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«DO BUDGET DEFICITS MATTER? The Brookings Institution Falk Auditorium March 11, 2003 Moderator: ALICE M. RIVLIN Director, Greater Washington Research ...»

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A Brookings Macroeconomic Forum


The Brookings Institution

Falk Auditorium

March 11, 2003



Director, Greater Washington Research Program and Senior Fellow, Economic Studies



Resident Scholar, American Enterprise Institute


Senior Fellow, Economic Studies, and the Arjay and Frances Fearing Miller Chair, The Brookings Institution; Co-Director, Tax Policy Center Professional Word Processing & Transcribing (801) 942-7044 DO BUDGET DEFICITS MATTER? - 3/11/03 2 RUDOLPH G. PENNER Senior Fellow and the Arjay and Frances Miller Chair, Urban Institute; Former Director, Congressional Budget Office (1983-87)


Senior Fellow Emeritus, Economic Studies Professional Word Processing & Transcribing (801) 942-7044


MS. ALICE M. RIVLIN: Good morning. I'm Alice Rivlin. I am delighted to welcome you to this panel on "Do Deficits Matter?” I won't say I'm delighted to be talking about that subject again. I had hoped we had put it behind us in the '90s and that everybody was quite comfortable with this subject, and here we are again.

I'm tempted to say the answer to this question is yes, and you can all go have a cup of coffee and go home, but economists don't work that way. It is in fact I think a singularly difficult subject to get across to the lay public and even sometimes to sophisticated audiences like this one because the deficit question leads economists into saying things like well, they matter in the long run but not in the short run, it's a hard thing for most people to grasp. And do they raise interest rates? Well yes, but sometimes they don't. So it is a complicated and difficult subject.

But to elucidate this matter this morning we have a set of very articulate and knowledgeable people with budget experience and we are going to start with Bill Gale who is an economist versed in budget and tax and is a Senior Fellow here at the Brookings Institution.


MR. WILLIAM G. GALE: Thanks very much.

My presentation has the very imaginative title of "Do Deficits Matter?” At le

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The basic issue can be described in what are called accounting identities. These are just definitions. They're central to the way economists structure and frame the world.

The amount that a country saves can be decomposed into the amount that the public sector saves and the amount that the private sector saves. This is a little bit of an artificial decomposition, of course, because we all are both the private sector and the public sector.

I remember a talk show around 1988 or so where one of the candidates said this is a really important issue but the American people shouldn't have to pay for this, the government should pay for it. The commentator sort of stared at him dumbfoundedly and said yeah, but aren't

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they the same? The answer is yes.

So national saving is the sum of private saving and public saving. Private saving occurs when people's income exceeds their expenditures. Public saving occurs when the government's tax revenue exceeds its expenditures.

The reason national saving is important is that by definition it funds what we'll call national investment. National investment is either domestic investment, that is investment here in the United States, or it's net foreign investment. I want to be clear, this is net foreign investment by American households. So it's the amount we invest overseas minus what other countries invest here.

For example, if we invest more overseas our net foreign investment goes up. If they invest more here and we don't change, then our net foreign investment falls.

So every dollar of national saving has to finance, by definition, a dollar of national investment, whether it's domestic investment or net foreign investment.

These identities are pretty simple.. But they have two relevant points to make. One is that if the budget deficit goes up-- a budget deficit is a reduction in public saving-- or the budget surplus falls, the government saves less. IIf that happens, national saving falls unless private saving rises by the full amount of the reduction in public saving. This sounds more complicated than it is. If the government saves $100 billion less, national saving falls unless the private sector saves $100 billion more.

The second step is that if national saving falls, that has to turn into a reduction in national investment. By definition, national saving and national investment are equal to each other.

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The substance relates to the point that Alice mentioned. We often say that deficits don't matter in the short run, they do matter in the long run. These identities can help explain why that is. I think it's actually not that they don't matter in the short run, it's that they matter in a different way in the short run.

Say you have an economy, like we currently have, with underutilized capacity. That is a slow-growing or slack economy. In an economy like that, reducing national saving, which is what the evidence suggests budget deficits do, increases the amount of output that is spent. It increases expenditures. That's a good thing in a slack economy. That boosts aggregate demand, it helps the economy return to a full employment growth path.

Professional Word Processing & Transcribing (801) 942-7044 DO BUDGET DEFICITS MATTER? - 3/11/03 3 So in the short run, in a slack economy the deficit can have beneficial effects. In the long run, though, in a full employment economy, a reduction in national saving turns into a reduction in national investment which then, other things equal, reduces the capital stock owned by Americans and hence reduces our future national income.

This is not that complicated and I want to use a family example for you.

Think of a family in which the the main breadwinner has lost his or her job and is looking for work. They're in a slow-down right now. It makes perfect sense for them to reduce their savings, for them to borrow more to tide themselves over the hard times. That's the equivalent of the beneficial effects of deficits in a short-run slack economy.

But now think of that same family saving for retirement. Saving for the long run. If they spend more than they earn every year for the next 20 years, they're in big trouble when it comes to retirement, because they haven't saved anything. That is, in the long run, persistent reductions in saving come back to bite them and they pay the price for that in terms of reduced income in retirement if they save less.

So it's perfectly consistent to say that borrowing can be beneficial in the short run, but sustained systematic borrowing can impose costs in the long run.

So far I have not mentioned interest rates, but I do want to show you how interest rates fit into this picture. The basic story so far is that deficits reduce national saving, that reduces national investment by definition, and that reduces the future national income of American households.

The question is when national saving goes down, How do national saving and national investment become equal again?

There's two ways that can happen. One is that interest rates rise. That would reduce domestic investment. The other is that you can get capital in-flows from overseas. That is, although we're not saving enough to finance our investment, other countries might lend us the funds. Either way, regardless of whether interest rates go up or not, you get the reduction in national saving..

So my view is that the effect of deficits on interest rates is a little bit of a red herring and that even if deficits don't affect interest rates, there's still an impact on national saving and that's the problem, that's the long term economic problem.

Think back to the family again, as a way to think about this. A family that never saves, that continually borrows a lot of money, might find that its credit card interest rate goes up. It

–  –  –

might find that it's become a bad credit risk and therefore it has to pay a higher interest rate. But even if it doesn't, even if its interest rate doesn't go up, it's still true that the act of not saving all its life means it has no income in retirement. So the channel that deficits reduce national saving which reduces future national income still holds. It's in place regardless of whether deficits raise interest rates or not.

This slide, which is in the back of one of the papers outside, basically tries to summarize these points. The main point is that the key issue is up at Point A. That is, what happens to private saving when public saving falls? If private saving rises by less than 100 percent of the decline in public saving, national saving has to fall and future national income has to fall.

Whether interest rates rise or not is down around Point C, and it's an interesting question but it's not central to the debate about national saving and future income.

Let me close with an example. This example is based on the experience of the last two years. This is a real-world example, it's not a hypothetical worst case scenario. This is actually what has happened the last two years.

Over the last two years the surplus estimated for the 2002-2011 period has fallen by $6 trillion according to CBO. If you assume that private saving rises by about 30 percent of that decline, which is a number based on a variety of econometric pieces of evidence, that implies that the capital stock owned by Americans will be $4.2 trillion lower in 2012 than if that deterioration had not occurred.

Now capital earns a rate of return. Using a conservative estimate of a six percent rate of return, the decline in capital turns into a reduction, by 2012, in annual future national income of about $2100 for every household in the country, or $800 per person.

That effect--reduced national saving reduces national investment, which then reduces future capital income--occurs regardless of whether interest rates go up or not.

The last point I want to make is that so far I've been talking about deficits in isolation. If you want to look at the effect of a policy that creates a deficit you need to look at the direct and indirect effects of the policy. For example, the 2001 tax cut will increase labor supply and investment directly by cutting marginal tax rates, but it's going to reduce national income through its effect on the budget deficit.

The net effect of the tax cut is uncertain because these effects work in opposite directions. at Several studies suggest that in the long run the net effect will prove negative, precisely because the constant gnawing away at national savings undercuts the future national income of the country.

–  –  –

So it's important to distinguish between the deficit holding everything else equal and the net effects of policies that create the budget deficit, but I'm sure we'll talk about that more in the additional time.

–  –  –

MS. RIVLIN: Thank you very much, Bill. Now we will hear from Eric Engen. Eric is a resident scholar at the American Enterprise Institute. He's been there only a relatively short time.

He had a long distinguished career at the Federal Reserve in the Division of Research and Statistics and he's an expert on budget, social security, pensions, and related issues.

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The first is that in my view oftentimes the conversation or debate about deficits is too narrowly focused in that it looks just at deficits. But deficits actually are the result of both spending and tax policy. We look at governments, spending very importantly is determined by how much, and oftentimes if you peel back all the layers of discussions about deficits or discussions about all kinds of other types of policies at the core is an issue of what is an appropriate size of government. So I think we need to when we're talking about deficits peel that layer back also.

As well, what's important in terms of spending is what we're spending it on. Is it investments that will pay off in the future or is it just for current consumption or is it just transfer payments that an individual will consume privately?

As well, we need to look at the effects of taxes on the economy as Bill noted. There's both a private effect of taxes in terms of their effect on capital formation and labor markets, in addition to the effects of taxes on deficits.

Now deficits are oftentimes viewed as a summary measure for fiscal policy, and as you'll see, I'll conclude they are important, but it does not describe many of the effects of fiscal policy.

To provide an example, although I feel that deficits matter I would be much more

–  –  –

concerned about a balanced budget where taxes and spending are both 70 percent of GDP as opposed to say half a percent of GDP deficit where taxes and spending are closer to say 20 percent of GDP. I think the effects on the economy would be markedly different in those cases and they would be more accurately described by the level of spending and taxes than the level of deficits.

Also when we talk about the deficit, the conventional measure that we use and the one that is most typically used in empirical work is the conventional measure that's reported by CBO or OMB, that's simply spending minus taxes, usually include both the on and off budget components.

But if you look at the academic literature, this appropriate measure of the deficit is much less settled. There are a lot of proposed adjustments that there's very sound economic rationale for making some of these adjustments. Some of these adjustments matter a lot, some matter less, but they can all at various times, depending on conditions in the economy, be very important.

One is the business cycle, or to use what CBO calls their standardized budget balance.

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