Why a $1 trillion deficit is not as scary as it sounds

As you might imagine, I find myself in a lot of discussions about US fiscal policy, and the budget deficit in particular. And there’s one thing I can count on in these discussions – at some point someone will announce, in dire tones, that we have a $1 trillion deficit. No, I don’t think the people making this pronouncement realise that they sound just like Dr Evil in the Austin Powers movies.

Anyway, we do indeed have a $1 trillion deficit, or at least we did; in fiscal 2012, which ended in September, the deficit was actually $1.089 trillion. (It will be lower this year.) The question is what lesson we should take from that figure.

What the Dr Evil types think, and want you to think, is that the big current deficit is a sign that our fiscal position is completely unsustainable. Sometimes they argue it means a debt crisis is just around the corner, although they’ve been predicting that for years and it keeps not happening. (US borrowing costs are near historic lows.) But more often they use the deficit to argue that the US can’t afford to maintain programmes such as Social Security, Medicare and Medicaid. So it’s important to understand this is completely wrong.

The US does have a long-run budget problem, due to our ageing population and rising healthcare costs. However, the current deficit has nothing to do with that problem, and says nothing at all about the sustainability of our social insurance programmes. Instead, it mainly reflects the depressed state of the economy – a depression that would be made even worse by attempts to shrink the deficit rapidly.

The first thing we need to ask is what a sustainable budget would look like. The answer is that in a growing economy, budgets don’t have to be balanced to be sustainable. Federal debt was higher at the end of the Clinton years than at the beginning – that is, the deficits of the Clinton administration’s early years outweighed the surpluses at the end. Yet because gross domestic product rose over those eight years, the best measure of our debt position, the ratio of debt to GDP, fell dramatically, from 49 to 33 per cent.

Right now, given reasonable estimates of likely future growth and inflation, we would have a stable or declining ratio of debt to GDP even if we had a $400 billion deficit. You can argue we should do better; but if the question is whether current deficits are sustainable, you should take $400 billion off the table right away.

The depressed economy

That still leaves $600 billion or so. What’s that about? It’s the depressed economy – full stop.

First of all, the weakness of the economy has led directly to lower revenues: when GDP falls, the federal tax take falls too, and in fact always falls substantially more in percentage terms. On top of that, revenue is temporarily depressed by tax breaks put in place to support the economy but will be withdrawn as soon as the economy is stronger (or, unfortunately, even before then). If you do the maths, it seems likely that full economic recovery would raise revenue by at least $450 billion.

Meanwhile, the depressed economy has also temporarily raised spending, because more people qualify for unemployment insurance and means-tested programmes such as food stamps and Medicaid. A reasonable estimate is that economic recovery would reduce federal spending on such programmes by at least $150 billion.

It turns out that the trillion-dollar deficit isn’t a sign of unsustainable finances at all. Some of the deficit is in fact sustainable; just about all of the rest would go away if we had an economic recovery. And the prospects for economic recovery are looking pretty good right now – or would be looking good if it weren’t for the political risks posed by Republican hostage-taking. Housing is reviving, consumer debt is down, employment has improved steadily among prime-age workers. Unfortunately, this recovery may well be derailed by the fiscal cliff or a confrontation over the debt ceiling; but this has nothing to do with the alleged unsustainability of the deficit.

Which brings us back to $1 trillion.

We do indeed have a big budget deficit, and other things being equal it would be better if the deficit were smaller. But other things aren’t equal; the deficit is a side effect of a depression, and the first order of business should be to end that depression – which means, among other things, leaving the deficit alone for now.

And you should recognise the hyped-up talk for what it is – another attempt to scare and bully the body politic into abandoning programmes that shield poor and middle-class Americans from harm.