Why Deficits No Longer Matter

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William Gale of Brookings Institute provides six takeaways from the Congressional Budget Office (CBO) 2014 Long-Term Budget Outlook.  Its findings suggest that not much has changed.  First, the size of the federal budget deficit is not a problem now or even the rest of the decade.  However if Congressional action is not taken soon, then the pain of deficit reduction will only worsen.  Unfortunately, that means more of the same with deficit spending continuing to spiral into the future.

Here are three reasons why proactively addressing deficit reduction is politically a poor one:

  1. Attacking the deficit by either restraining spending or raising taxes will be vigorously attacked by special interests.
  2. Politicians recognize that voters have short-term memories, so while significant deficit reduction will yield long-term benefits, it will likely cause short-term economic pain.
  3. They have been emboldened by Federal Open Market Committee (Fed) policies, whose expansionary monetary policies, have made deficit spending attractive.

The last point is most poignant.  While theory suggests that high deficits will lead to “crowding out” private sector borrowing, that has not happened.  Even though the debt to gross domestic product is historically high at 74 percent, current interest rates remain very low.  We can see this through a graph of the average U.S. prime interest rate, which is the interest rate charged to borrowers with good credit.

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A look at the graph above shows that the current prime interest rate of 3.25 percent is the lowest rate experienced since 1970.  If not for the Fed’s actions, the prime rate would undoubtedly be much higher.  On the surface, this appears to be attractive.  A lower interest rate will encourage more purchases of homes and boost employment rates.  That is true during the short run, but it is not without cost.

First, by artificially keeping interest rates low, we have discouraged saving and encouraged reckless borrowing.  A cursory look at saving rates show that the rate for a savings account is meager at 0.49 percent as of July 17th, 2014.  On the other hand, consumer debt has been higher at almost $3.195 trillion.  While that points to a bright present, it portends a dim future.  Lastly, this policy has exacerbated inequality where U.S. aggregate household wealth increased from $81.8 trillion from $59 trillion in 2009.

On the other hand, if Federal Reserve Chairman Janet Yellen were to adopt John Taylor’s prescription of stable pricing through use of the “Taylor Rule”, then markets will eventually correct themselves and the economy will be poised for more dynamic growth.  If implemented, then that would raise the fed funds rate from 0 percent to approximately 2 percent.

A higher fed funds rate would raise borrowing costs, thus spooking equity markets that could result in huge declines in wealth.  However, the upside is that it might strengthen the dollar and ease pressure on developing countries who have been forced to devalue their currencies to maintain their exports.  That would be a positive to global economic growth.  The other positive is that it will likely boost saving incentives with banks probably offering higher rates on saving.  Lastly with higher interest rates, consumers and businesses will be less likely to take on more debt, thus improving their long-term economic outlook.

John Taylor’s prescription is a risky one with much downside risk, but Congress will only respond to our deficit situation when they have incentive to do so.  Right now, interest rates are low, so much of the benefits of deficit reduction will not be enjoyed.  That will change if the Fed allows interest rates to move according to market conditions.

Unless the Fed changes course, it appears that the U.S. fiscal situation will likely remain the same.  While that might be comforting to those advancing in age, it is a dire signal for our youth.


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