Deficits and ... more deficits

The economics editorial debate in the U.S. has been focused lately on the Federal budget deficit. The U.S. now owes roughly $8.6 trillion in public debt. This continues to grow. In 2005, the Federal budget deficit was $319 billion. This dropped to $248 billion for the fiscal year ending September 2006. The projected deficit for 2007 is $423 billion. This is the apart from the additional accumulation of debt by state and local governments. (According to the Federal Reserve, state and local debt amounted to another $1.85 trillion in 2005). And of course, households also continue to accumulate debt. Much of this debt accumulation is funded by foreigners. Indeed, the exposure of foreign investors to U.S. debt and equity markets is now so large that they simply have to be getting nervous. A recent IMF working paper ('How Might a Disorderly Resolution of Global Imbalances Affect Global Wealth?' Francis E. Warnock; IMF Working Paper 06/170, July 1, 2006) examines just what this exposure means. By his estimates, a 10% decline in equity and bond markets, combined with a 10% drop in the dollar, would translate into a loss in foreign wealth equal to roughly 5% of foreign GDP. In the case of Canada, this is almost 6.25 percent of GDP. In contrast, in 1994 this would have been 2 percent. While attention in the U.S. has been focused on the budget deficit, tied to this debate is the ability of the U.S. to continue to finance its spending with foreign funds. Indeed, while the U.S. is borrowing more and more from abroad as a share of GDP, the prospects are not good. The bill for the retiring baby boomers has not yet come due. When social security payments and Medicaid and Medicare explode, things will get very interesting fiscally. Social security may be realtively well financed over the long term. Combined with the costs of Medicaid, Medicare, and the occasional optional war, however, the accounts are not so neat and tidy.

In retrospect, one gets the feeling that in the Clinton years, a (relatively) good faith effort was made by the baby boom generation to put the fiscal house in order for their looming retirement oblgations. This has all been squandered, of course, and there is no going back. Surprisingly, it looks like a number of editorial writers who have attacked Bush in the past for fiscal irresponsibility are now, for various reasons, instead rationalizing a shift in expenditures rather than restoring fiscal order. Paul Krugman ("Democrats and the Deficit," December 22 2006), for example, apparently does not now believe that the electorate is willing or able to support a fiscally responsible government. 'Rubinomics made sense in terms of pure economics, [but] it failed to take account of the ugly realities of contemporary American politics...'. If we are going to have deficits anyway, the logic runs, lets at least spend the money right.

The elephant in the room is the foreign lender. All of this hinges on the assumption that the Japanese will continue to print yen, the Chinese will continue to build up mountains of dollars, and the Europeans will continue to pour their pension savings into the U.S. debt and equities market. Can we really assume this will continue? If not, the budget pundits and apparatchiks are all in for a rude shock. We are in uncharted territory. According to the IMF, the U.S. current account deficit in 2006 was 6.6 percent of GDP. They project that this will be 6.9 percent of GDP in 2007. At this rate, foreign debt is accumulating faster than the underlying growth rate of the U.S. economy. By the standards of the last 100 years, these trends are simply unprecedented. Most likely, they are also unsustainable. They have implications for the dollar, U.S. asset prices, and "long-term" adjustments to the U.S. Fiscal balance that may not be so far away after all, if and when foreign investors change their collective mind. (See the CRS report 'Is the U.S. Current Account Deficit Sustainable?' for an overview of studies on how this might all play out.)

At the same time, with Krugman changing his tune, there has been a bit of bashing going on. Some examples can be found at the Marginal Revolution site. One post asserts that "Democrats resent me getting money that rightfully belongs to them..." Maybe Krugman is right that, in the current climate, serious discussion about fiscal responsibilty is not possible. To be honest, I resent everybody spending money that belongs to my kids (and grandkids for that matter...) Tax refunds in the face of continued borrowing does not mean no one will be paying the bill. I once tried to explain to my (then 12 year old) daughter how every American owes $28 thousand in public debt. She was not pleased.

© JFF & Intereconomics, LLC 2006