The Deficit

You should now start paying attention

For decades, the budget battle in Washington has been between “deficit hawks” and “deficit doves”. The hawks are those who feel that the US government is spending beyond its means, that the annual deficit is too high, and that we need to get our house in order. Doves prefer to allow higher deficits and believe the US should take advantage of the generous terms surrounding US debt.

For most of my career as an economist I’ve had a mildly dovish position. One fact that needs emphasized is that the United States absolutely, positively, can run a budget deficit every single year. While numerous politicians have said that the federal government needs to balance its budget just like every family in America, this is just false. People, unlike governments, have a lifecycle. The structure of our society is such that a person spends the first 18-25 years of their life not contributing to the economy. Instead, they are spending society's resources by adding to their human capital, primarily through schooling. This often entails going into debt. Then they begin working a full-time job, hopefully earning more than they spend and saving up for retirement. Then around age 65-70, most retire and enjoy the money they’ve saved during their working years. Thus, an individual needs to have years where income exceeds expenses.

The government doesn’t have this lifecycle. It would be totally fine for the US government to run a modest deficit every year till the second coming (or the zombie apocalypse, whatever comes first). That’s because the government is never going to retire and needs to live off a nest egg. There will always be Americans dying, working, and being born into the system. As long as the deficit stays suitably low, then no problem.

So what is a “modest deficit”? There is no hard and fast rule. The EU sets a (almost totally ignored) annual deficit limit of 3 percent of GDP. This is a fairly sensible number and is the correct way to look at the deficit. People may panic when they see that the US deficit is hundreds of billions of dollars, but it’s important to remember that the US economy produces tens of trillions of dollars worth of goods and services every year. It doesn’t matter how big or small the deficit is in numeric terms; the size of the deficit only matters when compared to the size of the economy.

This is where the US deficit is becoming concerning. Take a look at the US deficit compared to GDP over the last 80 years:

Other than the extreme outlier of World War II, the US deficit has generally stayed within reasonable limits. There were even a few periods where the government ran a budget surplus, most recently in the 1990s. Other than WWII, the biggest deficit in US history was during Covid, when the economy was mostly shut down for several weeks and trillions were plowed into the economy. Because of the massive deficits during WWII and Covid, it’s easy to miss what happened during the 2010s that is concerning. Zooming the graph in makes it more clear:

Look what’s happened since the budget surpluses of the late 1990s. Throughout the 2000s, the US economy ran deficits of around 3 percent. Then, during the Great Recession, the deficit went to 10 percent. So far this is all sensible. The government should run larger deficits when the economy is shrinking. But then look at what happened from 2014 to 2019. This was a healthy time for the American economy. 2014-2015 was still a bit sluggish, but the economy really took off from 2017-2019. And during that time, the deficit grew. This is bad. As I said in 2020, running a 4.5 percent deficit when the economy is hitting on all cylinders is not a good sign.

Government spending needs to be countercyclical, that is, government spending should be high when the economy is doing poorly and low when the economy is doing well. In the late 2010s it became clear that instead of being countercyclical, government spending is more like a ratchet. Spending increases during bad times, but no longer decreases enough during good times.

That leads us to where we are today. The deficit explosion during Covid was too large, but defensible. We were in uncharted waters. Today, the economy is doing well. Unemployment is low, wages are growing, and except for lingering inflation, the economy is on the right track. Yet the deficit has not shrunk to pre-Covid levels. The Congressional Budget Office (CBO) projects the deficit to be 5.8 percent in 2023. This is not acceptable. Moreover, the deficit is expected to rise to 10 percent in the next thirty years. As the CBO notes, 10 percent would be the highest budget deficit outside of WWII and Covid.

How big of problem will these high deficits cause? For that, it’s necessary to look at the national debt. The national debt is the summation of all budget deficits and surpluses the US government has ever run. Today, the US national debt stands at $33.5 trillion, or 124 percent of GDP. A chunk of this debt is money that the government owes itself, so publicly held debt is equivalent to 98 percent of GDP.

Other than saying that publicly held national debt is roughly the size of the US economy, it’s hard to put this number into context. It is one of the highest in the world, although Japan and Italy are higher, and other countries are at similar levels. Where does national debt become a major problem and a significant hindrance to growth? We don’t know. The national debt can be thought of in a similar way to climate change. At some point rising temperatures will create massive problems for the world. It might be a global temperature increase of two degrees Celsius. It might be four degrees. We don’t know. What we do know is that once we hit that point it will be painful and very difficult to get back. The national debt is the same way. At some point having a high national debt will severely restrict growth and lead to long-term stagnation. Is that point 150 percent of GDP? 200 percent? There’s no way to know. Because the US is such a unique country economists can’t even use other nations as a guide.

Given current projections, regardless of where the tipping point is, we will have too large of national debt by 2050. Because of this, I believe it’s time to move away from the dovish position and become more hawkish. This isn’t a problem that needs to be dealt with today, this month, or even this year, but it is a problem that needs to be addressed this decade. The US cannot afford to have a budget deficit of 5 percent when the economy is doing well. Something has to give. Hopefully voters are paying attention.