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June 29, 1984
Deficitsvs.Investment
Early this year, the Congressional Budget
Office (CBO) expressed the view shared by
many analysts that federal budget deficits
would increase from about $185 billion in
1 984 to just under $245 billion by 1987 if
current tax and spending programs remain
unchanged. These deficits average just over
5.0 percent of GN P, according to the CBO,
or more than double their average share of
income in the 1970s. Proposals to save
between $150 billion and $180 billion over
the next three years are significant steps in
the right direction, but these savings would
still leave substantial deficits. For instance,
the Reagan-GOP compromise budget plan
to save about $150 billion would still leave a
deficit of $198 billion in 1987 -4.3 percent
of G N P according to the CBO.
Should we be concerned with the size of
these deficits? This Letter explores the economic effects of cyclical and structural deficits and evaluates the possible impact of
prospective deficits on new capital investment in the
u.s.
Cyclical andstructural deficits
Deficits that occur during recessionsoften
playa positive, supporting rolefortheeconamy. They represent increases in government transfers, such as unemployment
benefits, at a time when federal revenuesfall
more than income because of the progressive income tax structure. As a result, these
"cyclical" deficits help cushion the severity
of the recession by providing people, rather
than the government, with revenue.
Sizeable deficits that linger on as the economy recovers and operates close to full
employment may not have positive economic effects. Such "full employment" or
"structural" deficits that result from a basic
mismatch between tax revenues and spending are expected from 1984 through 1987. If
they occur, it will be at a time when private
credit demands for the nation's available
savings are growing. The result will be
increased competition for savings that puts
upward pressure on interest rates. In turn,
higher interest rates will discourage, or
"crowd out," private sector spending on
items especially sensitive to interest costs,
such as housing and business capital spending on plant and equipment.
.
There are, however, a number oHactors that
may dampen, although not completely
elimi nate, the interest rate and crowding out
effects of structural deficits. These include
possible supply-side benefits that boost
national output and additional savings from
abroad attracted by higher interest rates in
the U.s.
Supply-side effects
Federal tax and spending programs may
lead to an increase in the nation's productive
capacity and savings, and thereby provide
the additional income and savings needed
to finance large federal expenditures. Such
programs may include government investment in the nation's infrastructure (roads and
dams, for instance) and tax or other
incentives to increase the supply and productivity of our work force and private
capital investments.
In 1981, we began hearing claims of positive
supply-side effects for budget programs that
sought to increase incentives to work, save,
and invest by cutting tax rates. Until recently, the benefits of these programs have not
been discernible. Indeed, in the past recession, individual and business savings rates
fell substantially below values predicted by
past trends. The accelerated depreciation
allowances given businessesin the Economic Recovery and Tax Act of 1981 probably encouraged the pick-up in business
spending that began in mid-1 983, but,
according to business spending plans and
forecasts, they will not be sufficientto I ift the
nation's longer term growth rate much
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important characteristic of these savings is
their relative constancy. The net private
domestic savings rate has been a fairly
steady 7.2 percent of Gross National Product since the end of the Second World War.
above the average 3.0 percent rate of the
past 20 years. As yet, most economists do
not foresee any positive supply-side effects
large enough to generate sufficient revenues
to make much of a dent in prospective
federal deficits.
Any major increase in federal deficits as a
percent of G N P therefore is likely to lead to a
decline in net domestic investment as a
share 61
G N P unless there are compensating
increases in the two other sources of savings: state and local government budget surpluses and net foreign savings flows into the
U.S. Although these other savings have increased as a percent of G N P over the postwar period, they have not increased as much
as budget deficits. Consequently, during the
post-war period, the growing federal deficits
have meanta decline in net domestic investment in the U.S. measured as a share of GNP.
Net foreign savings
In addition to any impact on domestic savings, deficits may generate flows of foreign
savings into the U.S. Of course, some U.S.
savings are also moving abroad so it is net
foreign savi ngs, or investment flows, that are
pertinent. Deficits will be associated with a
positive net inflow of savings into the u.s.
when they raise interest rates here relative to
those abroad. The higher returns in the U.S.
attract foreign savings, which increase the
pool of savings available for domestic
investments and the budget deficit and, in
turn, ease interest rate pressures in the u.s.
The net savings inflow also tends to raise the
international value of the U.S. dollar and
thereby reduce the competitiveness of U.S.
exports and increase the attractiveness of
foreign imports. The result, and the other
side of the savings inflow, is a deterioration
in our foreign trade position.
Between the 1950s and the 1970s, the total
U.S. net savings rate increased by roughly
1.2 percentage points. Over the same thirtyyear period, federal budget deficits as a
share of G N P increased 1.9 percentage
points, from a small surplus of 0.1 percent of
G N P in the 1950s to deficits of 1.8 percent of
G N P in the 1970s. The difference of 0.7
percentage points between the increase in
the total net savings rate and federal deficits
represents both a savings shortfall and the
amount of decline in net domestic investment-from
6.9 percent of G N P in the
1 9S0s to 6.2 percent in the 1970s. This
period is widely associated with the slowdown in productive investment in the U.s.,
and both declines in productivity and in
longer term economic growth.
To the extent that there are net foreign savings coming into the U.S., private capital
spending need not be crowded out of U.S.
markets, but industries depending on exports and those that compete with imports
will bear the brunt of the burden of higher
federal budget deficits.
Sources and uses of savings
These remarks have emphasized the need to
evaluate the economic effects of budget deficits in terms of the amo'unt and type of
savings available to finance them. In this
regard, net savings (total savings less depreciation) is the important concept for it represents the amount of income available for
both government deficits and domestic investment after replaci ng the worn out capital
stock.
The prospective savings shortfall
What will happen to new capital spending
in the U.S. if federal deficits increase from
1 .8 percent of G N P in the 1970s to average
5.2 percent overthe 1984-1 987 period, as
estimated by the CB O under current tax and
spending programs? To maintain the same
rate of net investment spending as in the
1 970s, total net savings would have to increase by the same 3.4 percent of GN P as
the deficits.
The major sources of net savings in the U.S.
are individuals and business, and the most
2
Deficits vs. Investments
locreasoas
Percenl 01 GNP'
3.5
3.4%
-----\
3.0
0"' .... '"
Newlnveslmenl
0.7%
2.5
2.0
NelForelgn
Savings
2.0%
1.5
1.0
0.5
Federal
Deficits
Savings
• Avg. 1970s10 Avg. 1984-1987
The budget savings proposed byCongressionalleaders of about $150 billion would
reduce deficits as a percentage of G NP
about 0.6 percentage points during the
1 984-1 987 period. Accordingly, net domestic investment could absorb these funds and
average about 6.1 percent of GN P over that
time-almost equal to its 6·.2percent rate in
the 1970s.
.
The outlook for future savings is highly conjectural, and the forecasting task is all the
more difficult because the net private
domestic savings rate fell substantially
during the 1980s, in part because ofthe two
back-to-back recessions. If we assumethat
the net private domestic savings rate will
return fairly rapidly to its 7.2 percent postwar average rate over the next four years,
and add to that rate state and local government surpluses of 1.5 percent of GN P (their
1983 value which is likely to continue along
with the current economic expansion), the
combined savings rate would be 8.7 percent. This figure is only 0.7 percentage
points higher than its 8.0 percent average in
the 1970s, and a far cry from the necessary
3.4 percentage point increase.
Risksin the outlook
The risks to this scenario appearformidable.
For one thing, the large capital flows from
abroad depend upon continued deficits in
our foreign current account which, in turn,
depend upon the political and economic
policies of other nations and foreigners
financial portfolio preferences. For another,
they depend upon a fairly rapid pick-up in
the net private domestic savings rate, which
has not begun as yet.
While increases in domestic savings alone
will probably not match increases in federal
deficits, they are likely to be supplemented
by an increased amount of savings from
abroad. The counterpart of the expected
large foreign current account deficits in the
U.S. over the next four years, which could
increase from $35 billion in 1983 to $90
billion by 1987, is an increase in expected
net foreign savings flowing into the U.S.;
these may amount to roughly 2.0 percent of
GNP. As a resuIt, the total amount of net
savings in the U.S. from both domestic and
foreign sources may average close to 10.7
percent of G N P between 1984 and 1987, or
an increase in the total net savings rateof2.7
percentage points from that in the 1970s.
Federal deficits of the size projected for the
next four years will require unprecedented
amounts of the nation's savings. During the
1960s, federal deficits absorbed four percent
of total net savings and during the 1970s, 22
percent. In comparison, they may absorb
between 40 and 50 percent of total net
savings over the next four years, depending
upon whether budget savings proposals
under Congressional consideration are
adopted.
Structural deficits of this size seriously
threaten to impede the rate of spending on
new capital for both business purposes and
residential housing. In the absence of an
historically unprecedented increase in the
private savings rate, it appears that new investment over the next four years may
average at best no more than it did in the
1970s, when it was at its lowest in thepost-·
war period.
Even so, this increase in total net savingsfalls
short of the 3.4 percent needed to finance
the mounting deficits without reducing new
capital spending in the U.S. The savings
shortfall will show up as a further decline in
net domestic investment-in both housing
and business spending-from 6.2 percent of
G N P in the 1970s to a possible 5.5 percent
over the next four years. This is as large a
decline in net investment as has occurred in
the last 30 years.
RoseMcElhattan
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B AN KI NG DATA-TWELFTH FEDERALRESERVE
DISTRICT
(Dollar amounts in millions)
Selected Assetsand Liabilities
large Commercial Banks
Loans, Leasesandlnvestments1 2
Loansand Leases16
Commercial and Industrial
Realestate
Loansto Individuals
Leases
U.S. Treasuryand Agency Securities2
Other Securities2
Total Deposits
Demand Deposits
Demand DepositsAdjusted3
Other TransactionBalances4
Total Non-TransactionBalances6
Money Market Deposit
Accounts-Total
Time Depositsin Amountsof
$100,000 or more
Other Liabilities for Borrowed MoneyS
Weekly Averages
of Daily Figures
ReservePosition, All Reporting Banks
ExcessReserves(+ )/Deficiency (-)
Borrowings
Net free reserves(+ )/Net borrowed(- )
Amount
Outstanding
6/13/84
180,073
160,754
48,521
60,061
28,280
5,003
11,939
7,380
188,582
44,910
30,213
12,435
131,236
Change
from
6/6/84
- 101
79
70
134
42
6
34
12
-1,1 26
- 700
- 174
- 350
77
Changefrom 12/28/83
Percent
Dollar
Annualized
4,9
4,048
7,5
5,399
12,0
2,558
1,162
4.2
1,629
13.2
- 2.5
60
- 9.8
568
- 20.7
783
2,415
2.7
- 19.0
4,327
- 7.7
1,118
- 5.7
340
2,251
3.7
39,063
-
256
-
534
39,477
17,773
19
-1,794
-
1,312
5,234
Weekended
6/4/84
-
2.9
7.4
- 49.2
Weekended
5/21/84
32
115
83
16
41
57
1 Includes lossreserves,unearnedincome, excludes interbank loans
2 Excludestrading account securities
ExcludesU.S. governmentand depository institution depositsand cashitems
ATS,NOW, Super NOW and savingsaccountswith telephone transfers
5 Includes borrowing via FRB,TI&L notes,Fed Funds,RPsand other sources
6 Includes items not shown separately
Editorial comments may beaddressedto the editor (Gregory Tong)or to the author .... Freecopiesof
Federal Reservepublications can beobtained from the Public Information Section, FederalReserve
Bank of SanFrancisco, P.O. Box 7702, SanFrancisco94120. Phone(415) 974-2246,
3
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