In this week of financial market turmoil, there was a notable bit of good news: the US federal budget deficit shrank to 2.8 percent of GDP, its lowest level since 2007. The numbers mark a striking drop, from $1.4 trillion in 2009 to $483.4 billion in the fiscal year that concluded last month. The improvement was the result of a number of factors – economic growth, tax hikes, and spending restraint from the sequester foremost among them.
Herewith, three thoughts inspired by the welcome new numbers:
A debate has raged about whether a misguided devotion to austerity is a major cause of global economic malaise. (I wrote about this a couple months ago in the context of France, where austerity is much-blamed but little-practiced). In the United States, at the time of the budget sequester, there were cries that we were casting ourselves back into the economic abyss by tightening at the wrong time.
In fact, looking across the world, the two countries that seemed to adhere most closely (and publicly) to a policy of austerity have also enjoyed some of the fastest growth. In the World Economic Outlook released this month, the IMF opined: “Among advanced economies, the United States and the United Kingdom in particular are leaving the crisis behind and achieving decent growth.” US growth was 2.2 percent in 2013 while the U.K. came in at 1.7 percent.
The intellectual heft behind the austerity opponents comes from the work of Lord John Maynard Keynes. The idea was that a government could stabilize demand through its use of fiscal policy. It would run deficits in bad times and surpluses in good ones, thereby offsetting the spending of consumers and businesses and smoothing out economic cycles. This is not the place to debate the merits of a Keynesian approach (though it came under heavy attack over the years from some very prominent macroeconomists). Rather, the latest deficit numbers show how far we’ve strayed even from an orthodox Keynesian approach.
According to the National Bureau of Economic Research, which officially dates US business cycles, the most recent recession lasted from December 2007 to June 2009. That means we are in the 64th month of the post-recession expansion. The NBER reports that for the 11 business cycles since 1945, the average time period from trough to peak was 58.4 months.
Note that across this business cycle, the federal deficit hit its minimum of near one percent of GDP in 2007. It peaked near 10 percent of GDP in 2009. It has been shrinking since, but after a long, tepid expansion, we have only gotten the deficit just below 3 percent of GDP. The implication is that we are not following an orthodox Keynesian prescription – we’re fluctuating between smaller and bigger deficits, not between deficit and surplus.
3. Debt and Context
Past deficits stay with us and future deficits will be driven by big structural factors beyond business cycles (a point Megan McArdle makes very well). The past deficits accumulate into the federal debt. If our deficits in bad times were offset by surpluses in good, the size of the debt would stay fairly constant. Instead it has grown. From just over 60 percent of GDP in 2007, it is now a notch below 100 percent of GDP.
This has a couple important implications. First, should the United States encounter a cyclical downturn, there is much less “fiscal space” to pursue deficit-driven demand. Second, it makes the United States vulnerable to a return to normalcy in financial markets. In FY 2008, on the eve of the financial crisis, the United States paid about $454 billion in interest on the federal debt. For the latest fiscal year, FY 2014, those payments were $431 billion. How could this be, with the debt escalating so rapidly, both in levels and as a share of GDP?
The key is the extraordinary low interest rate environment. In November 2007, the US government paid an average interest rate of 4.9 percent on its interest-bearing debt. In September 2014, that number was 2.4 percent.
It is impossible to say just when interest rates will return to historical norms. Speaking this week at The Chicago Council, Martin Wolf emphasized just how exceptional the present period of low rates is. Unless one believes that this extraordinary period will persist indefinitely, though, there will come a time when rates pop back up. When that happens, the cost of servicing the large US debt will pop up as well, even if we maintain more positive numbers like the one that came in this week.