February 02, 2004

Deficits DO Matter

Just one last follow up to the topic broached less week about deficits. After sending the article below to my colleague, his question came back, "Can you prove that higher deficits slow down capital formation?" The answer...in the affirmative...below. If you measure government deficits as a measure of GDP, they seem smaller. But the key economic question, in terms of sustainability and capital formation, is government deficits as a percentage of gross saving. To what extent is government borrowing crowding out private investment and capital formation? First, some back ground from a 1994 Fed research paper titled “Fiscal Policies Aimed at Spurring Capital Formation: A Framework for Analsyis” (exciting title.) The authors, Robert Chirinko and Charles Morris had this to say about the negative impact of government deficits on capital formation: “Government deficits create a shortfall in private capital formation by reducing the pool of saving available for private sector borrowers, thus “crowding out” private capital formation. To the extent that deficits are not used for investment purposes {ed note: simple redistribution of income or debt service payments are not, in the economic sense, “investment”} total capital formation is reduced.” And to buttress the point that because its big bad Uncle Sam, and he can borrow at below-market rates and punish the rest of the market, the authors ad this: "An important feature of government borrowing is that it is insensitive to interest rates. That is, the government will borrow whatever it needs to finance its deficit no matter what the interest rate, because its budget deficits are always financed. As a result, deficits reduce the funds available for private capital formation.” It follows that larger government deficits reduce capital formation even more. But again, how do you measure the size of the deficit? At what size does it begin to matter? Auburn economist Dr. Roger Garrison published an article last summer on the very subject. Garrison said, in a nutshell, don’t look at GDP, look at gross private saving. The main purpose of GDP, as Senator Everett Dirksen once said, was to make everything else look small in comparison. Garrison says, “GDP makes for a politically attractive but economically irrelevant indicator. How much is government borrowing relative to the funds available for borrowing?” The Fed study authors tell us that in the 1970s, the federal deficit was 11% of private saving. Last summer, when Garrison ran his figures, the projected federal deficit of $304 billion was just under 20% of gross saving of $1.5 trillion. With a projected federal deficit of $521 billion, and gross savings in 2003 (excluding December) of $1.8 trillion, the federal deficit is nearly 30% of gross savings. Bingo. Rising deficits absorbing more of already meager private savings. The end result is what the Fed study’s authors tell us: “high (and growing) federal budget deficits increase competition for the scarce pool of private saving, raise interest rates, and crowd out private investment.” You might argue that foreign investment ads to the pool of available savings, reducing the negative impact of higher government borrowing. But foreign savings have also been going to finance government deficits, not towards investment and capital formation. Garrison says, “In recent years changes in international capital flows have been the primary consequence of increased deficits. This means that the US Treasury is going to to head with the U.S. export industry. Foreign funds flowing directly or indirectly into the Treasury are funds that are not spent on U.S.-produced goods ands services.” This LOOKS good in the short term, when all those foreign funds are keeping bond yields low and stock prices high. For one, it’s tenuous. The drop in the dollar has increased the cost of owning dollar-denominated assets. That means foreigner are a lot less likely to lend their savings to losing American financial investments. Ultimately, this points to the utter insustainability of budget deficits, at least at lower rates. Either the federal government begins to absorb even more of dwindling private savings, and pushes bond prices up (at the expense of stocks), OR the Fed’s raise rates to keep borrowing.


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