FRBSF Economic Letter
98-03; January 30, 1998
The Budget Deficit
The 1997 accounting year of the federal government ended last September
30, recording a budget deficit of $22 billion--not quite 0.3% of national
product. President Clinton will submit a balanced budget for fiscal 1999.
For all intents and purposes, the budget is in balance.
But "balance" is a fuzzy concept. There are plausible technical
adjustments and corrections to the budget that would have put it into
either surplus or deficit last year. For example, treating government
investments as capital expenditures to be depreciated--as a business would--would
have produced a budget surplus of some $43 billion. Other technical adjustments
and corrections--for example, removing the Old Age Survivors Disability
Insurance and Medicare trust funds from the unified budget totals--would
have pushed the fiscal 1997 budget deeper into deficit. The important
thing to note is 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. Even though relatively little was done to affect
the future course of the deficit in 1997--the President-congressional
deficit-reduction agreement of 1997 was small 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.
But just because this past year's federal budget was in rough balance
does not mean that the fiscal situation in the U.S. 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 benefits that the government
has promised 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 the congressional leadership
announced the third deficit-reduction agreement in this decade, which
carried 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 (Figure 1).
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 strong recovery
of the U.S. economy from the recession of the early 1990s and by the 1990
and 1993 deficit-reduction agreements.
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. 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 reducing the
deficit as a share of GDP by some 2.0 percentage points.
The remaining 2.4 percentage points of reduction in the deficit as a
share of GDP are a reduction in the cyclically adjusted deficit. The bulk
of this is due to policies enacted in the 1990 and 1993 agreements, such
as 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 Resolution 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 the effects of a given change in government spending and taxes on real
GDP (known as 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 reduced aggregate
demand by between 3 1/2% and 5 1/2% of GDP; under most circumstances this
would trigger 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. The Federal Reserve's efforts to keep interest
rates relatively low managed to offset successfully 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-1990s 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 (Figure
2). The era of overwhelming deficits--deficits so large that they
are not just a serious economic problem but the economic
problem--dates from 1981. By combining tax cuts with increases in defense
spending, 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 15 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. And even today
the story is not clear, in large part because for more than fifteen years
those who developed Reagan administration fiscal policy have argued among
themselves over just who made the key mistakes and over just what the
key mistakes were.
By absorbing capital that otherwise would 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.
Higher estimates come from models that characterize the U.S. as a "closed
economy"--that is, one in which international capital does not flow
in or out, so that no part of the deficit can be financed from abroad.
Assuming a 10% real pretax social rate of return on investment and assuming
that technological change and savings behavior do not respond to the deficit
lead to the conclusion that U.S. real production today is 5% less than
had the federal budget been balanced since 1981. But the "closed-economy"
assumption is highly inappropriate, even though the savings assumption
may not be.
Lower-end estimates come from models that characterize the U.S. as an
economy in which all budget deficits can be thought of as financed
from abroad. Such models lead to the conclusion that U.S. real GDP today
is some 1.5% less than had the federal budget been balanced since 1981.
But the assumptions of these models are inappropriate as well.
These estimates of between 1.5% and 5% provide us with boundaries to
calculate the lost annual income for the economy as a whole--roughly between
$1,000 and $3,500 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 even 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. Indeed, looking back,
perhaps the single most important step in bringing the federal deficit
down was a procedural step, the Budget Enforcement Act (BEA) of 1990 imposed
by President Bush as part of his price for agreeing to the 1990 budget
deal. It changed the rules of Congress, making any proposal that would
increase the deficit automatically out of order, and requiring supermajority
votes to suspend this rule. It also made the Congressional Budget Office
(CBO) immensely powerful, for it was the CBO that decided whether a legislative
proposal would increase or reduce the deficit, and therefore whether the
proposal was in or out of order. By and large, all agree that the CBO
has handled its power well, delivering decisions that have been professional
and technical, rather than political. And the CBO's ability to use its
power has been very effective in the past seven years in preventing Congress
from passing bill after bill that each adds a drop or two to the deficit.
The U.S. political system has demonstrated some flexibility and competence.
And that is certainly cause for some celebration.
The long-run finances of the social insurance
state
While we should celebrate the achievement of rough balance in fiscal
1997, we also need to look further ahead and recognize the temporary nature
of the current fiscal policy success. Further into the future the fiscal
outlook turns downward again, with renewed and growing budget deficits
beginning late in the next decade.
This worsening scenario is 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% per person per year. But the United
States today in fact grows more slowly--at an average speed of less than
1.5% 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 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 makes this choice, the easier
the process of adjustment will be. The longer the choice is delayed, the
more disruptive and difficult will be the process of transition and adjustment
to a sustainable social insurance system.
J. Bradford DeLong
Professor of Economics, UC Berkeley
and Visiting Scholar, FRBSF
Opinions expressed in this newsletter do not necessarily reflect
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