacting tax cuts or spending increases today. Budget projections are inherently uncertain, but such uncertainty does not provide a rationale for fiscal profligacy. The uncertainty surrounding budget projections means that the outcome in the future can be either better or worse than expected today. Such uncertainty can actually increase the incentive for more saving ahead of time—in other words, for more fiscal discipline. In addition, it is much harder for the political system to reduce deficits than to expand them. As a result of this asymmetry, enacting a large tax cut or spending increase today is costly because it reduces the flexibility to adjust fiscal policy to future events. Therefore, large tax cuts or spending increases today carry a cost typically excluded from traditional analysis: They constrain policy-makers’ flexibility to respond to unforeseen events in the future.

Thus, in our view, to ensure healthy long-run U.S. economic performance, substantial changes in fiscal policy are needed to deal preemptively with the risks stemming from sustained large budget deficits and the economic imbalances they entail. The political system, however, seems unwilling to address the threat posed by future deficits and to make the necessary choices to put the nation on a sustainable fiscal course.4 Failing to act sooner rather than later, though, only makes the problem more difficult to address without considerable instability, raises the probability of fiscal and financial disarray at some point in the future, and runs the risks of further constraining policy flexibility in the future.

We emphasize that our focus is on the effects of ongoing, sustained budget deficits. It is important to underscore that temporary budget deficits can be beneficial by providing short-term macroeconomic stimulus when the economy is weak and has considerable unused resources of capital and labor. When necessary to spur a weak economy, policy-makers could employ various fiscal policy programs, each with relative advantages and disadvantages in different contexts. Whatever decisions are made about short-run fiscal policy when the economy is weak, the objective should be budget balance over the business cycle.

The next section of this paper presents projections of federal government budget deficits over the next 10 years and thereafter, including baseline projections and sensitivity analysis. Section III presents the conventional view of the effects of federal budget deficits. Section IV discusses the potentially more important financial and economic effects not included in the conventional view. A final section provides some perspectives on approaches for restoring fiscal discipline.