The Deficit Threat and the Recovery

The federal deficit represents a serious long-term problem. It is not, however, a threat to our economic recovery, nor will it be a threat anytime soon. Our near-term problem is weakness in private demand rather than excess government borrowing. The deficit will become a problem when the private sector’s demand for investment funds recovers. A crucial question at that point will be whether the government can curb its appetite for borrowing.

The most recent CBO forecast predicts a deficit next year of $1.43 trillion, or a bit less than 10% of expected GDP. While this is a shockingly big number, it is unlikely to pose an appreciable risk to the recovery. On the contrary, the tax and spending policies that cause the deficit are providing much of the stimulus that has reduced the severity of the recession and given us the prospect of an economic expansion this year and next.

The usual argument against big government deficits is that they boost interest rates and cut the flow of savings into private investment. Falling private investment is certainly an important reason for current economic weakness. In quantity terms investment has fallen almost one-third since 2007.

Business investment hasn’t shrunk because of high interest rates or too much government borrowing, however. It has dropped because private companies see little demand for the goods and services they can already produce. If factories, retail outlets, and shipping companies have vastly more capacity than they need to serve customers’ demand, there is no rationale for them to make investments that will expand existing capacity. When house prices are tumbling and local markets have tens of thousands of vacant homes and apartments, developers have little reason to add to the glut by building new homes.

Government borrowing is not impinging on investors’ access to borrowed funds. In fact, extraordinary actions by the national government and Federal Reserve have kept credit flowing to businesses and consumers in the face of a severe financial crisis. Weak private demand has reduced the need for businesses to expand or even to maintain their existing capacity, and this is likely to remain true for the next couple of years. The federal government has plenty of scope to maintain the stimulus programs already in place and to expand the programs if weak private demand should threaten to derail the recovery.

When private demand recovers there will be a powerful case for reducing the public deficit. Can we count on Congress to accomplish this task? In politics there are no guarantees. It requires political courage for legislators to reduce the growth in spending and to hike taxes. While it is relatively easy for opponents to mobilize public sentiment against tax increases or spending cuts, it is much harder for budget analysts and public officials to make a persuasive case that these measures will benefit voters in the long run.

In spite of the difficulties, legislatures in most major democracies, including this one, have eventually faced up to their responsibilities. Public spending has not spiraled out of control; taxes have not fallen to zero; the burden of government debt has not become unsustainable. A betting man would put his money on the proposition that Congress will do the right thing . . . eventually.