Deficits DO Matter

In 2002, former Vice President Dick Cheney famously said to then-Treasury Secretary Paul O’Neill, “Reagan proved that deficits don’t matter.” At the time, Cheney was advocating for an extension of the large-scale tax cuts that were enacted in 2001 as a policy response to an economic recession. The 9/11 terrorist attacks only increased the urgency for further action. Cheney believed, as most Republicans do, that lower tax rates on businesses and wealthier individuals incentivize investment, and those investments eventually “trickle down” to the middle class in the form of more jobs and higher wages. Further, the increased economic activity sparked by the tax cuts will eventually lead to higher tax revenue, justifying the short-term deficits.
Cheney’s view eventually prevailed, as O’Neill was fired from the Bush administration and another round of tax cuts was passed in 2003. The debt created by those tax-cuts, though, was never really paid back as annual deficits have continued uninterrupted since 2001. Still, it’s important to put Cheney’s comments in context. In 2002, the federal government had just recorded four straight years of budget surpluses that collectively reduced federal government debt held by the public by $450 billion, or 12%. In fact, at the end of 2001, federal debt held by the public of just $3.3 trillion (31% of GDP) was quite manageable compared to nearly $15 trillion (76% of GDP) at the end of 2017. (It should be noted that gross federal debt, which includes federal debt held by the public plus Treasury securities held by federal trust funds and other government accounts, currently stands at well over $20 trillion, or about 105% of GDP.) This may not excuse Cheney’s blasé attitude toward deficits, but if someone made that comment today it would be far more shocking.
There has been a lot going on in Washington in recent weeks. The Tax Cuts and Jobs Act of 2017 was signed into law on December 22. Just seven weeks later President Trump signed into law a major budget agreement. And now the President has put forth his plan to revitalize our national infrastructure. What do all these initiatives have in common? They all cost money, and a lot of it. Most economists are beginning to see consistent $1 trillion+ annual deficits starting in 2019, and this doesn’t even factor in any federally funded infrastructure investment. Treasury Secretary Mnuchin seems completely unfazed by the possibility of having to fund over $1 trillion in annual deficit spending. This despite the facts that 1) the Fed is currently raising interest rates; 2) the Treasury has done a wholly inadequate job of extending the duration of its debt so as to lock in low interest rates; 3) the Fed is now in “Quantitative Tightening” mode, which means that a major source of consistent Treasury demand will be getting smaller; and 4) economic growth has accelerated in recent months, both organically and as a result of the tax cuts. Each of these factors suggest that interest rates could be rising even more in the months/years to come, making the Treasury’s job of affordably funding trillion-dollar deficits a lot harder. What’s more, all that federal-government borrowing could start to “crowd out” private investment, effectively slowing economic growth. Which brings me to my second question: what happens if we have a recession?
Aside from the need to fund huge annual deficits, our leaders should also be cognizant of the fact that our profligate spending now, at a time of relative prosperity and consistent growth, leaves us with much less ammunition to jump-start the economy in the event of a recession. This is not a trivial matter. Typically, when the economy goes into recession, unemployment rises, business activity slows, and tax revenue goes down. Furthermore, in response to the slowdown, the federal government usually steps up its spending and investment to support the economy. The net effect of lower tax revenue and higher government spending is large budget deficits. If we’re running unsustainably high deficits already, how on earth will Mnuchin expect to raise even more money to cover revenue shortfalls in a recession?
In the chart below, you will see that the deficit as a percentage of GDP (blue line) spiked during or following every recession (indicated by the gray bars) over the past 50 years. You will also see that the recessions (gray bars) correspond to big spikes in the unemployment rate (orange line). This makes sense as unemployment usually rises during times of recession. But take a look at what happens beginning in 2016. The federal deficits (we use Wells Fargo estimates for 2018 and 2019) are about to blow out even as the unemployment rate (a proxy for economic health) continues to drop (to possibly well under 4%). Absent major wars, we’ve never done what we’re about to do.
Source: Federal Reserve
The projected deficits over the next several years are not sustainable. The markets may not mutiny this year or next, but eventually there is going to be a problem. At the very least, the situation will require major changes to our entitlement programs. So don’t be surprised if that’s the next item on the docket!