fiscal deficits, economic growth, and government … fiscal deficits, economic growth, and...

26
SCHWARTZ CENTER FOR ECONOMIC POLICY ANALYSIS THE NEW SCHOOL WORKING PAPER 2011-10 Fiscal Deficits, Economic Growth, and Government Debt in the USA Lance Taylor, Chris t ian R. Proano, Laura de Carvalho and Nelson Barbosa SEPTEMBER 2011 Schwartz Center for Economic Policy Analysis Department of Economics The New School for Social Research 6 East 16th Street, New York, NY 10003 www.economicpolicyresearch.org Suggested Citation:. Taylor, Lance, Proano, Christian R., Carvalho, Laura de and Barbosa, Nelson. (2011) “Fiscal Deficits, Economic Growth, and Government Debt in the USA” Schwartz Center for Economic Policy Analysis and Department of Economics, The New School for Social Research, Working Paper Series ~ ~

Upload: trinhminh

Post on 07-Jul-2018

229 views

Category:

Documents


0 download

TRANSCRIPT

Page 1: Fiscal Deficits, Economic Growth, and Government … Fiscal Deficits, Economic Growth, and Government Debt in the USA ‡ Lance Taylor, Christian R. Proaño, Laura de Carvalho, and

SCHWARTZ CENTER FOR ECONOMIC POLICY ANALYSISTHE NEW SCHOOL

WORKING PAPER 2011-10

Fiscal De�cits, Economic Growth, and Government Debt in the USA

Lance Taylor, Christian R. Proano,Laura de Carvalho and Nelson Barbosa

SEPTEMBER2011

Schwartz Center for Economic Policy AnalysisDepartment of Economics

The New School for Social Research6 East 16th Street, New York, NY 10003

www.economicpolicyresearch.org

Suggested Citation:. Taylor, Lance, Proano, Christian R., Carvalho, Laura de and Barbosa, Nelson. (2011) “Fiscal De�cits, Economic Growth, and Government Debt in the USA” Schwartz Center for Economic Policy Analysis and Department of Economics, The New School for Social Research, Working Paper Series

~

~

Page 2: Fiscal Deficits, Economic Growth, and Government … Fiscal Deficits, Economic Growth, and Government Debt in the USA ‡ Lance Taylor, Christian R. Proaño, Laura de Carvalho, and

2

Fiscal Deficits, Economic Growth, and Government Debt in the USA‡

Lance Taylor, Christian R. Proaño, Laura de Carvalho, and Nelson Barbosa§

Abstract

A simple model illustrates interactions between the “primary” fiscal deficit (total deficit minus interest

payments), economic growth, and debt. The deficit/income ratio responds counter-cyclically to growth

while growth may respond positively (a “Keynes” case) or negatively (à la “Merkel”) to the deficit. The

recent Great Recession in the USA was atypical in that there was a weak counter-cyclical fiscal response.

The increase in government net borrowing was significantly less than the decrease in private borrowing

– an historically unprecedented asymmetry. Econometric estimates verify the historical pattern and

further suggest that there is a strong positive effect on growth of a higher primary deficit, even when

possible increases in the interest rate are taken into account.

Keywords: fiscal austerity, debt sustainability, business cycles, financial crisis.

JEL: E60, E62, E32

Address for correspondence: Christian R. Proaño, Department of Economics, The New School for Social

Research, 6 East 16th Street, New York, NY 10003, USA. email: [email protected] ‡ We would like to thank Armon Rezai and Codrina Rada for comments on previous versions of this

study. The usual disclaimers apply.

§ The New School for Social Research (LT), The New School for Social Research (CRP), The New School

for Social Research (LC), Universidade Federal do Rio de Janeiro (NB).

Page 3: Fiscal Deficits, Economic Growth, and Government … Fiscal Deficits, Economic Growth, and Government Debt in the USA ‡ Lance Taylor, Christian R. Proaño, Laura de Carvalho, and

3

1. Introduction

After a renewal of Keynesian thinking in the wake of the 2007-09 Great Recession, in early 2010

economic policy debate in the United States and other rich economies became obsessed with the

effects of the fiscal deficit on economic performance. In the eyes of most commentators, only severe

austerity could reestablish fiscal sustainability, economic stability, and growth. In the 1930s Keynes

thought he had demolished the Treasury View forever. Seventy-five years later, it had returned with a

vengeance.

The German finance minister Wolfgang Schäuble made the prevailing view crystal clear. Writing

in the Financial Times in mid-2010, he justified fiscal austerity as follows: “[…] restoring confidence in

our ability to cut the deficit is a prerequisite for balanced and sustainable growth. Without this

confidence there can be no durable growth. […] This is the lesson of the recent crisis. This is what

financial markets, in their unambiguous reaction to excessive budget deficits, are telling us and our

partners in Europe and elsewhere.”

There are two main arguments for “expansionary austerity” as a means to overcome

recessionary periods.

The first is that a bigger government deficit automatically leads to lower private investment and

economic growth. The reasoning is based on standard textbook theory, which suggests that government

borrowing increases demand for loanable funds. Given a constant supply of savings (Say’s Law in fiscal

garb), a higher fiscal deficit would crowd out capital accumulation and perhaps drive up interest rates as

well.

The second argument, echoed among others by the German Finance Minister Schäuble, is even

more hypothetical. It asserts that there is a threshold level of fiscal or sovereign debt beyond which

Page 4: Fiscal Deficits, Economic Growth, and Government … Fiscal Deficits, Economic Growth, and Government Debt in the USA ‡ Lance Taylor, Christian R. Proaño, Laura de Carvalho, and

4

investors (the famous bond vigilantes) would fear the inability of the government to meet its obligations

and so require higher bond yields. But with historically low interest rates in mid-2011, no vigilantes

could be seen on the horizon of the US economy.

These two arguments animated empirical attempts to find a negative impact of high deficits or

debt on capital formation and economic growth. While Alesina and Ardagna (2010) focused on

providing empirical evidence for a short-term positive impact on economic activity from spending cuts,

the threshold argument was fueled primarily by the study of Reinhardt and Rogoff (2010). Based on data

manipulation and correlation analysis for dozens of countries over nearly two hundred years, they

claimed to identify a debt level of 90% of GDP beyond which a country is likely to slide into a debt crisis.

Even if one ignores the numerous technical criticisms made to such findings (for instance the

IMF World Economic Outlook (2010) and Jayadev and Konczal (2010), and Irons and Bivens (2010)

provided extensive critiques of Alesina-Ardagna and Reinhardt-Rogoff respectively), it is clear that

studies supporting expansionary austerity neglected the possibility that economic growth is not only

affected by fiscal policy, but may improve public finances and contribute to sustainability. Such dynamic

interactions are crucial for determining the causes and consequences of the recent deterioration of the

deficit and prospects for the future in the USA (the principal focus of this paper).

We adopt the approach of examining the effect of changes in the deficit and its two components

– spending and revenues – on economic growth, also taking into account the other direction of

causality, that is the counter-cyclical response of the fiscal position to the state of the economy. The

reaction of the interest rate, which is central to arguments for expansionary austerity, is also analyzed in

the econometrics presented below.

The remainder of this paper is organized as follows. We begin with a summary of fiscal

arithmetic and presentation of a simple model capturing the bidirectional causality between the fiscal

Page 5: Fiscal Deficits, Economic Growth, and Government … Fiscal Deficits, Economic Growth, and Government Debt in the USA ‡ Lance Taylor, Christian R. Proaño, Laura de Carvalho, and

5

deficit and growth. Historical evidence about trends and cycles of these variables over 50 years in the

USA is quickly reviewed. Next we present a vector-autoregression (VAR) analysis of dynamic interactions

among fiscal deficits, economic growth, and interest rates. The results suggest that after the counter-

cyclical response of the “primary deficit” (that is, the total deficit minus payments of net interest) to

growth is taken into account, higher spending or lower taxes do lead to more rapid expansion of output.

Policy implications are taken up in conclusion.

2. Relationships among deficits, debt, and economic growth

Traditionally, the “burden of debt” has been analyzed in a medium- to long-term framework first

constructed by Domar (1944). It serves as background for the study of the conjuncture that is the focus

of this paper.

2.1 Long-term fiscal arithmetic and debt sustainability

If one ignores capital gains, the change in total government debt is the sum of the primary deficit and

interest payments on debt outstanding. Let Δ be the ratio of fiscal debt to output �, and δ the ratio of

the primary deficit to �. The growth rate of � is �, and � � � � is the real interest rate with � as the

nominal rate and the rate of inflation. It is well known that (in continuous time for simplicity) the

change in the debt/income ratio is given by

Δ� � �Δ� � � � �� � ��Δ

(1)

This accounting shows that the debt-to-GDP ratio increases with the ratio of the primary deficit

to GDP and the difference between real effective interest rate and real GDP growth. A constant debt-to-

GDP ratio with Δ� � 0 is achieved when the condition (2) below is satisfied.

Page 6: Fiscal Deficits, Economic Growth, and Government … Fiscal Deficits, Economic Growth, and Government Debt in the USA ‡ Lance Taylor, Christian R. Proaño, Laura de Carvalho, and

6

� � �� � ��Δ (2)

The debt-to-GDP ratio is decreasing when the primary deficit-to-GDP ratio is smaller than the term in

the right hand side of (2), i.e. the government can “grow out” of its deficit. Following Domar, this

relationship was emphasized in World Bank publications more than 50 years ago. It is often called a

solvency condition. It can be restated as:

Δ � �/�� � �� (3)

The expression in the denominator is the difference between two small numbers. A faster growth or a

lower interest rate has a very large effect on reducing the steady state debt-to-GDP ratio, which is not

the case for a reduction in the ratio of the primary deficit to GDP in the numerator.

Assuming that the interest rate and the growth rate of GDP cannot be influenced by the

government, Buiter (2010) argued that the U.S. needs to promote a permanent tightening of the

primary fiscal balance by at least 8% of GDP, or would have to inflate away the real burden of its debt in

order to achieve fiscal sustainability.

If one takes into account the existence of dynamic interactions between the primary deficit, the

growth rate, and the interest rate, achieving debt sustainability in terms of a constant debt-to-GDP ratio

may not require this type of austerity program. It is clear from (2) and (3) that as long as the growth

rate of GDP is positive and higher than the real effective interest rate on debt, a positive primary deficit-

to-GDP ratio may be associated with a decrease in the debt-to-GDP ratio.

2.2 Channels of interaction in the short to medium run

Several possible relationships among the variables at hand are considered in the current debate

and can be examined via econometric estimations. They are summarized in the Table 1.

Page 7: Fiscal Deficits, Economic Growth, and Government … Fiscal Deficits, Economic Growth, and Government Debt in the USA ‡ Lance Taylor, Christian R. Proaño, Laura de Carvalho, and

7

Linkage Direction

Counter-cyclical fiscal deficit

� �� �� �

Brazilian deficit stabilization

Δ �� �� �

Bond vigilantes Δ �� � �

Crowding-out � �� � �

Short-run fiscal effect on g � �� �� � or �

Long-run fiscal effect Δ �� �� � or �

IS story � �� �� �

LM story � �� � �

Debt-deflation (with � � 0

and stable and � 0 so

that � � 0)

� �� �� � � (or � �� � �)

Table 1. Possible linkages between primary deficits, interest rates and GDP

We concentrate on joint conjunctural dynamics of δ, �, and Δ. A tractable approach is to assume that

the deficit/output ratio δ shows “reversion to mean” but is affected by the growth rate and fiscal policy,

�� � ������, �� � � (4)

where �� is a function of economic growth � with ∂δ" ∂g⁄ � δ%& � 0 as a reflection of the inherent

counter-cyclicality of the fiscal deficit, and of the shift factor � which stands for fiscal activism.

Similarly suppose for the law of motion of � that

�� � '��, �, �� (5)

The sign of ∂g� ∂⁄ δ can be either positive (generally Keynesian worldview) or negative (following

Schäuble and his chief Angela Merkel). Presumably ∂g� ∂⁄ g � 0 (growth is self-stabilizing) and (�� (⁄ � �0. Taken together, equations (4), (5) and (1) represent a system of three differential equations with the

following Jacobian matrix:

Page 8: Fiscal Deficits, Economic Growth, and Government … Fiscal Deficits, Economic Growth, and Government Debt in the USA ‡ Lance Taylor, Christian R. Proaño, Laura de Carvalho, and

8

)* )+ ),

)*� �� ���% � 0 0

)+� - . 0 �/ 0

),� 1 �Δ � � �

The well-known Routh-Hurwitz local stability conditions for a three-dimensional system of

differential equations are Trace < 0, Determinant < 0, and Sum > -Determinant/-Trace, where Sum is the

sum of the three 2 x 2 determinants for the differential equations taken pairwise.

The determinant of the above Jacobian matrix is Det � 4αb � aαδ%& 8�j � g�. It is straightforward

to show that if j � �, then even if � and � are self-stabilizing and a � 0 the determinant will be positive

and the system will be unstable. The Sum condition may be violated as well.1

We can analyze the dynamics of (2) and (3) in the (�, �) plane shown in Figure 1. Along the

horizontal axis, � will usually take positive values with primary surpluses (or � � 0) being sporadic or

non-existent in most countries (Brazil is a notable exception in recent decades.) The locus of points or

nullcline along which �� � 0 will have a negative slope – faster growth is associated with a lower deficit

in steady state.

One can postulate a hump or concave shape for the �� � 0 nullcline. Presumably, if growth is

slow then increasing the primary deficit from a low (possibly negative) value should stimulate the

economy from the demand side, as well as allowing higher public investment with private sector

crowding-in, etc. The usual orthodox arguments suggest that (especially) if the primary deficit is “too

high,” then reducing it should increase growth.

The outcome for the conjuncture is something like Figure 1. In the “Keynes” situation toward

the left, raising � and thereby δ" will generate faster long-term growth at the point where the nullclines

cross with a higher long-term ratio of debt to output. “Merkel” presumably thinks the opposite, i.e. γ

and �� should be reduced to increase � and decrease Δ.

Page 9: Fiscal Deficits, Economic Growth, and Government … Fiscal Deficits, Economic Growth, and Government Debt in the USA ‡ Lance Taylor, Christian R. Proaño, Laura de Carvalho, and

9

In more formal terms the comparative static behavior of the 2 x 2 dynamical system for δ and g

around a steady state is summarized in the equations

;�� ���<- �/= ;��

��= � >�?0 @

in which - can take either sign and ? � �(��/(� is a policy-determined shift in the target ratio of the

deficit to output. Solving the system shows that with a positive determinant (that is, a very strong

destabilizing Merkel effect with - A 0 does not apply), an increase in B will raise δ in steady state. The

growth rate will increase if a is positive (the Keynes case in Figure 1) and decrease otherwise (Merkel).

Growth rate �

�� � 0 �� � 0

�� � 0 B A D C

Merkel

Keynes

Primary deficit/output δ

Figure 1: Conjunctural dynamics of the primary deficit and the growth rate.

In Figure 1, the dashed line represents the effect of a fiscal expansion in the Keynes case. From

an initial equilibrium at point A there would be counter-clockwise cyclical convergence toward a new

steady state at B. As will be seen below, such cycles show up in the data. The dynamics work differently

in the Merkel case. A reduction in the primary deficit from point C will give rise to monotonic – not

Page 10: Fiscal Deficits, Economic Growth, and Government … Fiscal Deficits, Economic Growth, and Government Debt in the USA ‡ Lance Taylor, Christian R. Proaño, Laura de Carvalho, and

10

cyclical – convergence to a new steady state at D. Besides the empirical evidence presented below, this

simple dynamic observation casts further doubt on the Merkel- Schäuble (or, in the UK, the Cameron-

Osborne) worldview because fiscal deficits regularly adjust counter-cyclically.

Space limitations preclude a full analysis of the three-dimensional system in the variables �, �

and Δ. But four conclusions can be verified easily.

In the “Merkel” case, a “permanent” reduction in fiscal stimulus γ will shift the steady state

debt/output ratio Δ downward. This effect is reversed in the “Keynes” case.

It is more interesting to consider the solvency condition � � � � � � � � with � as the

nominal interest rate and PD the inflation rate. Suppose that the growth rate is relatively low and the

nominal interest rate is close to zero so that � � � � � � . A reduction in g (perhaps to a level less

than zero) could also force price deflation with � 0. The implication is that the solvency criterion g � j could turn negative and destabilize the system. In a Keynesian situation the growth rate would steadily

fall and the deficit/output ratio increase without limit. We are back to Irving Fisher’s (1933) debt-

deflation scenario.

In a Merkel economy, the deficit hawks’ nightmare is a similar catastrophe that could play out if

aggressive inflation targeting of the nominal interest rate i in response to an increase in g (and

presumably makes g � �. The targeting could be courtesy of the central bank, or perhaps more likely

in the folklore, the vigilantes.

Finally, adjustment in the debt ratio Δ will be “slow” in comparison to � and �. The implication is

that shifts in Δ will affect the other variables in situations in which �� and �� are “close” to zero. In other

words we can trace the impacts of a changing debt ratio by observing how the nullclines in Figure 1 shift

in response. Through the various crowding-out arguments, presumably a higher Δ will reduce the

growth rate, shifting the �� � 0 nullcline downward. In the Keynes case, the outcome would be lower �,

higher �, and a higher steady state level of Δ itself.

Page 11: Fiscal Deficits, Economic Growth, and Government … Fiscal Deficits, Economic Growth, and Government Debt in the USA ‡ Lance Taylor, Christian R. Proaño, Laura de Carvalho, and

11

It is not obvious why the primary deficit should be affected by the level of debt. Perhaps on

political grounds austerity hysteria would create a negative effect of Δ on ��, making the nullcline shift to

the left. The outcomes in a Keynesian world would be lower � and a reduced level of �.

In sum, a higher debt ratio could slow growth with an ambiguous effect on the primary deficit.

The steady state debt ratio would probably rise, worsening the long run outcome. Active fiscal policy

could offset these shifts, but as of autumn 2011 such moves did not appear to be on the cards.

3. Fiscal trends and cycles in the United States: 1960-2010

In the United States fiscal decisions emerge from a political process involving the executive and

legislative branches of several levels of government – there is no decision center about fiscal policy per

se. The Federal government, the central player, collects only about two-thirds of total government

revenue, with state and local governments receiving the rest. The key difference between the levels is

that while the federal government can easily sell Treasury securities to finance its deficit, states and

localities largely have to cover current expenditures with current revenues. The Federal government

thereby plays the major role in determining overall fiscal trends and cycles.

3.1 Recent and historical patterns

The primary deficit of the federal government (current spending on goods and services minus

revenue) is the best single metric for fiscal policy, rising when real GDP declines and falling when GDP

increases. This countercyclical pattern helps stabilize the economy against shifts in private sector

demand. A larger primary deficit in a downswing is partly due to “automatic stabilizers” (such as lower

tax receipts and higher social spending) and partly the result of ad-hoc fiscal policy measures. As we

have seen, the change of net federal debt is the sum of the primary deficit and net interest payments (or

total net borrowing) of the federal government. In 2010 real debt was growing about 4% per quarter,

with the primary deficit providing around 3.5% of the increase.

Page 12: Fiscal Deficits, Economic Growth, and Government … Fiscal Deficits, Economic Growth, and Government Debt in the USA ‡ Lance Taylor, Christian R. Proaño, Laura de Carvalho, and

12

Figure 2. Primary Deficit and Net Interest Payments of the Federal Government as a share of GDP in

the United States (1960-2011).

Figure 2 shows the primary deficit and net Federal interest payments as shares of GDP. The

shaded areas signal recessions as dated by the National Bureau of Economic Research (NBER). In the

wake of the recession in the early 2000s the deficit rose by about 8%, and by about 10% after 2007 (it

fell by 1% after the third quarter of 2009). Net interest outlays are relatively stable and small (about

1.7% of GDP), so that the primary deficit and total government net borrowing move closely together.

As illustrated in Figure 3, in the early 1960s, the government debt to GDP ratio was around 50%.

It then fell to around 30% in the 1970s, and started to grow again in the 1980s, fell in the 1990s when

the government ran a primary surplus and interest rates declined, and shot up during the recent

recession as the primary deficit rose and GDP dropped.

Figure 3 also presents the history of annual real effective interest3 and growth rates. Prior to the

late 1970s the interest rate tended to lie below the growth rate. It spiked upward with the Federal

-0.06

-0.04

-0.02

0

0.02

0.04

0.06

0.08

0.1

0.12

19

60

-I

19

61

-IV

19

63

-III

19

65

-II

19

67

-I

19

68

-IV

19

70

-III

19

72

-II

19

74

-I

19

75

-IV

19

77

-III

19

79

-II

19

81

-I

19

82

-IV

19

84

-III

19

86

-II

19

88

-I

19

89

-IV

19

91

-III

19

93

-II

19

95

-I

19

96

-IV

19

98

-III

20

00

-II

20

02

-I

20

03

-IV

20

05

-III

20

07

-II

20

09

-I

20

10

-IV

Recessions Net Interest Payments (% of GDP)

Federal Gov Primary Deficit (% of GDP)

Page 13: Fiscal Deficits, Economic Growth, and Government … Fiscal Deficits, Economic Growth, and Government Debt in the USA ‡ Lance Taylor, Christian R. Proaño, Laura de Carvalho, and

Reserve’s anti-inflationary monetary shock, and

recession.

Figure 3. Federal Net Debt-to-GDP ratio, real GDP growth

moving averages) in the United States (1960

Figure 4. Peak-to

-10%

-5%

0%

5%

10%

15%

20%1960-I

1961-I

V

1963-I

II

1965-I

I

1967-I

1968-I

V

1970-I

II

1972-I

I

1974-I

Debt-to-GDP ratio (Right Axis)

Effective Real Interest Rate on Federal Debt

2001-I

2001-II

0.00%

0.50%

1.00%

1.50%

2.00%

2.50%

3.00%

3.50%

4.00%

-5.0% -4.0% -

Real GDP g

row

th (annualized m

ovin

g a

vera

ge)

tionary monetary shock, and drifted downward since then, falling abruptly during the

GDP ratio, real GDP growth, and real effective interest rate (annualized

States (1960-2011)

to-peak fiscal counter-clockwise cycle (2001-2007)

1974-I

1975-I

V

1977-I

II

1979-I

I

1981-I

1982-I

V

1984-I

II

1986-I

I

1988-I

1989-I

V

1991-I

II

1993-I

I

1995-I

1996-I

V

1998-I

II

2000-I

I

2002-I

2003-I

V

2005-I

II

2007-I

I

2009-I

GDP ratio (Right Axis) Recessions

Effective Real Interest Rate on Federal Debt Real GDP Growth

II

2001-III

2001-IV 2002-I

2002-IV

2003-III

2003-IV

2004-I

2004-IV 2005-I

2005-IV

2006-IV

2007-I

2007-IV

-3.0% -2.0% -1.0% 0.0% 1.0% 2.0% 3.0%

Primary Deficit as a share of GDP

13

drifted downward since then, falling abruptly during the

`

and real effective interest rate (annualized

0.0%

10.0%

20.0%

30.0%

40.0%

50.0%

60.0%

70.0%

80.0%

2009-I

III

3.0% 4.0%

Page 14: Fiscal Deficits, Economic Growth, and Government … Fiscal Deficits, Economic Growth, and Government Debt in the USA ‡ Lance Taylor, Christian R. Proaño, Laura de Carvalho, and

14

Figure 4 illustrates the counter-clockwise cycle modeled in Figure 1 between the fiscal deficit

and growth, for the period 2001-07.

Figure 5 summarizes background data on primary spending and revenue of the Federal

Government in the USA. Since the 1980s both variables have varied in the range of 16% to 21% of GDP.

Except for a short period in the mid 1990s when Federal receipts reached 21% of GDP, confirming the

observation in Figure 2, there has been an overall primary deficit, the normal situation in developed

economies.

Figure 5. Primary Revenues and expenditures of the Federal government as a share of GDP in the

United States (1960-2011).

3.2 The asymmetric Great Recession

Figure 6 shows “net borrowing” or deficit finance as practiced by the overall government and

private sectors, with the shaded areas again representing periods of recession as defined by the NBER. A

positive level of net borrowing by a sector signals that it is adding to the level of aggregate demand.

0.1

0.15

0.2

0.25

0.3

1960-I

1961-I

II

1963-I

1964-I

II

1966-I

1967-I

II

1969-I

1970-I

II

1972-I

1973-I

II

1975-I

1976-I

II

1978-I

1979-I

II

1981-I

1982-I

II

1984-I

1985-I

II

1987-I

1988-I

II

1990-I

1991-I

II

1993-I

1994-I

II

1996-I

1997-I

II

1999-I

2000-I

II

2002-I

2003-I

II

2005-I

2006-I

II

2008-I

2009-I

II

2011-I

Recessions Federal Primary Spending (% of GDP)

Federal Primary Revenue (% of GDP)

Page 15: Fiscal Deficits, Economic Growth, and Government … Fiscal Deficits, Economic Growth, and Government Debt in the USA ‡ Lance Taylor, Christian R. Proaño, Laura de Carvalho, and

15

Private net borrowing (or spending on investment, consumption, interest, and taxes minus income)

typically rises as the economy emerges from a recession while government net borrowing falls.

Figure 6. Government and private net borrowing as a share of GDP in the United States (1960-2011).

Private borrowing usually peaks soon before a new recession, when government borrowing

starts to rise. Government revenue declines and spending rises during and after recessions due to the

functioning of automatic stabilizers, which leads the overall fiscal deficit to have the counter-cyclical

pattern described above. In effect, changes in the government deficit stabilize the system against

fluctuations in private borrowing. Historically, private net borrowing has led the cycle, with government

borrowing lagging behind.

These observations are well known3. The recent period, however, differs from the historical

pattern in a crucial dimension. In previous recessionary periods swings in net borrowing by the

government and private sectors have been by and large symmetric. But during the 2007-2009 crisis the

-0.12

-0.07

-0.02

0.03

0.08

0.13

1947-I

1948-I

V

1950-I

II

1952-I

I

1954-I

1955-I

V

1957-I

II

1959-I

I

1961-I

1962-I

V

1964-I

II

1966-I

I

1968-I

1969-I

V

1971-I

II

1973-I

I

1975-I

1976-I

V

1978-I

II

1980-I

I

1982-I

1983-I

V

1985-I

II

1987-I

I

1989-I

1990-I

V

1992-I

II

1994-I

I

1996-I

1997-I

V

1999-I

II

2001-I

I

2003-I

2004-I

V

2006-I

II

2008-I

I

2010-I

Recessions Private Net Borrowing Government Net Borrowing

Page 16: Fiscal Deficits, Economic Growth, and Government … Fiscal Deficits, Economic Growth, and Government Debt in the USA ‡ Lance Taylor, Christian R. Proaño, Laura de Carvalho, and

16

reduction in net private borrowing was not matched by the increase in net government borrowing.

Indeed, Figure 6 shows that the (roughly) 8% increase in government net borrowing as a share of GDP

did not offset a fall of about 12% in private spending minus income.

Figure 7. General government real revenues and expenditures as compared to private domestic

components of effective demand (2007Q3=100)

Large decreases in the different components of private spending as compared to the evolution

of real government revenues and expenditures can be seen in Figure 7. Both diagrams suggest that the

government did not offset the decrease in private sector effective demand, as it had in prior recessions

(as can be observed from the nearly offsetting movements of the solid and dashed curves in Figure 6).

Figure 7 also shows that household residential investment, which has historically led previous upswings

in GDP, did not recover. The recovery of business investment was also on the weak side. Consumption is

thus the only component of private spending that reached again its prior real value of the second

quarter of 2007. Small wonder that government receipts also recovered slowly.

40

50

60

70

80

90

100

110

120

2007-III 2008-I 2008-III 2009-I 2009-III 2010-I 2010-III 2011-I

Business Investment Personal Consumption Residential Investment

Government Revenue Government Expenditure

Page 17: Fiscal Deficits, Economic Growth, and Government … Fiscal Deficits, Economic Growth, and Government Debt in the USA ‡ Lance Taylor, Christian R. Proaño, Laura de Carvalho, and

17

4 Econometric analysis

Using quarterly data from the Bureau of Economic Analysis (BEA) from 1961 to 2011 (first

quarter), we studied relationships among the core variables discussed in Section 2 – GDP, federal net

debt, primary deficit, primary revenues, primary spending, and the effective interest rate. All variables

were deflated using the GDP deflator. With the exception of the primary deficit and the real effective

interest rate, which can assume both positive and negative values, all variables were used in their

logarithmic form in the models.

4.1 Methodology and results

The presence of unit roots was tested for all variables using the augmented Dickey-Fuller (ADF)

test. There was evidence of a unit root in all series, indicating that they were all non-stationary in levels

and stationary in first differences. These results supported the use of a VAR model in first differences or,

in case of cointegration, of a Vector Error Correction (VEC) in levels for the study of the short- and long-

run relationships outlined in Table 1. In order to determine how many lags to use in the regressions,

several selection criteria were used, namely the Akaike information criterion (AIC) and the Schwartz

Bayesian information criterion.4

We estimated three models with differing characteristics. The first is a 2-dimensional VEC

directly relating federal net debt (lnDebt) to real GDP (lnGDP), with the real effective interest rate as an

exogenous variable in order to control for its possible effect on the two variables of interest. This model

therefore examines the long-run relationship of cointegration between debt and GDP, while providing

estimates of the short-run interactions between real debt growth and real GDP growth in its two

directions of causality. The same model is then estimated adding an NBER recession dummy (taking

value 1 during recession periods and 0 otherwise) as a control variable, which allows us to identify the

influence of the business cycle on the resulting dynamics. The importance of timing for the effectiveness

Page 18: Fiscal Deficits, Economic Growth, and Government … Fiscal Deficits, Economic Growth, and Government Debt in the USA ‡ Lance Taylor, Christian R. Proaño, Laura de Carvalho, and

18

of fiscal policy shocks on economic activity has been emphasized in recent econometric studies, e.g.

Mittnik and Semmler (2010), Fazzari et al. (2011), and Baum and Koester (2011).

Motivated by the results of this first model (to be discussed in detail below), a three-

dimensional VAR further examines the short-run relationships in Table 1 by distinguishing the two

components of real debt growth that enter into fiscal accounting: the interaction between the first

differences of the real primary deficit (DPriDef), the real effective interest rate (DIntRate) and real GDP

growth (DlnGDP).

Finally, we further break down the primary deficit in its revenue (DlnRev) and spending

(DlnSpend) components in a four-dimensional VAR, therefore allowing for a more precise study of

spending and tax multipliers and their cyclicality.5

4.2 Effects on the fiscal position of economic growth

As already observed in Figures 2, 5 and 6, the shares in GDP of both total government net

borrowing and the federal primary deficit rise during recessions (when GDP growth slows down),

highlighting the counter-cyclical role of fiscal policy. This effect is made clear in all the three models

estimated (regression coefficients and statistics are shown in the Appendix). The impulse response

functions in Figure 8 suggest that after controlling for the impact of interest rates, a 1% contraction in

quarterly real GDP would increase real debt by about 0.7% after one year, which based on 2011 levels

would lead to an increase of at least 5% in the debt-to-GDP ratio of the Federal government

(equivalently, if real GDP grows one percent, real debt would contract 0.7% in a year).

This result is broadly consistent with the findings of Reinhardt and Rogoff (2010) associating

high debt-to-GDP ratios with low real GDP growth rates, except that causality runs the other way: high

debt-to-GDP ratios are a consequence, and not the cause, of low growth.

Page 19: Fiscal Deficits, Economic Growth, and Government … Fiscal Deficits, Economic Growth, and Government Debt in the USA ‡ Lance Taylor, Christian R. Proaño, Laura de Carvalho, and

19

Figure 8. Impulse response to one standard deviation innovations in a two-dimensional VEC

The strong counter-cyclicality of the fiscal position is also clear in the results of the three-

dimensional VAR, as represented by the impulse response function in Figure 9. If the growth rate of real

GDP jumps down by 0.25% in one quarter, the primary deficit would increase by around 1.5% of GDP

after 3 years. According to these estimates, the decrease in real GDP growth of 0.5% between the last

quarter of 2008 and the first quarter of 2009 alone would have left the primary deficit at least 2% higher

as a share of GDP by the end of 2010. These numbers are broadly consistent with data presented in

Figure 5 prior to the Great Recession.

These results also imply that given the value of the primary deficit in the first quarter of 2011-I

of 8.3% of GDP, a further drop of 1% in the annual GDP growth (initially from 2.7% to 1.7%, but leading

to lower rates for many quarters) would make the primary deficit as a share of GDP jump to almost 10%

in 2012.

Conversely, a return to growth can substantially improve the fiscal position of the government.

An increase of 1% in the annual growth rate of GDP (say, from the current rate of 2.7% to 3.7% next

year) would reduce the primary deficit from 8.3% of GDP to 6.8% in one year.

-.0012

-.0008

-.0004

.0000

.0004

.0008

.0012

.0016

.0020

.0024

.0028

2 4 6 8 10 12 14 16 18 20 22 24 26 28 30

Without control for recessionWith control for recession

Response of lnGDP to lnDebt

-.05

-.04

-.03

-.02

-.01

.00

2 4 6 8 10 12 14 16 18 20 22 24 26 28 30

Without control for recession

With control for recession

Response of lnDebt to lnGDP

Page 20: Fiscal Deficits, Economic Growth, and Government … Fiscal Deficits, Economic Growth, and Government Debt in the USA ‡ Lance Taylor, Christian R. Proaño, Laura de Carvalho, and

20

Figure 9. Accumulated impulse responses to one standard deviation innovations in a three-

dimensional VAR

Estimates of the four-dimensional VAR as represented in Figure 10 show that the previous results are

mainly driven by the response of federal revenues to the state of the economy. A decrease of 0.25% in

quarterly real GDP growth in the last quarter of 2007 would have reduced the share of primary revenues

in GDP by around 1.1% in 5 quarters, from 18.7 to 16.6% of GDP in the first quarter of 2009.6

4.3 The reaction of economic growth to fiscal policy (and bond vigilantes)

As shown in Figure 8, the VEC indicates that there is a significant positive impact of an increase

in federal debt on real GDP, providing evidence against expansionary austerity. After controlling for the

-.02

.00

.02

.04

.06

5 10 15 20 25 30

Accumulated Response of DLNGDP to DPRIDEF

-.02

.00

.02

.04

.06

5 10 15 20 25 30

Accumulated Response of DLNGDP to DINTRATE

-30

-20

-10

0

10

20

30

5 10 15 20 25 30

Accumulated Response of DPRIDEF to DLNGDP

-30

-20

-10

0

10

20

30

5 10 15 20 25 30

Accumulated Response of DPRIDEF to DINTRATE

-.005

.000

.005

.010

.015

5 10 15 20 25 30

Accumulated Response of DINTRATE to DLNGDP

-.005

.000

.005

.010

.015

5 10 15 20 25 30

Accumulated Response of DINTRATE to DPRIDEF

Page 21: Fiscal Deficits, Economic Growth, and Government … Fiscal Deficits, Economic Growth, and Government Debt in the USA ‡ Lance Taylor, Christian R. Proaño, Laura de Carvalho, and

21

impact of interest rates, an increase in real debt of 5% would lead to a 0.6% growth of real GDP after

one year. Figure 8 also highlights the importance of the state of the economy for the impact of an

increase in debt on economic activity -- the response of lnGDP to lnDebt is significantly smaller when

recessionary periods are controlled for. In other words, the response of GDP to an increase in public

debt is likely to be substantially larger during a recession than in expansionary periods. Conversely, the

results indicate that the implementation of a debt consolidation plan may affect the economy more

negatively during a recession.

Figure 10. Accumulated impulse responses to one standard deviation innovations in a four-

dimensional VAR

-.02

.00

.02

.04

.06

5 10 15 20 25 30

Accumulated Response of DLNGDP to DLNSPEND

-.02

.00

.02

.04

.06

5 10 15 20 25 30

Accumulated Response of DLNGDP to DLNREV

-.02

.00

.02

.04

.06

5 10 15 20 25 30

Accumulated Response of DLNGDP to DINTRATE

-.02

.00

.02

.04

.06

5 10 15 20 25 30

Accumulated Response of DLNSPEND to DLNGDP

-.02

.00

.02

.04

.06

5 10 15 20 25 30

Accumulated Response of DLNSPEND to DLNREV

-.02

.00

.02

.04

.06

5 10 15 20 25 30

Accumulated Response of DLNSPEND to DINTRATE

-.02

.00

.02

.04

.06

.08

5 10 15 20 25 30

Accumulated Response of DLNREV to DLNGDP

-.02

.00

.02

.04

.06

.08

5 10 15 20 25 30

Accumulated Response of DLNREV to DLNSPEND

-.02

.00

.02

.04

.06

.08

5 10 15 20 25 30

Accumulated Response of DLNREV to DINTRATE

-.005

.000

.005

.010

.015

5 10 15 20 25 30

Accumulated Response of DINTRATE to DLNGDP

-.005

.000

.005

.010

.015

5 10 15 20 25 30

Accumulated Response of DINTRATE to DLNSPEND

-.005

.000

.005

.010

.015

5 10 15 20 25 30

Accumulated Response of DINTRATE to DLNREV

Page 22: Fiscal Deficits, Economic Growth, and Government … Fiscal Deficits, Economic Growth, and Government Debt in the USA ‡ Lance Taylor, Christian R. Proaño, Laura de Carvalho, and

22

Results from the three-dimensional VAR imply that this response is even stronger if the increase

in real debt growth fully comes from an increase in the primary deficit: a one time jump of about 0.5% in

the share of the primary deficit to GDP would raise the rate of quarterly real GDP growth for more than

four years by around 0.1% per quarter (or 0.4% annualized), with the maximum increase being 0.15%

after 5 quarters.

Conversely, a decrease in the share of the primary deficit to GDP from its early 2011 level of

8.3% to, say, 5% by the introduction of a sharp austerity program could reduce the growth rate of GDP

by around 2.5% per year for a few years ahead.

Figure 10 shows a positive response of real GDP growth to an increase in spending which

persists for more than 20 quarters, with the highest impact being after one year. A one-time shock in

the quarterly growth rate of primary spending of 0.5% would generate an increase of 0.2% in annual real

GDP growth in the first year (equivalently, a cut of 0.25% in quarterly spending growth, say from 0.4% –

as in the third quarter of 2010-III to 0.15% would reduce the annual rate of real GDP growth by up to

0.1% for a few years)

A negative response of real GDP growth to increases in revenue can also be observed in Figure

10, but the impact seems to be smaller than the one observed for changes in spending. An exogenous

increase in the growth rate of primary revenues of 0.5% would reduce the annual growth rate of GDP by

much less than 0.05% in the first two years.

Finally, the response of real GDP growth to changes in the real effective interest rate on federal

debt is ambiguous and not persistent, as observed in Figures 9 and 10. The same applies to the response

of the interest rate to changes in the primary deficit and its components. The implication is that in the

historical record as captured by the VAR models, bond vigilantes have not ridden in when the U.S.

federal primary deficit has gone up.

Page 23: Fiscal Deficits, Economic Growth, and Government … Fiscal Deficits, Economic Growth, and Government Debt in the USA ‡ Lance Taylor, Christian R. Proaño, Laura de Carvalho, and

23

5 Implications for the policy debate

The bottom line as of autumn 2011 was that the Treasury View dominated policy discourse (in

extreme form in the USA thanks to the Tea Party and its allies) even though the results just reviewed

show that in order to achieve a situation with a low fiscal deficit and high economic growth, the federal

government should focus on further stimulating economic activity through fiscal policy. One way to do

this is to increase public spending, which would accelerate growth, and subsequently increase revenues.

However, this course of action appeared to be blocked by political aversion to raising the primary deficit

from its already high level, even if the bigger gap would just be temporary.

Given this constraint, another alternative is to follow an old but still useful result of Keynesian

macroeconomics (Haavelmo 1945): a balanced increase in taxes and spending, with the gain in

government revenues coming mostly from the rich and the increase in spending going mostly toward

the middle class and poor, in the form of income transfers and public investment with large multiplier

effects on employment. Since the propensity to spend of the wealthy is smaller than the propensity to

spend of those receiving the increase in spending, the net effect of a balanced increase in taxes and

spending would be expansionary for income. This course of action might even reduce the primary

deficit in the short run because of the impact of faster growth on government revenues.

Unfortunately, mainstream economic thought in the USA appeared to be too ideological to

recognize straightforward answers from economic history and, more importantly, the political climate

may have become too polarized to implement even a fiscally neutral stimulus.

Page 24: Fiscal Deficits, Economic Growth, and Government … Fiscal Deficits, Economic Growth, and Government Debt in the USA ‡ Lance Taylor, Christian R. Proaño, Laura de Carvalho, and

24

Bibliography

Alesina, A. and Ardagna, S. 2010. Large Changes in fiscal policy: taxes versus spending,Tax Policy and the Economy, 24, 35– 68.

Barbosa-Filho, N., Rada, C., Taylor, L. and Zamparelli, L. 2008. Cycles and trends in U.S. net borrowing

flows, Journal of Post Keynesian Economics, vol. 30, no. 4, 623-648.

Baum, A. and Koester, G. 2011. The impact of fiscal policy on economic activity over the business cycle –

evidence from a threshold VAR analysis, Deutsche Bundesbank Discussion Paper Series 1: Economic

Studies, no. 3.

Buiter, W. 2010. Sovereign debt problems in advanced industrial countries, Global Economics View,

Citigroup, April 26.

Domar, E. 1944. The “burden of debt”and the national income, American Economic Review, vol. 34, no.

4, 798-827.

Fazzari, S., Morley, J. and Panovska, I. 2011. Fiscal Policy Asymmetries: A Threshold Vector

Autoregression Approach, mimeo, available at http://artsci.wustl.edu/~gradconf/Papers%202010/Papers%202010/panovska.pdf.

Fisher, I. 1933. The debt-deflation theory of Great Depressions, Econometrica, vol. 1, no. 4, 337-357.

Granger, C. 1969. Investigating Causal Relations by Econometric Models and Cross-spectral Methods,

Econometrica, vol. 37, no. 3, 424-438.

Haavelmo, T. 1945. Multiplier Effects of a Balanced Budget, Econometrica, vol.13, no.4, 311-318.

International Monetary Fund (IMF). 2010. Will it hurt? Macroeconomic effects of fiscal consolidation,

World Economic Outlook October 2010: Recovery, risk and rebalancing, 93-124.

Irons, J. and Bivens, J. 2010. Government debt and economic growth, Economic Policy Institute Briefing

Paper, no. 271, 1-9.

Page 25: Fiscal Deficits, Economic Growth, and Government … Fiscal Deficits, Economic Growth, and Government Debt in the USA ‡ Lance Taylor, Christian R. Proaño, Laura de Carvalho, and

25

Jayadev, A. and Konczal, M. 2010. The Boom Not The Slump: The Right Time For Austerity, The Roosevelt

Institute. Available at: http://www.rooseveltinstitute.org/sites/all/files/not_the_time_for_austerity.pdf

Mittnik, S. and Semmler, W. 2010. Regime dependence of the fiscal multiplier, SCEPA Working Paper, no. 8.

Reinhart, C. and Rogoff, K. 2010. Growth in a Time of Debt, American Economic Review, vol. 100, no. 2,

573-78.

SCHÄUBLE, W. 2010. Maligned Germany is right to cut spending, Financial Times, June 24. Available at:

http://www.ft.com/cms/s/0/216daeba-7f0c-11df-84a3-00144feabdc0.html#axzz16XzY0fWx

Page 26: Fiscal Deficits, Economic Growth, and Government … Fiscal Deficits, Economic Growth, and Government Debt in the USA ‡ Lance Taylor, Christian R. Proaño, Laura de Carvalho, and

26

Notes

1 The simplifying assumption for equation (1) is that short-term decisions are taken without paying attention to the

debt ratio. As discussed below, one could bring in such effects by including a non-zero value in the second row of

the third column in the Jacobian matrix, and seeing if that shifts the nature of a steady state.

2 The real effective interest rate in the diagram is real interest payments divided by the real level of debt lagged

one quarter minus the quarterly inflation rate, annualized. It closely tracks real 10-year returns given by the Fed.

3 See Barbosa-Filho et al (2008) for an empirical study of the cycles and trends in US net borrowing flows.

4 Results are available from the authors upon request.

5

Because the VAR models discussed here were estimated using the (stationary) first differences of the

macroeconomic variables previously mentioned, the following results have a clear short-term focus. However,

estimates of analogous vector-error-correction (VEC) models (which are able to capture long-term relationships)

delivered comparable results.

6 These simulations were based on the impulse response functions given the initial values of the variables in the

period in question.