This is a rock-solid piece that summarizes the current situation well (imo of course. : ))
http://economix.blogs.nytimes.com/2012/06/01/confusion-about-the-deficit/?partner=rss&emc=rss
June 1, 2012, 6:00 am
Confusion About the Deficit
By LAURA DâANDREA TYSON
Is a decrease in the federal budget deficit good or bad for jobs and growth in the American economy? This deceptively simple question confuses thousands of students who enroll in introductory economics every year, and it will undoubtedly confuse millions of voters this year.
Based on misleading political rhetoric â a naïve assumption that government budgets are like individual or family budgets (and poorly taught economics courses) â most voters believe that a large government deficit is necessarily bad for the economy.
Following this logic, the large spending cuts and tax increases scheduled to occur in January 2013 should be good for the economy because they would sharply reduce the deficit.
But the Congressional Budget Office has just issued a sober warning that these measures, which would reduce the fiscal deficit by about 5 percent of gross domestic product between 2012 and 2013, are likely to throw the economy back into recession.
Even Mitt Romney, who is attacking President Obama for fiscal profligacy and has pledged to balance the budget if he is elected, has acknowledged that slashing more than a trillion dollars from the deficit next year would bring on another recession.
But if a significant decrease in the deficit would be bad for the economy, does that mean an increase in the deficit would be good for the economy?
At the heart of the confusion lies the fact that there is no one answer. No wonder students and voters are confused. The effects of an increase or a decrease in the deficit depend on the economyâs specific conditions. Under current conditions, an increase in the budget deficit would be better for the economy than the decrease scheduled to take effect next year.
Hereâs why.
By itself an increase in the deficit, either in the form of an increase in government spending or a reduction in taxes, causes an increase in demand. But how this affects output, employment and growth depends on what happens to interest rates.
When the economy is operating near capacity, government borrowing to finance an increase in the deficit causes interest rates to rise. Higher interest rates reduce or âcrowd outâ private investment, and this reduces growth.
The âcrowding outâ argument explains why large and sustained government deficits take a toll on growth; they reduce capital formation. But this argument rests on how government deficits affect interest rates, and the relationship between government deficits and interest rates varies.
When there is considerable excess capacity, an increase in government borrowing to finance an increase in the deficit does not lead to higher interest rates and does not crowd out private investment. Instead, the higher demand resulting from the increase in the deficit bolsters employment and output directly, and the resulting increase in income and economic activity in turn encourages or âcrowds inâ additional private spending.
The crowding-in argument is the right one for current economic conditions. The economy is operating far below capacity, as evidenced by the high unemployment rate and the considerable gap between the actual and potential levels of output.
Nominal short-term interest rates are near zero, and the Federal Reserve is committed to keeping them there for the foreseeable future in an effort to strengthen private spending.
The yield on the 10-year Treasury, the best measure of the cost of borrowing for the federal government, has fallen below 2 percent (to a historic low of 1.6 percent this week as a result of concerns over the future of the euro), despite the fact that the deficit is about 8.5 percent of gross domestic product. In 2007, before the onset of the Great Recession, when the deficit was only 1.2 percent of G.D.P., the 10-year Treasury offered a yield of 4.6 percent.
The remarkable combination of surging deficits and falling borrowing rates for the federal government indicates that the American economy is slowly recovering from a balance-sheet recession.
In the wake of the real estate bubble and ensuing financial crisis, the private sector has curtailed spending to reduce debt and rebuild assets. The result has been a significant and sustained contraction in private demand, reflected in a sharp and unprecedented swing in the gap between private saving and investment from an average deficit (investment exceeding saving) of $267 billion in 2005-7 to an average surplus of $789 billion in 2008-11.
This implies a large drop in private demand of about 7.4 percent relative to G.D.P. in 2008, when the recession took hold.
As part of deleveraging, the private sector has also increased its demand for safe financial assets and has been willing to pay a premium for them. In terms of liquidity, risk and returns, Treasury bills and bonds are the closest thing to cash. They can be used as collateral to secure lending and as a convenient place to store savings without much costly due diligence.
In the wake of increasing doubts about the viability of the euro, foreign investors, including central banks, have also been stashing larger shares of their balances in United States Treasury debt, driving its yields down further.
Indeed, the demand for such debt is so strong that the Treasury is exploring how to let investors enter negative yields when bidding at its auctions. Despite fear-mongering by deficit hawks, there is no evidence of bond-market vigilantes poised to flee United States government debt because of concerns about the governmentâs creditworthiness.
Instead, investors are becoming more anxious that political stalemate will drive the United States off a fiscal cliff and into recession at year-end.
Under prevailing economic conditions, there is a strong case for expansionary fiscal policy, even at the expense of an increase in the deficit. Additional fiscal support would increase output and employment now.
It would also increase output and employment in the future because stronger demand now would encourage more private investment and stem the loss of skills and productivity associated with long-term unemployment and declining labor-force participation.
Indeed, the longer the current output level remains below the economyâs potential, the larger the loss of potential output in the future.
The question that needs to be asked is whether the future gains in potential output and growth that would result from expansionary fiscal policy today would outweigh any future losses of output and growth caused by the repayment of the governmentâs additional debt.
Under current conditions, with a significant gap between actual and potential output, a high rate of long-term unemployment and a real government borrowing rate at zero or lower, the answer to this question is almost certainly yes.
Indeed, Lawrence H. Summers and J. Bradford DeLong assert in a recent paper that under these conditions, expansionary fiscal policy is likely to be self-financing â the future gains in potential output are likely to offset the policyâs cost.
The self-financing hypothesis is particularly compelling for expansionary fiscal policies targeted at investment.
The government can currently borrow funds and repay less than it borrows in constant dollars. Many job-creating public investment projects in education, research and infrastructure would earn much higher rates of return in terms of future growth. The government could also borrow to finance new loan-guarantee programs and tax incentives to leverage private investment in these areas.
Congress should adopt a multiyear plan that begins to reduce the long-run deficit gradually when the economy has recovered and when borrowing by the federal government begins to crowd out private spending.
For now, however, insufficient private spending rather than excessive government borrowing is what is impeding job creation, discouraging investment and eroding skills. Under these conditions, additional growth-enhancing fiscal measures to âcrowd inâ private spending are warranted.
http://economix.blogs.nytimes.com/2012/06/01/confusion-about-the-deficit/?partner=rss&emc=rss
