 Not All Deficits Are Created EqualFinancial Analysts Journal, 2006, vol. 62, issue 3, 12-19 Abstract: Recent academic and popular discussions of budget deficits rely on a simplistic, and largely false, conception of the effects of deficits. The effects depend on the source of the deficit and on private-sector responses to it. Also important are whether budget changes arise passively through the workings of the business cycle and whether deficit-inducing policy actions are permanent or transitory. The key expectations arising from the simple theories connecting interest rates and deficits are precisely opposite to what modern theory and evidence indicate.Recent academic and popular discussions of budget deficits rely on a simplistic—and largely false—conception of the effects of deficits. This literature ignores the fact that the effects of deficits depend on their source and on private-sector responses to them. Also significant are whether budget changes arise passively through the workings of the business cycle and whether deficit-inducing policy actions are permanent or transitory.As to source, on the one hand, large movements in U.S. budget deficits/surpluses are principally a result of the business cycle. Deficits caused by downturns in the business cycle are associated with interest rate reductions and boost aggregate demand, thereby limiting the extent of cyclical decline. Deficits caused by tax reductions also can be beneficial. For example, they can lead to offsetting changes in private saving and investment. Deficits caused by tax incentives for capital formation can be even more beneficial because their incentive effects can boost investment, productivity, and growth. Moreover, deficits associated with cuts in individual income tax rates can lower market interest rates and required expected market rates of return. On the other hand, deficits caused by increased government spending can be harmful because of their crowding-out effects, even when these effects are not brought about by higher real interest rates and/or by an increase in the value of the dollar.Correct theory and evidence show that deficits are typically not related to higher real interest rates. Usually, they are associated with lower interest rates, because the rate of return to capital is depressed or the tax wedge between market yields and the after-tax rate of return to investors is reduced by tax rate cuts. In either case, market interest rates fall when deficits increase.Finally, the widely popular idea that current account deficits arise from budget deficits is also not correct, at least for the U.S. economy during the past 25 years. Current account movements are related to international capital flows that respond more to incentives for domestic investment than to budgetary developments.Not surprisingly, the key expectations of simple theories now circulating—especially about interest rates, the current account deficit, and the dollar—are precisely opposite to what modern theory and evidence indicate. Investment and asset allocation decisions that rely on the popular misrepresentations of why and how deficits matter do material damage to investor interests. Date: 2006 Downloads: (external link) Related works: Export reference: BibTeX RIS (EndNote, ProCite, RefMan) HTML/Text Persistent link: https://EconPapers.repec.org/RePEc:taf:ufajxx:v:62:y:2006:i:3:p:12-19 Ordering information: This journal article can be ordered from Access Statistics for this article Financial Analysts Journal is currently edited by Maryann Dupes More articles in Financial Analysts Journal from Taylor & Francis Journals |
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