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The Disastrous Impact of Large and Sustained Federal Budget Deficits

Morgen on December 11, 2009 at 7:30 am

Just came across some rather grim analysis of the economic impact of massive, ongoing federal budget deficits from a group of prominent economists. It’s a little dated (2004) but still highly relevant considering that the deficit situation has dramatically worsened since then. Some highlights:

Substantial ongoing deficits may severely and adversely affect expectations and confidence, which in turn can generate a self-reinforcing negative cycle among the underlying fiscal deficit, financial markets, and the real economy:

  • As traders, investors, and creditors become increasingly concerned that the government would resort to high inflation to reduce the real value of government debt or that a fiscal deadlock with unpredictable consequences would arise, investor confidence may be severely undermined;
  • The fiscal and current account imbalances may also cause a loss of confidence among participants in foreign exchange markets and in international credit markets, as participants in those markets become alarmed not only by the ongoing budget deficits but also by related large current account deficits;
  • The loss of investor and creditor confidence, both at home and abroad, may cause investors and creditors to reallocate funds away from dollar-based investments, causing a depreciation of the exchange rate, and to demand sharply higher interest rates on U.S. government debt;
  • The increase of interest rates, depreciation of the exchange rate, and decline in confidence can reduce stock prices and household wealth, raise the costs of financing to business, and reduce private-sector domestic spending;
  • The disruptions to financial markets may impede the intermediation between lenders and borrowers that is vital to modern economies, as long-maturity credit markets witness potentially substantial increases in interest rates and become relatively illiquid, and the reduction in asset prices adversely affects the balance sheets of banks and other financial intermediaries;
  • The inability of the federal government to restore fiscal balance may directly reduce business and consumer confidence, as the view of the ongoing deficits as a symbol of the nation’s inability to address its economic problems permeates society, and the reduction in confidence can discourage investment and real economic activity;
  • These various effects can feed on each other to create a mutually reinforcing cycle; for example, increased interest rates and diminished economic activity may further worsen the fiscal imbalance, which can then cause a further loss of confidence and potentially spark another round of negative feedback effects.

Although it is impossible to know at what point market expectations about the nation’s large projected fiscal imbalance could trigger these types of dynamics, the harmful impacts on the economy, once these effects were in motion, would substantially magnify the costs associated with any given underlying budget deficit and depress economic activity much more than the conventional analysis would suggest. Indeed, the potential costs and fallout from such fiscal and financial disarray provide perhaps the strongest motivation for avoiding substantial, ongoing budget deficits.

Where did this analysis come from? It wasn’t The Cato Institute or The Heritage Foundation as one might expect. It’s from a research report published in 2004 by the left-leaning Brookings Institution, and was co-authored by none other than White House Budget Director Peter Orszag (along with Robert Rubin and Allen Sinai).Orszag

At the time, federal budget deficits were expected to total about $5 trillion in the proceeding 10 years. As things turned out, deficits totaled over $5 trillion from 2005-2009, and the current forecast is for nearly $10 trillion in additional debt to be added over the next 10 years.

Expect to see a major PR campaign initiated by the White House in January ahead of the State of the Union address focusing on the Administration’s commitment to getting the budget situation under control. However, it’s hard to see how they will have much credibility given that in the interim not only is the President hoping to sign a massive new entitlement program in ObamaCare, but Democrats are also crafting a new stimulus bill which will likely cost at least $75-100 billion.

Orszag talks a good game but the plain truth is that this Administration has exponentially increased spending without restraint. And not only did President Obama vote for the budget deficit he “inherited” as a Senator in 2008, he praised it for helping “restore fiscal responsibility in Washington“. In fact, he lauded the Democrat-controlled Congress for rejecting cuts in domestic programs proposed by the Bush Administration.

Welcome to the New Era of Responsibility. “Fiscal and financial disarray” riding on a wave of Hope and Change.

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Category: Politics |

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