The Budget Deficit J. Bradford DeLong Federal Reserve Bank of San Francisco Weekly Letter Draft December 2, 1997; DRAFT 2.1 1839 words 3 figures Introduction The 1997 accounting year of the federal government ended last September 30. For fiscal 1997 the federal government recorded a budget deficit of less than $24 billion--less than 0.3 percent of national product. There are plausible technical adjustments and corrections to the budget that would have put it into surplus: for example, correcting debt interest payments for the reduction in the real value of outstanding government bond principal from inflation would have produced a budget surplus of some $89 billion; or treating government investments as capital expenditures to be depreciated--as a business would--would have produced a budget surplus of some $43 billion. Alternative technical adjustments and corrections--for example, removing the OASDI and Medicare trust funds from the unified budget totals--would have pushed the fiscal 1997 budget deeper into deficit. "Balance"is a somewhat fuzzy concept. But the important thing to note is that for all intents and purposes the federal budget this past fiscal year was in balance. No matter what concept of the deficit one prefers, or what technical adjustments and corrections one makes, the deviation of the budget balance from zero remains too small for it to have a substantial impact on the American economy. On one level, the improvement in the deficit in this decade is a heartening and important achievement--a striking success of economic policy management. Even though relatively little was done to affect the future course of the deficit in 1997--even though the President-Congressional deficit-reduction agreement of 1997 was small in magnitude compared to previous deficit-reduction agreements--the cumulative total reduction in the deficit so far this decade is a substantial economic policy victory. It shows that the American system possesses more flexibility than many had thought: a decade ago "structural" explanations of the deficit as rooted in the institutional interaction of the President and Congress, and thus as unavoidable, were common. The reduction in the deficit is a substantial economic policy victory because it means that the deficit is no longer a significant drag on American economic growth. The era starting in the late 1970s in which the deficit was a serious economic problem, and the era starting in the early 1980s in which the deficit was an overwhelming economic crisis are now over. But just because this past year's federal budget was in rough balance does not mean that the United States's fiscal situation is stable. The long-run fiscal crisis of the social insurance state--the fact that Medicare and Social Security taxes are inadequate to pay the Medicare and Social Security benefits that the government has promised to pay over the next century--remains unresolved. And successive administrations and congresses keep passing up opportunities to begin resolving it. Reducing the Budget Deficit In the summer of 1997 the President and Congressional leadership announced the third deficit-reduction agreement in this decade: a 1997 agreement carrying forward the work of the bipartisan 1990 deficit reduction agreement and the Democratic 1993 deficit reduction program. However, there was one significant difference between the 1997 agreement and the previous agreements. The amount of deficit reduction contained in the 1997 agreement was relatively small. The 1990 and 1993 deficit-reduction agreements appeared to be between six and eight times as large in the relative size of their effects on the economy. The reason for its small relative size is that given the course of the American economy there was simply not that much deficit left to reduce: in 1992 the federal government budget deficit had amounted to 4.7% of GDP, but in 1997 it amounted to only 0.3% of GDP. Thus the bulk of the work of eliminating the deficit had already been done--by the 1990 and 1993 deficit-reduction agreements, and by the strong recovery of the U.S. economy from the recession of the early 1990s. In fiscal 1997, the U.S. unemployment rate averaged some 2.5 percentage points below its level of fiscal 1992. According to Okun's Law, such a reduction in unemployment reflects an increase in GDP relative to potential output of some 6.25%. Such an increase in output relative to potential has a striking effect on the deficit: at the margin an extra dollar of real GDP increases federal tax collections by some $0.25 and decreases federal spending by some $0.07. Thus the improvement in business cycle conditions since 1992 is responsible for a reduction in the deficit as a share of GDP of some 2.0 percent of GDP: nearly half of the reduction in the deficit since 1992 from 4.7% to 0.3% of GDP is due to the reduction in the unemployment rate and the increase in GDP relative to potential output. The remaining 2.4% of GDP reduction is a reduction in the cyclically-adjusted deficit. The bulk of the reduction in the cyclically-adjusted deficit is due to policies enacted in the 1990 and 1993 agreements: increases in taxes, and reductions in spending growth below the growth rate of the economy as a whole. And a final component is due to "extraordinary" factors, like the end of expenditures by the Reconstruction Trust Corporation which had been set up to handle the consequences of the 1980s Savings and Loan crisis. The success of U.S. economic policymakers in reducing the deficit without imperiling continued economic recovery is worthy of note. Standard estimates of Keynesian multipliers today are less than they used to be: in the range of 1.5 to 2.2. Nevertheless the substantial reduction in the cyclically-adjusted deficit between 1992 and 1997 was a source of contractionary pressure on aggregate demand, reducing aggregate demand by between 3.6% and 5.3% of GDP and under most circumstances triggering a mild-to-moderate recession. Yet in the U.S. the mid-1990s have not seen any signs of recession, in part because the economy in 1992 was poised for cyclical recovery and in large part because of the skillful conduct of monetary policy: monetary policy to keep interest rates relatively low managed to successfully offset any contractionary impact of reductions in the cyclically-adjusted deficit without triggering renewed inflation. Given how often the Federal Reserve, the Congress, and the President are blamed for an inappropriate or faulty monetary and fiscal policy mix, it is worth pausing to note that in the mid-1980s the policy mix appears to have been exactly right. The End of the Era of Deficits In the United States the era of large government deficits dates from 1974. The era of overwhelming deficits--of government budget deficits so large that they are not a serious economic problem but the economic problem--dates from 1981. Back in 1981 the Reagan administration and its Congressional supporters made a mistake in budgetary policy that amplified the fiscal difficulties that had been created by slow growth in the 1970s and that gave the United States some fifteen years of unprecedented peacetime budget deficits. It is difficult today to understand the thought processes of those who set fiscal policy for the Reagan administration. Certainly no one intended to create large budget deficits that would drain the pool of capital for investment, and retard the growth of the American economy. But even today the story is not clear, in large part because those who developed Reagan administration fiscal policy have for more than fifteen years argued among themselves over who made the key mistakes, and over just what the key mistakes were. By absorbing capital that would otherwise have funded private investment, the deficits left the U.S. with a lower capital stock, a less productive economy, and a debt owed to overseas investors that must now be amortized. How destructive were these deficits? Different assumptions about the structure of the U.S. economy and different methodologies lead to different results. A standard closed-economy Solow growth model assuming a ten percent real pretax social rate of return on investment and exogenous technological change and savings behavior leads to the conclusion that U.S. real production today is five percent less than had the federal budget been balanced since 1981. But the closed-economy assumption is highly inappropriate, even though the exogenous savings assumption may not be. Assuming that the U.S. economy is "small" in the sense that international economists use the word, and that all budget deficits can be thought of as financed from abroad leads to the conclusion that U.S. real GNP--and here the distinction between GDP and GNP is important--today is some 1.5% less than had the federal budget been balanced since 1981. But the small-country assumption is inappropriate as well. Thus it is straightforward to obtain estimates that run between 1.5% and 5.0% in lost annual income for the economy as a whole--between roughly $1000 and roughly $3,500 in lost annual income for the average American worker--as the net consequence for economic growth of the era of deficits. It is possible to obtain estimates that are lower (or higher), but they require making assumptions about the structure of the economy that are more speculative. The end of the era of deficits means that the total drag on the economy inflicted by cumulative budget deficits--is no longer increasing. It also means that fears common in the 1980s that the U.S. political system had broken down and was no longer capable of producing rational fiscal policy decisions have turned out to be overly alarmist. The U.S. political system has demonstrated some flexibility and competence. And these are certainly cause for some celebration. The Long-Run Finances of the Social Insurance State However, the fact that the U.S. government budget was in rough balance for fiscal 1997 is not cause for too much celebration. Further into the future the fiscal outlook turns downard again, with renewed and growing budget deficits beginning late in the next decade. Renewed and growing deficits are projected because the United States today has a social insurance system, a Medicare and Social Security system, that was designed back in the 1970s for an economy that would be growing at a measured average rate of 2.5 percent per person per year. But the United States today does not have an economy that grows at a measured average rate of 2.5 percent per person per year. It has an economy that grows more slowly, at an average speed of less than 1.5 percent per person per year. Thus the taxes that have been earmarked to pay for Social Security and Medicare as the U.S. population ages and the baby-boom generation approaches retirement are not going to cover the costs of providing currently-promised benefits for far into the next century. At some point before the baby-boom generation reaches retirement age, the United States as a country will have to decide either to cut Social Security and Medicare benefits below levels that have been implicitly and explicitly promised, or to raise social insurance taxes. The sooner the American political system make this choice, the easier the process of adjustment will be. The longer that the choice is delayed, the more disruptive and difficult will be the process of transition and adjustment to a sustainable social insurance system.