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Do deficits matter?
Some economists dismiss fears about long-term budget deficits -- but they're in the minority.
February 2, 2004: 3:02 PM EST
By Mark Gongloff, CNN/Money Staff Writer

NEW YORK (CNN/Money) - In 2004, the U.S. federal budget deficit will likely be the biggest in history, with more big deficits in store for years to come. But should we care?

Some economists say we shouldn't, that they've never hurt the economy before and that they'll help the economy grow faster, paying for themselves in the long run.

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Many more economists, however, say deficits eventually could threaten the economy by driving up interest rates and cutting into household income -- though that probably wouldn't happen right away.

On Monday, President Bush unveiled a $2.4 trillion budget proposal for the fiscal year 2005, a budget that includes expected deficits of about $521 billion in 2004 and about $363 billion in 2005.

Recent studies, conducted by both liberal think tanks and neutral investment banks, said additional costs not included in this budget plan could add more than $3.3 trillion to the budget in the next decade. That would promise deficits for years to come.

The '80s experience

But so what?

Supporters of the president say massive deficits under President Reagan and the first President Bush fueled a surge in business investment and economic growth that increased tax revenue, which helped the deficits fix themselves.

They also note that -- contrary to fears that an increase in government borrowing to pay for the deficits would "crowd out" private investment and drive interest rates higher -- mortgage rates, 10-year Treasury note yields and other key interest rates fell during the Reagan and first Bush presidencies.

"Investment strategies based on the supposed link between deficits and interest rates have never been profitable," Brian Wesbury, chief economist at Griffin, Kubik, Stephens & Thompson in Chicago, wrote in a research note last year.

Something similar could be happening now, according to a recent note by Credit Suisse First Boston chief economist Neal Soss. He said tax cuts had increased corporate cash flow, helping companies spend money without taking on debt. Less demand for debt has helped keep interest rates low.

"The result is that corporate America can finance a resurgent [capital spending] program with relatively little draw on capital markets," Soss wrote. "Concerns about the size of the federal budget deficit per se are thus misplaced."

There's no doubt that, so far, despite big budget deficits in recent years and expectations of even bigger deficits down the road, interest rates are still near historic lows.

It's not that simple

But many economists believe low rates are due to several other factors, including the long-term weakness in the labor market that has kept wage and salary growth weak, putting a lid on inflation and allowing the Federal Reserve to keep short-term interest rates at the lowest in more than 40 years.

What's more, the apparently insatiable demand for U.S. Treasury debt by foreign central banks, including the Bank of Japan, has helped keep bond prices high and -- since prices and yields move in opposite directions -- interest rates low. This could help ease the "crowding out" effect of government debt, in which Treasuries compete with corporate bonds and push yields higher.

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"The Bank of Japan has effectively crowded out 'crowding out,'" said Alan Ruskin, research director at 4CAST Ltd., a market and economics research firm.

Other economists point out that it's overly simplistic to say the Reagan deficits fueled an investment boom and then paid for themselves in higher economic activity and tax revenue.

For one thing, the Reagan tax cuts were offset by a series of subsequent tax hikes, implemented by Congress in the early 1980s, by the first President Bush in the late 1980s and by President Clinton in the early 1990s.

Contrary to the fears of supply-side economists, who have supported the Reagan and Bush tax cuts, the economy grew despite these tax hikes, while spending discipline in the 1990s helped turn deficits into surpluses.

And an April 2000 study by Harvard economist Benjamin Friedman for the National Bureau of Economic Research said Commerce Department data showed that, contrary to popular belief, the Reagan deficit did not lead to an investment boom -- all rates of domestic investment actually slowed down in the 1980s.

"The familiar conclusion that sustained government deficits at full employment depress private capital formation has stood up well," Friedman wrote.

The Baby Boom wrinkle

A Federal Reserve study, published in May 2003, tried to judge the impact of deficits on interest rates while weeding out other factors that might have had an impact. The result: the study found that every percentage point in the ratio of deficits to gross domestic product pushed long-term interest rates higher by a quarter percentage point. GDP is the broadest measure of the nation's economy.

In other words, if the deficit is 5 percent of GDP in 2005, as the current forecasts would suggest, then long-term interest rates -- all else being equal -- would rise by 1.25 percentage points, potentially slowing down economic growth.

"I think you would be hard-pressed to find an economist, aside from the supply-siders, who would argue against the idea that deficits matter," said former Fed economist Wayne Ayers, now chief economist at Fleet Boston Financial.

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What's more, the economy in the 1980s and early 1990s did not face the looming retirement of millions of Baby Boomers, who will begin retiring en masse at the end of this decade. That will draw down Social Security and Medicaid benefits and put an enormous strain on federal finances, potentially leading to a reduction in those and other benefits, tax hikes, or both.

Fed Chairman Alan Greenspan, who has spoken of the dangers of deficits before, is expected to again address them in his testimony to Congress later this month.

Former Treasury Secretary Robert Rubin recently published a study suggesting budget deficits could not only lead to higher interest rates, but also to reduced consumer and business confidence and reduced international confidence in the U.S. economy. The ripple effects, he said, could be disastrous.

"They can all come together and begin to feed on each other, in which case you could have a very severe and seriously threatening set of economic impacts that would create an immensely difficult problem for our economy and our political system," Rubin said in a conference call with reporters last month.  Top of page

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