Don’t Sweat The Deficit
. . . that is, if spending restraint emerges.


David Malpass

The Bush administration raised its budget-deficit estimates considerably for both fiscal year 2003 and 2004 in its mid-session review released last week. The Office of Management and Budget (OMB) now projects that the deficit will increase to $455 billion in the year ending in September, a big jump from the $158 billion actual deficit in fiscal year 2002, and much higher than the OMB’s February estimate of $304 billion. For the next fiscal year, the OMB raised its estimate from $307 to $475 billion in February. Unless economic growth comes in above expectations, that estimate will likely go higher due to spending on Iraq.

The acceleration in the growth in government spending — the OMB expects federal spending to hit $2.27 trillion in fiscal year 2004 — remains a vaild concern. But the latest evidence of the increasing fiscal deficit will not have much effect on the economy, the dollar, or the financial markets. Deficits are expected during periods of sluggish economic growth, and are considered appropriate economic policy.

As a percentage of gross domestic product, the government’s outstanding debt (marketable debt held by the public) is rising only modestly. It is projected to rise from 37.5 percent of GDP in this fiscal year to a peak of 40.6 percent in fiscal year 2006. The debt-to-GDP ratio was lower in the 1970s, but that was the result of inflation driving tax revenues up faster than debt service costs — a temporary effect.

At under 40 percent, the U.S. debt-to-GDP ratio is among the lowest in the industrial world. The corresponding net debt-to-GDP ratios in Germany and France are above 40 percent, while Japan’s is nearly 70 percent (with gross debt-to-GDP now above 140 percent).

Importantly, the U.S. government’s debt service cost stays at a relatively low level, and this is a fair measure of the burden of the federal government’s debt on the economy.

More, this fiscal year’s deficit is expected to be only 4.2 percent of GDP. The deficit expanded to a larger portion of GDP after the 1982 recession (a record 6 percent of GDP) and after the 1990-91 recession.

There is fear out there that the substantial increase in the fiscal deficit will have a big impact on interest rates and bond yields — which are now rising primarily due to the stronger growth outlook. Despite constant media assertions to the contrary, there’s not much connection between fiscal deficits and interest rates, or even much credible documentation of a strong connection. This is especially true given the U.S.’s low debt-to-GDP ratio.

Bond yields primarily reflect growth and inflation expectations, as well as credit quality. As the U.S. reflation continues and economic growth accelerates, Treasury bond yields, and then short-term interest rates, will move still higher in fits and starts.

Empirical data do not show a relationship between bond yields and the budget deficit:

The yield on 10-year bonds fell throughout the 1980s, even as the fiscal deficit moved above 4 percent of GDP over a number of years.

The August 1993 tax hike was followed by an increase in 10-year bond yields to nearly 8 percent by November 1994 from 5.5 percent when the tax hikes were passed.

The 10-year yield rose to 6.7 percent by early 2000 from a low of 4.5 percent in late 1998, even as the budget was producing surpluses.

Fiscal deficit estimates have been increasing for roughly two years. During that time, bond yields and interest rates moved to major new lows.

So why the increased deficit? The continued sluggishness of the U.S. economy and the military action in Iraq are the primary factors behind the increased OMB estimates.

Per the OMB, the sluggish economy caused $66 billion (44 percent) of the $151 billion increase in the deficit estimate for this fiscal year, and $95 billion (57 percent) of the $168 billion increase for next year.

Note that the costs of the military action in Iraq were not included in the OMB’s February budget estimates. In the current estimate, Operation Iraqi Freedom will add $47 billion to fiscal year 2003 spending and $20 billion to fiscal year 2004 spending.

The key budget issue is the rate of growth of government spending; current and future spending is a better measure than deficits of the resources absorbed by the government.

Total government spending rose 7.9 percent in nominal terms in fiscal year 2002. The OMB now expects it to increase another 10 percent this fiscal year. But the OMB’s latest $475 billion deficit estimate for fiscal year 2004 assumes a 3.8 percent decline in defense spending, holding the spending increase to 2.7 percent. Expect that estimate to increase.

A big chunk of the spending problem is the growing share of government spending going to Social Security, Medicare, and pensions. This “mandatory spending” does not require congressional approval and does not pass through the annual appropriations process.

The addition of prescription-drug benefits to Medicare would further increase the government’s mandatory spending and would likely materially increase the growth rate of overall government spending.

Meanwhile, the rest of government spending, called “discretionary spending,” has accelerated sharply. It is an important cause of the recent increase in the deficit. In the past three fiscal years, discretionary spending has increased at an 8.7 percent annual rate after having risen at a 1.6 percent annual rate for the preceding 10 years.

Even without the additional spending on the Iraq war, discretionary spending will grow quite rapidly this fiscal year.

But keep in mind, as GDP growth accelerates — perhaps in excess of 4 percent next year — tax receipts will increase. This should cause the deficit to stabilize and then to decline if economic growth continues and any sort of spending restraint emerges.