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FRBSF

WEEKLY LETTEA

January 15, 1988

Do Deficits Matter?
Congressional negotiators and the President
have recently reached agreement on a package
cifspending cuts and revenue increases that are
designed to reduce the federal budget deficit by
$30 billion this year and $46 billion next year.
Agreement was reached on November 20, the
same date on which the revised version of the
Gramm-Rudman-Hollings deficit reduction plan
mandated $23 billion in automatic spending
cuts to be split evenly between military and nonmilitary spending.
The recent action by the government to take
positive steps to reduce the budget deficit was
prompted by financial market developments
during October. The sharp drop in the stock
market that month - including a record oneday crash that took more than 500 points off the
Dow Jones Industrial Average - was interpreted
by many as a no confidence vote by financial
markets in the government's ability to address
the deficit problem.
Implicit in this interpretation is the notion that
financial market participants believe continued
high deficits would be detrimental to the economy. This belief is consistent with the view of
most economists that sustained budget deficits of
the size the u.s. government has been running
are undesirable.
However, an influential minority of economists
disagree with the proposition that federal budget
deficits matter that much for the economy.
Indeed, looking back over the past few years, it
might be difficult to identify the undesirable
effects said to be caused by budget deficits. Certainly, the general economic performance of the
u.s. economy over the last several years gives
few indications of serious problems. The unemployment rate dipped below 6 percent in September for the first time since December 1979;
the current economic expansion just became the
longest peacetime expansion on record; and
inflation has declined to alow level compared
to the prior decade.
The difficulty in choosing between these two
opposing views on the effects of budget deficits

is discussed in this Letter, as the evidence supporting each view is inconclusive.

Deficits do matter
Most economists probably share the view that
budget deficits do matter for the economy. They
matter in part because they affect real interest
rates (market interest rates corrected for
expected inflation). According to this view,
when the government switches from financing
its expenditures with current taxes to a policy of
debt financing, it must raise funds in the credit
markets. This increased demand for credit on the
part of the government will tend to put upward
pressure on real interest rates. In addition, the
reduction in current taxes increases disposable
income, leading to a rise in spending by the private sector. This increase in the aggregate
demand for goods and services results, in the
short-run, in a rise in production and real GNP.
The rise in real income and teal interest rates
acts through two major channels to affect the
private sector. First, as disposable income rises,
households will increase both their consumption
and their saving. The rise in savings implies an
increase in the supply of credit, and this works
to reduce (although not eliminate) the initial
excess demand for credit created by greater government borrowing. Second, the rise in real rates
of interest reduces private demands for credit as
government borrowing crowds out private
borrowing.
A higher real interest rate in the countryrunning
the budget deficit also leads to an appreciation
in the value of the country's currency and therefore to a rise In imports relative to exports. This
worsening of the trade balance increases the
supply of imported goods and helps to meet the
increased demand for goods and services
induced by the tax cut. In this process, the need
to finance the increase in net imports becomes
synonymous with the increase in overseas
borrowing.
By raising real interest rates, a shift to deficit
financing of government expenditures leaves the
economy with a lower stock of private capital

FRBSF
and, by increasing overseas borrowing, leaves
the economy with a greater foreign debt. The
economy must then divert resources in the
future to pay interest on the larger foreign debt.
Not all changes in the budget deficit would be
expected to affect real interest rates in this manner. For example, changes in both interest rates
andthebudget deficit might be caused by
movements in the level of economic activity. A
fall in income associated with a business cycle
downturn would lower tax revenues and lead to
a larger budget deficit while, at the same time,
the income decline might lower real interest
rates.
In this case, an increased budget deficit occurs
together with lower real interest rates, but the
deficit is not the cause of falling rates. Instead,
both the deficit and interest rates are responding
to the level of economic activity. Only changes
in the deficit not due to cyclical influences,
often measured by changes in the "high employment budget deficit", would be expected to
cause real rates to rise and to crowd out private
investment.
This simple story about the impact of deficit
spending on the economy has several implications that can. be used to test its accuracy. First,
an increase in the government's high employment deficit should be associated with a rise in
real rates of interest. Second, such deficits
should also be associated with an appreciation
of the currency. And third, they should be associated with a decline in net exports.

Evidence
The experience of the U.S. in the 1980s certainly seems consistent with the view that deficits matter. Realized real interest rates-market
interest rates minus the actual rate of inflation have been atvery high levels during the past
several yea.rs. The high levels may reflect the
sharp decline in.the rate of i.nflationduring the
198ds ifmarket rates incorporated expectations
of a continuation of the high inflation rates of
the. late 1970s.. However, most estimates indicate that market rates were quite high relative to
expected inflation aswell.
In addition, the rising deficits of the early 1980s
were associated with an appreciation of the dollar. The value of the dollar rose. by 37 percent

from January 1980 to its peak in February 1985.
Accompanying this appreciation was a shift from
a trade surplus for the u.s. in 1982 to record
trade deficits during the last three years.
A single episode like that in the 1980s, however,
is not sufficient to prove the case that budget
deficits are responsible for high real interest
rates, the dollar appreciation, and the trade deficit. Other factors, such as restrictive monetary
policy or changes in tax policy, could be
responsible. Blame could more convincingly be
placed on the budget deficits if earlier periods
with large high employment deficits also were
associated with high real rates, a strong dollar,
and a deterioration in the trade balance.
Unfortunately, the evidence from U.S. history is
far from clear. In fact, many researchers have
failed to find any association between budget
deficits, real interest rates, and the value of the
dollar in periods prior to the 1980s. The relevance of this evidence on earlier budget deficits
is open to question, however.
Most previous deficits in the u.s. were associated either with wartime expenditures or with
revenue declines during business cycle recessions. Wartime controls on the economy may
alter the relationship between deficits and real
interest rates that would normally occur in a
peacetime setting, whereas interest rate movements during a recession are not being caused
by the associated deficits and therefore cannot
provide evidence on the impact of a shift in the
cyclically adjusted deficit. In contrast to earlier
deficits, the current situation is characterized by
a large peacetime, high employment deficit.
The unusual behavior of the deficit in the 1980s
is illustrated quite clearly in the chart, which
shows the deficit as a fraction of GNP from 1950
to 1986. The recessions in 1975, 1980, and
1982 led to large increases in the deficit as
federal tax revenues declined during each business downturn. Unlike the experience following
the 1975 recession, the current deficit did not
decline significantly as a fraction of GNP during
the economic expansion following the 1982
recession. The decline during 1987 is usually
attributed to a one-time windfall gain in tax revenues resulting from the Tax Reform Act of
1986.
Because the deficit experience of the last few
years is so different from that of the previous
thirty, the current deficit may matter even
though earlier deficits did not.

Ratio of the Deficit to the GNP

.06
.05
.04
.03
.02
.01
.00 +--;~~+-'''d-=-''''''-L-''d--'-----------.0 1 +-----,------,------,-------,-----,--,---,---------,
1955

1960

1965

1970

1975

1980

1985

Deficits don't matter
Given the weak historical evidence on the
impact of deficits, some economists have argued
that the choice between financing government
expenditures by current taxes or by deficit
financing really does not matter. Proponents of
this view point out that there are theoretical
grounds for expecting deficits not to matter.
They argue that when a government borrows, it
is implicitly committing itself to raising taxes in
the future when the borrowing must be repaid:
Forward-looking households will realize that
any tax cut today must lead to tax increases in
the future. Households will simply save any tax
cut in order to have the greater wealth in the
future necessary to meet the higher expected
level of taxes. Since household savings rises to
the same extent as the government's credit needs
increase, there is no upward pressure on real
interest rates, and thus no effect on foreign
exchange rates or the trade balance.
Under this view, the recent high real interest
rates and the trade deficit must be due to factors
other than the shift from tax to deficit financing
of federal government expenditures. If this view
were correct, a shift to debt financing should be
associated with an increase in the private savings rate. Thus, the behavior of the savings rate
provides a means of testing this view.

Evidence

u.s.

The experience of the
during the last few
years seems strongly at odds with the view that
deficits don't matter. Instead of rising, the ratio
of net private savings to GNP has fallen from an

average level of just over 8 percent during
1971-1980 to 7.5 percent during 1981-1986. As
a result of the private sector's failure to increase
its saving, the sum of private saving and the
(dis)saving of the government sector - net
national savings - has declined from 7 percent
of GNP in the 1971-1980 period to just over 3
percent of GNP in 1981-1986.
However, the historical evidence on the relationship between saving and deficit financing is
mixed. In addition, the proponents of the view
that deficits don't matter are really referring to
the effects of a shift from tax to deficit financing
of a fixed level of government expenditures, and
total federal government expenditures as a fraction of GNP have risen during the Reagan
presidency.
High real interest rates and the trade deficit may
reflect the rise in government expenditures and
not the method by which they are financed. That
is, by purchasing more of total income, the government leaves less for private consumption and
investment. Real interest rates must then rise and
the dollar appreciate in order to crowd out private spending. This must occur no matter what
method is used to finance the increased government expenditures. Thus, the 1980s may not
constitute evidence that the method used to
finance expenditures matters.

Conclusions
Do deficits matter? Most economists would
probably view the high real rates, strong dollar,
and trade deficits of the early 1980s as evidence
of the direct effects of the federal budget deficit.
However, in periods prior to the 1980s,
researchers generally have failed to find any
strong relationship between deficit spending,
real interest rates, and trade deficits. The supporting evidence for the opposing view that deficits don't matter also is weak. A skeptic
therefore is unlikely to be swayed from his or
her view, whether that view is that deficits do
matter or that deficits do not matter.

Carl E. Walsh

Opinions expressed in this newsletter do not necessarily reflect the views of the management of the Federal Reserve Bank of San
Francisco, or of the Board of Governors of the Federal Reserve System.
Editorial comments may be addressed to the editor (Gregory Tong) or to the author .... Free copies of Federal Reserve publications
can be obtained from the Public Information Department, Federal Reserve Bank of San Francisco, P.O. Box 7702, San Francisco
94120. Phone (415) 974-2246.

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BANKING DATA-TWELFTH FEDERAL RESERVE DISTRICT
(Dollar amounts in millions)

Selected Assets and Liabilities
Large Commercial Banks
Loans, Leases and Investments1 2
Loans and Leases 1 6
Commercial and Industrial
Real estate
Loans to Individuals
Leases
U. S. Treasury and Agency Securities 2
Other Secu rities 2
Total Deposits
Demand Deposits
Demand Deposits Adjusted 3
Other Transaction Balances4
Total Non-Transaction Balances 6
Money Market Deposit
Accounts-Total
Time Deposits in Amounts of
$100,000 or more
Other Liabilities for Borrowed MoneyS

Two Week Averages
of Daily Figures

Amount
Outstanding
12/23/87
207,931
183,939
52,324
72,644
37,574
5,437
16,676
7,316
208,339
53,624
36,416
20,193
134,522

Change
from
12/16/87

Change from.12/24/86
Dollar
Percent?

-

-

162
123
570
49
387
11
61
22
1,398
1,206
290
71
121

-

2,775
5,914
2,503
5,325
4,627
155
3,316
179
5,364
5,968
3,673
1,110
506

43,471

-

677

-

31,838
19,405

314
1,812

-

-

-

Period ended
12/14/87

-

-

-

-

-

-

-

-

1.3
3.1
4.5
7.9
10.9
2.7
24.8
2.3
2.5
10.0
9.1
5.8
0.3

-

6.9

875
7,271

-

2.6

- 27.2

Period ended
11/30/87

Reserve Position, All Reporting Banks
Excess Reserves (+ )/Deficiency (-)
Borrowings
Net free reserves (+ )/Net borrowed( -)

114

105

4

9

110

96

Includes loss reserves, unearned income, excludes interbank loans
.Excludes trading account securities
3 Excludes U.S. government and depository institution deposits and cash items
4 ATS, NOW, Super NOW and savings accounts with telephone transfers
S Includes borrowing via FRB, TT&L notes, Fed Funds, RPs and other sources
6 Includes items not shown separately
7 Annualized percent change
1

2

-

3,227

-

-

-

-