How worried should we be about the deficit?

There have been many posts on this topic lately, start with Paul Krugman and Brad DeLong if you need to catch up.  Today I have a few simple points:

1. Even if "it is fine to borrow more" is the most likely scenario, it is not the only scenario.  Let's take a page from Marty Weitzman on climate change.  The worst-case scenarios matter too, because they can be very, very bad.  We need to think probabilistically about this issue.

2. Are there current intelligent discussions of the implied interest rate volatility embedded in current options prices?  If we are looking for market tests, why not start there?  Focusing on the point estimate of the market interest rate(s) discourages you from thinking probabilistically.

3. I know less about Belgium but I am not reassured by Krugman's point that "Italy can do it."  I and many other observers consider Italy's economy to be a basket case which will only get worse.  Nor is Japan in a satisfactory place, economically speaking.

4. Krugman writes: "Belgium is politically weak because of the linguistic divide; Italy is
politically weak because it’s Italy. If these countries can run up
debts of more than 100 percent of GDP without being destroyed by bond
vigilantes, so can we."

I would interpret this evidence differently.  A high deficit often is an unfavorable symptom of bad politics, even if you think the high deficit is economically OK on its own terms.  It's a sign that you have dysfunctional institutions and decision-making procedures, as indeed they do in Belgium and Italy.  I believe that the not-always-swift American voter in fact understands high deficits — correctly — in this light.  They don't hold theories about "crowding out," rather they sense something in the house must be rotten.  And so they rail against deficits, as do some of their elected representatives.  It's a more justified reaction than the pure economics alone can illuminate.

When water regularly overflows from your toilet, you want the toilet fixed, whether or not the water is doing harm.


I've followed politics for quite a few decades now, and I've learned deficits matter during Democrat administrations and don't matter during Republican administrations.

It would be fine to apply a purely mechanical/technical/"hydraulic" analysis to the deficit if it were being used as a stimulus in the sense that Keynes intended, i.e. temporary spending that uses the multiplier to avoid government planning as a solution to the consequences of the business cycle trough. The problem is that this deficit is a consequence of bad policies and decision-making systems, rather than a decision to shift exogenous economic activity away from a future peak and towards the trough. Particularly the Bush wars and the Obama health bureaucracy.

Much the same is true of my country (Ireland), in which we actually ran deficits in some years during the large economic expansion at the beginning of the decade, due to an incomes policy dictated by the largest businesses and trade unions that depended on a house price bubble and easy money. So this isn't anti-American or anything (or anti-Belgian or anti-Italian). It's a common theme in polities with problems.

You missed Krugman's point.

"4. Krugman writes: "Belgium is politically weak because of the linguistic divide; Italy is politically weak because it’s Italy. If these countries can run up debts of more than 100 percent of GDP without being destroyed by bond vigilantes, so can we."

I would interpret this evidence differently. A high deficit often is an unfavorable symptom of bad politics, even if you think the high deficit is economically OK on its own terms. It's a sign that you have dysfunctional institutions and decision-making procedures, as indeed they do in Belgium and Italy. "

Exactly. This is precisely why California has such a ridiculous deficit and debt.

"I've followed politics for quite a few decades now, and I've learned deficits matter during Democrat administrations and don't matter during Republican administrations."

It must be strange to see the world solely through the lens of political teams.

You have never seen libertarian criticism of deficit spending by Republican politicians? Let me give you a hint. People can oppose deficit finance without favoring tax increases. People can oppose an expansion in the size of government while considering deficit finance a compounding problem.

There are plenty of critics of "big government" Republicans.

Just because Republican politicians and the pundits who repeat their talking points ignore such views and instead make a partisan case doesn't mean that such views don't exist.

Take off your blinders! There is more to the world than the rhetoric of politicians and their lackeys in the media.

How can it be that deficits don't matter because we are in a recession and yet it is critical to focus on medical spending reform because it is a long-term budget problem and the bill is fiscally responsible?

Being an Italian living in Belgium, I drew the attention of Krugman to the inappropriate, to say the least, comparison he made. I posted comments in his blog. He is now making jokes about the issue without explaining a) his concept of sustainability of deficits and debts and solvency b) the correlation, if any, between increasing deficits and debts and creating jobs c) what if, in the worst scenario, US bond vigilantes (chines) decide to dump dollars and treasuries which ends up in situations of “self-fulfilling solvency traps†.

It's cliche by now, but where were these guys years ago when Bush killed the surplus?...Ok I know that was somewhat to dealing with an economic crisis, but the huge tax cuts and all that after, those were just political gifts. The "American voter" is not what interpets this. The "American carrer-minded Senator" is. I read here earlier a post talking about the Congress's lack of will in making similar budget cuts to the one's in the healthcare bill. But as I see it about 49 senators are willing to bother to put these "unpopular" cuts in the bill in the first place. I believe it is the other 38 Republicans who have decided that its really not in America's intrest to do anything about the largest fiscal crisis ever predicted to be probable. Then there is the 12 senators who could careless because they are in the senate to secure for themselves more power and care little for the "American voters" they serve. I would dont mind your style guide, but I would prefer to redefine SG2 to: Republicans don't care, and carrer-minded senators from the "middle" made the bill bad, not us" since I think if I followed it all correctly this is what happened. If Republicans actually cared about this issue, or if any of the "centrist" were less carrer-minded and more country-minded then our congress could function to blance out it's revenue with its expenses, and what is weird about all this talk of socialism is that they would probably do this in a way that maintains much more of the "freedom" or markets enjoy, as opposed to the future the others are trying to ensure....(I rarely hear praise of the markets of police states)

Back in the 80s, when I was in my 20s, I used to lie in bed at night worrying about the national debt and ongoing deficits and how we were mortgaging the future and there wouldn't be any social security left when I hit 65, etc. It was the most pressing issue of the time, in my mind. In the 90s Newt Gingrich and Bill Clinton wrestled deficits to the ground and actually had a surplus one or two years. I was so relieved; I thought now we can get on to other things. National health care, infrastructure investments, stuff that will allow us to prosper in the future.

Then Bush and the Delay Republicans took over and cut taxes for the rich in the early 2000s. We were back to deficits in order to make rich people richer. It was the most irresponsible thing and I felt betrayed as a deficit hawk. These people had no intention of getting the country on a solid financial basis; they just wanted to cut taxes. That betrayal turned me. No more worrying about deficits. No more responsibility. If we solve deficits, politicians just come in and cut taxes for the wealthy. Now I'm pro-debt. I'm sick of being responsible so others can take advantage. Expand government spending left and right. When the Republicans come back into power, they will limit spending growth, but they will also be forced to raise taxes to deal with the debt. That's the way to go now. You can't trust politicians of any party with a balanced budget.

As for your point about American voters worrying about deficits, Krugman wrote a brilliant reply already - voters say they're worried about deficits, but even during the biggest deficit reduction in modern history, they thought deficit increased. So it's sort of like worrying about "crime", "corruption" and so on - it's a concern completely disconnected from reality. Null hypothesis says voters will worry the same amount about deficits/crime/corruption regardless of changes in their levels.

Republicans seek to stave the beast of a growing government.

Democrats seek to starve the beast of free enterprise.

Republicans argue that borrowing from one group of Americans (and paying them interest) while taxing other Americans to fund needed spending can on net have a benefit.

Democrats are arguing that who gets the interest payments doesn't matter as long as you reward political supporters.

Good point about Weitzman, Tyler. And for those who (correctly) accuse Republican pundits of only caring about deficits when Dems are in power, let's recall this Krugman column from 2003. Yes, there wasn't a "liquidity trap" back then, but he was freaking out about a 10-year projected deficit of $1.8 trillion. He even said he refinanced his house, so confident was he that "skyrocketing" deficits (in the range of 3 - 4% of GDP) would push up interest rates.

At least part of Tyler's argument seems to be based on the political reality that it will be hard to deal with the deficit down the road. When you support large tax cuts, even when it is unlikely politically that there will be large corresponding cuts in defense or entitlements, then you cannot say the deficit is an important priority.

"When water regularly overflows from your toilet, you want the toilet fixed, whether or not the water is doing harm."
The debt question misses the deeper point. Yes, we should do something to fix the toilet from overflowing but when and how? If the house is on fire, the leaky toilet is sort of a secondary concern. Heck, maybe it'll help douse the flames. Then, how do we fix the toilet once the fire's out? do we bring in a new toilet and pipes, or do we fix it around the existing parts, or do we also have to fix the exterior main pipes leading into the house?
So, do we fix the deficit before or after the recession? Do we cut spending or raise taxes? If we cut spending, where? If we raise taxes, on whom? By how much? And oh, by the way, try doing either without honking off a salient block of voters.

All that really needs to be said about this topic and this thread is that the very first comment was blatantly, hypocritically and ignorantly hyper-partisan, and that was just the tip of the iceberg. I see no way out of America's financial problems PRECISELY because this thread is representative of virtually ALL discourse on the topic. Garbage in, garbage out.

It's also about ROI, which means what the money is spent on.

Voters can be upset about what the money is spent on.

When it suits his purposes Krugman talks about the "popularity" of this or that transfer program. When spending is unpopular, he calls the voters egg-no-ra-mooses

I was going to make exactly Morten's point. Your house is on fire--why are you worrying about the leaking sistern.

If CW is so reliable then why was it so happy to run up personal and private debt in the good times? This is nonsense, surely. Government should be saving in the good times and spending in depression. CW seems to have it quite backwards (though the deficit does need a long-term solution).

I don't sense any comprehension of the corrosiveness of unemployment here--what a catastrophe it is and how it blights and retards generations, especially the young. The current situation is downright scary.

You might want to think about this a different way: think about the runup in household debt in the last ten years: household debt to GDP increased from 68% to 102% of GDP. At the same time, financial institutions increased leverage dramatically. Consumers are deleveraging, saving and reducing borrowing. Financial institutions are deleveraging, and are acquiring US debt as part of their restored capital base. In the process of deleveraging, there is a demand for US debt for bank balance sheets (as opposed to flaky mortgages). So, current debt may not be a big problem, although, if we runup consumer debt and releverage, it could be. In the longer term, starting now, we should be thinking about countercyclical tax policies--one's that kick in to reduce debt when we get back to full employmenet, rather than producing policies that runup or expand deficits through tax cuts when we get to full employment.

Point #1 (Weitzman) is just plain stupid. Worst-case scenarios have incomparable magnitudes, and there is nothing irreversible about fiscal policy. I've heard this argument before (Andy Biggs made it comparing Social Security and global warming) and I attacked it as completely wrong. It would probably work well for you as a sound bite on TV, but it doesn't stand even the slightest rational scrutiny.


More idiots lost in the "left vs. right" mindset.

Get a clue.

Perhaps Italy carries an implied bailout in their debt in the same way that Fannie/Freddie did. Suppose Italy fell apart. Would not the U.S. and Europe prop it back up, at least to some degree, even if in an altered structure?

The U.S. is the world economic backstop. A reasonable assessment of economic stability of debt pricing should reflect that. And generally does.

It does indeed seem to be commonsense that, beyond some reasonable level of time and size, high deficits are bad are bad. In the lead-up to the 2008 crisis there were concerted efforts in politics, big-business markets, and economics profession to countermand that intuitive logic. Despite their differences, Italy and Japan have both been like countries on debt-drip life-support awaiting arrival of doctor to correct underlying institutional sickness. Meanwhile the hospital beds are filling up fast – UK, et. al. We need you USA --- get yourself off the drip. I found Russ Roberts discussion this week with Carmen Reinhart on EconTalk useful in getting across the basic point: the *overarching* factor in all big economic crises of emerging and advanced economies is current account deficit, which correlates with availability of credit. Risk associated with moral hazard, implicit guarantees, too-big-to-fail, etc. are all after the fact of debt. They are secondary and merely aggravating to factors that create capacity to over-borrow. After the crisis private sector debt tends to get passed on to public sector. I’ve been reading Buchanan and Wagner’s ‘Democracy in Deficit’ (1977). They did not hold out much hope that politics would ever put a stop to the free lunch. They were non-partisan on that point. I wonder if Krugman has read it. It’s rather prescient to put it mildly... Future hope lies in a marriage of brave-intelligent-visionary leadership with good ol’ voter commonsense. Debts are (probably) bad.

Italy and Belgium free ride on European Central Bank. There is hope that in worst case scenario Germany will bailot weaker eurozone countries.

Even in the context of believing the market efficient, it's an error to look solely at the interest-rate market to conclude that one can run a larger deficit.

Suppose the market is efficient, and the current deficit is x, and an alternative scenario is a much larger deficit of y. Because the market is efficient, it will have internalized the probability that it thinks x will happen and the probability that y will happen, and this probability will be reflected in the price (the interest-rate). So it's quite possible that the market has simply decided that the probability of y is very low. That is, the interest-rate market may not be saying that y is not a problem; it may be saying simply that y will not happen. Maybe not, of course, but this kind of information (the probability that y will happen) cannot, even under the best scenario, be gleaned simply by looking at the interest-rate market. There are too many factors, and those who are justifying their positions by looking at the interest-rate market, even spot or option, are wrong.

We need vigorous economic growth to stimulate the economy and reduce unemployment. That is the only way that real estate will recover.


@Koen: You're right to say that the pre-Euro Belgian debt of +100% of GDP is different than the current American situation. Belgian debt during that time was mainly owned domestically. But for the purposes of a fire sale of government bonds, does that really matter?

"I'm terrified about what will happen to interest rates once financial markets wake up to the implications of skyrocketing budget deficits."--former Enron adviser Paul Krugman, New York Times, March 11, 2003

Oh wait... a Republican was President then!

Sure, the deficits have quadrupled since that time, but never mind. I'm sure there is nothing to worry about now!

Well, I am a Belgian, even worse I am a Belgian economist !

And be sure: the Belgian debt has been, and remains, a real drag on the economy !!
Only one recommendation: don't let the deficit and the debt run away, it takes years to build debt, it takes decades to get rid off it.

Also, I had a debate with Paul Krugman himself, in Belgium (!), last week, on the debt matter.

You can read the report and the comments of the debate here:

Kind regards !

Geert Noels
Econopolis NV/SA

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