Do Deficits Matter?

This is a classic question posed to Economics students for several decades. In fact, I can remember being asked that question in Econ 1 in 1978. Most of the students said yes, the professor answered "not really". A better, although less precise answer would have been, "it depends".

First some terminology so we are on the same page. A deficit is the amount of money spent in a year that is more than revenue. This amount gets added to the national debt, which is the accumulation of all annual debts and surpluses over the years. Sometimes, perhaps because they both begin with the same letter, they are used interchangeably. We will actually use both terms to help give some depth to the discussion.

The graph below measures the entire national debt as a percentage of GDP (Gross Domestic Product) or the amount of goods and services produced in the US in a year. I like this measure because it gives us a sense of how big the debt is compared with our economy and also effectively adjusts the amount for inflation.

(Numbers courtesy of presidentialdebt.org)
As you can see by looking at the graph for 1978, my professor was probably more correct than the students as that level of 34% is lower than the level for almost any year since. We would be very happy now to get our Debt/GDP ratio down to 34%. This ratio floated up from a low of 32.9% at the end of 1981 to 67.1% at the end of 1993. At that point it hovered and then dropped during the Clinton Administration. However, only the only surplus was in 2000 (drop of 2% in actual dollars). In the preceeding years, the debt just didn't rise as fast as GDP, and therefore became a smaller percentage.

While that might seem like it is obscuring debt increases (and to some extent it is), it is giving a better picture of the impact. To get a better look at it, imagine that we are running a deficit and adding to the debt every year for 10 years and that each year, our GDP grows by 3%. However, our annual deficit is only a single dollar. At the end of this 10 year period, our deficit will be $10 larger (insignificant on a $13 Trillion debt) but our GDP will be almost 35% larger. Our national debt as a percentage of GDP will have shrunk by about 25%.

So again, why is that important? Well, assuming that our Government Revenue (read taxes) as a percentage of GDP remains fairly constant, our ability to pay the interest on our national debt is relative to our GDP. If the debt becomes too large as a percentage of GDP, the interest payments begin to take on too large a percentage of our tax revenue, thereby squeezing out other expenditures and/or increasing the debt even further. In fact, the US has among the lowest ratio of tax revenue to GDP among developed countries. This chart also includes state and local taxes and shows that almost all of Europe is higher than the US with only Mexico, Turkey, Korea, and Japan lower.

So what is the correct level of debt/GDP? Well, assuming that there is no reasonable way we can make this 0% anytime within our lifetime, it appears that bringing it back to a level under 70% would be prudent. Once we are there, we should attempt to find non-draconian ways to bring it back into the 50% range which is the long-term post-WWII average.

So now that we have that question answered, how do we make that happen? Well that is a topic for at least a few future posts, but just a few comments and a nice toy for you to play with. I am happy the Republican Party with a large assist from the Tea Party has gotten religion about deficits. I won't slap them about that belief running in stark contrast to their last 30 years of leadership because I really hope they mean it this time. I think they will be in trouble in 2 years if they don't follow through on it this time, so, for their sake and the sake of the country, I hope they are good on their word. They will also have to face the fact that you can't reduce the deficit significantly without increasing taxes and making reductions in defense spending and Social Security and Medicare benefits.

However, you can make adjustments to Defense, Social Security and Medicare and make some tax adjustments that don't seem devastating. Want to play King of the World (or at least Chief Poo-bah of the US Economy? Try your hand at this nifty interactive toy from the New York Times that lets you figure out how to balance the budget. Let me know what percentage of tax increases and spending cuts you come up with by leaving a comment. Enjoy.