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March 22, 2005

Guest Viewpoint: Deficits have long-term costs for U.S.

By Mark Thoma
The public has not always been as willing to accept government deficits as it is today. Before 1980, deficits were tolerated during wars and recessions, but persistent deficits were not routine.

Because our heirs will inherit dams, airports, power grids, freeways, parks, sidewalks and so on, and because they are better off when our wartime enemies are defeated, some argue that it is fair to bill them for those assets by passing on debt of equal value to them.

However, before 1980, we chose to keep the budget roughly in balance unless a war or a recession forced deficits to occur. Between World War II and 1980, public debt - the accumulation of all past deficits - fell as a percentage of the gross domestic product.

The principles involved in combating recessions are similar to the strategies an individual might pursue to smooth out swings in income. One strategy is to borrow during bad times and repay during good times. This enhances the bad times and attenuates the good, leading to a much smoother path for income over time.

The same is true of a government's fiscal policy. During recessions, the government runs a deficit to stimulate the economy, and then pays it off during the subsequent boom. If governments do this according to plan and adjust as needed, their budgets will be balanced on average and their economies will be more stable.

But everyone knows how hard it is to keep a promise that today's excess will be followed by a strict diet tomorrow. Elected officials are no different, and it doesn't help that the promises were often made by their predecessors. Running deficits is much easier than raising taxes or cutting spending, especially when the deficit can be blamed on someone else and the public does not exact a political price.

Should we care if the budget is balanced? Deficits have two main costs. The first is the effect on interest rates. When the government runs a deficit, it borrows money and competes with businesses and individuals for available savings. This increased demand for capital drives up interest rates unless new savings satisfy the increased demand.

Deficit spending has the benefit of causing the output of goods and services in the economy to increase. The negative aspect is that interest rates are forced upward - reducing business investment, housing purchases and so on.

The reduction in investment has long-lasting effects, because it lowers future economic output. Thus, deficit spending trades an increase in current output for a reduction in future output of goods and services.

The second cost arises when deficits are financed by the foreign sector. Recently, 94 percent of newly issued debt has been purchased by foreigners, increasing their share of the total to 43 percent. Because of this, interest rates have remained low as the deficit has increased. But the cost of this is that the interest on the borrowed money will flow out of the United States. This is a drain on the economy.

In addition, borrowing from abroad brings a risk of increased interest rates. If foreigners become uneasy about holding U.S. debt and begin trying to sell U.S. bonds, U.S. interest rates will rise quickly. This will weaken the economy, especially in states with interest-sensitive industries such as housing and manufacturing.

As we think about Social Security and the assets our children will have available to them in their retirement years, we also should consider the debts we send them. I inherited a well-developed infrastructure and the security gained from winning World War II from my parents and grandparents, and I'm helping to pay their Social Security in return. Fair enough.

I didn't inherit a rising debt burden when I was born, and I don't know what changed in the 1980s that justifies increasing the debt burden on those who were born after me.

Mark Thoma (mthoma@uoregon.edu) is a macroeconomist and a member of the economics department at the University of Oregon. The views expressed are his own.