When Do Deficits Matter and Why

I was challenged yesterday as to whether my pro-stimulus views mean I think that "deficits don't matter." On the contrary, belief that running a fiscal deficit during an economic downturn can be a useful tool of macroeconomic policy is part and parcel of the belief that deficits do matter and that contrary to the practice of the Ronald Reagan and George W Bush administrations we should not run large structural deficits over the course of the business cycle.

But the question is: What about deficits matters? You often hear deficits discussed as a kind of morality play. Government should "live within its means," whatever that means. Or else you hear conservatives—who don't care even the slightest bit about deficits—complain about "deficits" when what they mean is "spending when a Democrat is in the White House."

In the real world, though, deficits matter for a specific reason. If the government tries to borrow a huge amount of money, investors will start demanding generous interest rates in exchange for lending. And if investors can get high rates lending to the government, which is safe, they'll start demanding even higher rates of non-government borrowers. That becomes a problem for the private sector. Investments that are profitable at a low rate of interest are unprofitable at a high rate of interest, so the overall pace of investment and growth declines. Bad. The Federal Reserve can, however, act to keep interest rates low. The problem with this is that Fed action to lower interest rates might produce too much inflation. Inflation, when it gets high, is not just annoying but starts to really erode the workings of the price system and thus the whole economy. Again: Bad.

But those are specific reasons. We're not currently in a situation where Fed action to keep interest rates low is producing an undesirably large quantity of inflation. Inflation is currently below two percent and has been below two percent for a while. So there's not currently any problem with running a large deficit. On the contrary, we have a problem whereby a large number of able-bodied adults and other potentially valuable resources are lying idle.

Something to consider to test your intuitions about deficits is to consider the case of a country that has no national debt. During the upswing this country (call it "Norway") has been running budget surpluses and building up a nest egg. Then—bam!—a recession hits, and tax revenues fall below what's needed to finance government programs. In this situation I think it's very intuitive that the right thing to do is to spend down the nest egg for a year or two rather than add to people's problems with higher taxes or reduced spending. It's unfortunate that America wracked up a giant debt load in the 2000s rather than staying on the late-nineties trajectory, but that unfortunate fact doesn't alter the basic logic fiscal logic of a downturn.