Budget Deficits and a Balanced Budget Amendment:

I received this email from a reader:


I have yet to encounter articles on the desirability of Fed budget deficits. Today's [Wednesday's] news states that due to increased tax revenue, the Fed deficit this year was reduced $100 B, but is still at $338 B. This in conjunction with a story I saw in Monday's WSJ (about corporate cash reserves being at an all-time high) had me thinking about the following: As corp debt is to some degree desirable, can gov't debt ever be?

Principally, corporations leverage themselves so that they can invest in what they are good at and make a considerably higher return than the interest rate on their debt. Could there ever be such an economic justification for gov'ts? Or is it just poor management, coupled with crisis spending, i.e., wars, hurricane relief, etc?

I would be interested to see you post on this topic on the VC.

This is something that I also haven't seen much commentary on and since this is something I have thought about a bit (its actually related to questions of household savings and that sort of thing that I work with all the time), so I'll give my thinking on it. I offer this to stimulate discussion and I hope other economists will offer their views too, especially if they have relevant empirical evidence that sheds light on the question.

The answer is yes, my view is that I think deficits could be ok but only under limited circumstances. In general, however, they are difficult to justify. Thus, it is likely that they are more defensible in theory than in practice. Whether the current budget deficits are defensible is an empirical question, I think, for reasons that I will elaborate, but that it is doubtful that much of recent budget deficits are justified.

First, as suggested in the email there is an analogy to corporate debt, if the government is making profitable investments in collective capital investment projects that the private sector would not undertake efficiently. So that if the government was building infrastructure, as local governments do when they go into debt to build schools or road. Or, arguably, investments in national defense or anti-terrorism could be these sorts of collective capital investments if they actually build a sort of anti-terror infrastructure. The federal government does not issue bonds in the same way that a municipal government does, but under this logic, they would be instrumentally similar.

There are, however, two qualifications to this. First, it must be that the investments are profitable investments, i.e., as mentioned in the email, where the rate of return exceeds the interest rate paid (which is actually the opportunity cost, as we will get to in a second). Unlike private businesses, however, there is no real accounting for the economic return on these projects, so it is pure speculation whether the return exceeds the interest rate. Given the amount of pork in infrastructure budgets (see the recent budget-busting highway bill) and the tendency to allocate these funds to political ends, rather than their highest-valued economic purpose, there is some doubt as to whether they recover their cost. As for investments in anti-terror and miliary expenditures, others have detailed the ways in which much of this money too has been diverted to other (pork) ends. So the WSJ definitely has a point in noting that the war against terror is certainly the sort of thing in which most people would agree it is appropriate to fund through deficit spending (just like wars are usually funded through deficits) and that this is probably a wise investment in theory, it also seems clear that in practice some of this money has been inappropriately diverted to nonproductive ends.

The second qualfication, of course, is that the money is actually being invested, not merely spent on consumption. To the extent that the deficit is caused by things like transfer payments (such as social security), etc., then it is difficult to see why this should be funded by deficits rather than taxes.

The second circumstance is what households do with the money. A "deficit" is nothing more than a deferred tax increase--either we pay today, or we pay in the future plus interest. So a deficit simply means that we have more money today, and less money whenever "we" have to repay the loan. There are three things that we can do with this "windfall." (1) We could simply save it in anticipation of higher taxes later--for instance, if we bought Treasury Bills then we would in theory perfectly break even vis a vis our future tax liability, or we could save the money and bequest it to our children to pay off our portion of the taxes. In this scenario (which is essentially similar to what is called "Ricardian Equivalence") deficits would be perfectly neutral. (2) We could spend our greater current income on current consumption, in which case this is a simple intergenerational wealth transfer, allowing us to consume today beyond our true wealth and trying to get someone else to pay for it.

Or, (3) We could invest it ourselves in some sort of individual investment and capital development. This is the most interesting arguemtn. It could be that if there are imperfections in certain capital markets for some reason, it might make sense for the government to borrow on our behalf and give us the money. For instance, the government essentially does this when it guarantees student loans--because of the riskiness of these sorts of investments in human capital, it is conceivable that such a private loan market might not work perfectly efficiently, and so a guaranteed student loan program might enable more efficient investments in human capital markets. So, if people are using their "extra" money, say, to quit working and go back to school to develop more valuable skills, and for some reason this is the most efficient way to enable them to do this, then it might make sense.

Again, however, the qualifications are substantial. My recollection from the Ricardian Equivalency literature (and any economists out there can set me straight on the current empirical state of the world on this question) is that people tend to save some of this and consume a substantial portion of this. Perhaps they invest some of it as well, but for most of those investments my guess is that the case for funding them through deficit spending is pretty week.

In the end, the case for budget deficits boils down to an empirical question about what the government and private individuals do with the money they get today, and the recognition that deficits today are just future taxes. In general, however, I am skeptical that capital markets are so incomplete that it makes sense to fund individual human capital investment through government deficit spending. And much of the deficit spending by the government today seems unrelated to true investment ends as well.

Two other arguments have also been made that I won't really discuss much, as they are more political and philosophical arguments, rather than economic arguments.

If the problem with deficits, roughly stated, is excessive government spending that funds current consumption (rather than investment), some have argued that deficits have the practical utility of constraining the overall size of the spending budget. This is Milton Friedman's famous justification for Reagan's budgets. This assumes, however, that there is some limit on public tolerance for budget deficits--it is no longer clear that this is the case. I had a long talk with James Buchanan a few weeks ago, and he strongly believes that this is the case, and that today, spending would be lower if we forced it to be financed by taxes rather than permitting deficits.

Some have also made a philosophical argument that even if there is an intergenerational wealth transfer, it is justifiable, because our children and grandchildren will almost certainly be wealthier than us, and (oversimplified) that they "wouldn't mind" lending us some money today, just as we leave money for them in our wills. This doesn't seem to be particularly persuasive to me, but it is one argument that is occasionally made to justify even deficits that fund current consumption.

As for a balanced budget amendment to the Constitution, the idea seems to be an idea that has disappeared as a political matter, nonethless I think that the intellectual argument is interesting. Leaving aside practical enforcement problems for a moment, I understand the strongest argument in favor of a balanced-budget amendment to be a public choice sort of argument, rather than an economic one. The idea would be that to the extent that a balanced budget amendment created some constraint on spending, it would be to create a sort of prisoners' dilemma game among politicians--i.e., I could only get more for my project if you got less. The logic of the argument would be that through this competition for limited funds, politicians would have the incentive to identify and plunder one anothers' pork projects, thereby increasing the public scrutiny on pork. Under the current system, by contrast, they can logroll each others' pork and shove the cost into the deficit. The argument would be, therefore, that the effect of a balanced-budget amendment would be to reduce expenditures on pork more than expenditures on public goods.

My sense of this argument for a balanced-budget amendment is that it too seems theoretically sound, but that the enforcement problems with a balanced-budget amendments, and the need for exceptions, would probably render it unenforceable in practice. In particular, it seems that any such BBA would probably put most entitlement spending off-budget, so it would not constrain exactly that which it would be intended to constrain in theory. Which is why I think the idea has fallen out of favor--in addition, of course, to changes in the political winds in Washington that no longer see it as, um, "necessary".


Professor Larry White notes in the Comments that he and Roger Garrison wrote a more extended discussion of this issue in the late-1990s in The Free Market, "Do Deficits Matter?" They also discuss Steven Landsburg's argument (also referenced in the Comments). I especially commend it for its discussion of Ricardian Equivalence, which I lacked the space to go into in the main post.

Scott Scheule (mail) (www):
Steven Landsburg wrote a column on the subject for Slate that you might find interesting.
7.14.2005 4:28pm
afdsa (mail):
Todd -- you manage to ignore the most common, and best, argument for temporary budget defecits -- recession busting. If you assume, like a Keynesian or the now theoretically grounded neo-keynesians, that there are some market imperfections that prevent pure market clearing (the familiar prices are sticky downward comment), an immediate injection of spending now can overcome these imperfections. You can argue that this type of intervention is better done by the fed through interest rates, but it is now a much more intellectually respectable position that temporary budget deficits can allievate recessions (since the rise of the neo-keynesian movement (see akerloff's nobel prize winnign speach for the simplest exigesis of these ideas).

Now, as for permanent budget deficits, well.....
7.14.2005 4:33pm
Zywicki (mail):
I understood the question to be referring to current budget deficits, since we don't seem to be in a recession.

But you are right that is another argument that is made during recession.
7.14.2005 4:40pm
Splunge (mail):
What about the political arguments for a deficit? Hamilton argued for the assumption by the Federal gov't of the states' debts after the Revolution, and the Virginians against, in part simply because long-term debt would necessarily increase the power of the Federal government, since it would have to have a larger budget and larger cash flow as well as substantial permanent taxing authority.

If you're a net tax-eater instead of tax-payer (e.g. gov't employee, student, teacher, professor, many roles in the medical field, some in the legal field, et cetera), or if your status and power derive substantially from that of the Federal government, then you may have significant political reasons for preferring or at least not minding a Federal deficit.

Even if you're a substantial tax-payer, as alas far too few Americans are, you may be happier (or less disgruntled) if the Fed is running a deficit, because it gives the impression that the gov't is nearly starved for tax revenue.

I realize these are not direct economic reasons for the deficit -- also that many people, myself included, would find these reasons unpalatable and unconvincing at best -- but the secondary economic consequences of social and political attitudes towards the Federal government's spending and power (e.g. consumer confidence, attitudes towards Gov't securities, rates of voluntary tax compliance) are substantial, arguably even as large as the direct economic consequences.
7.14.2005 4:46pm
One quick thought when trying to compare gov't borrowing to corporate borrowing is that some of the reasons that make debt financing attractive to corporations would not be applicable to the government, the most important example of which is tax shielding. Many corporations determine (or should, in theory) their leverage by borrowing debt until, at the margin, the value of the tax shield is offset by the increase in business risk from additional leverage. Since governments don't pay tax, tax shielding would obviously be irrelevant and would make debt much less attractive.
7.14.2005 5:39pm
Lawrence H. White (mail) (www):
Roger Garrison and I wrote a piece on the subject for The Free Market that you might find interesting. We argued that Landsburg overlooks good reasons to worry about federal budget deficits.
7.14.2005 5:46pm
A balanced budget amendment is just too unenforceable. A budget is just too complex and everyone plays games with it. For example, to make the current deficit look more reasonable, the administration left Iraq and Afghanistan completely out of their budget request, saying "we'll submit a supplemental request later." The budget is more of a political document than a balance sheet.
7.14.2005 5:55pm
John Penta (mail):
Steve: You leave out something.

Namely, a balanced budget may seem like a perpetually-possible thing now. But what if we have a balance-of-payments crisis, or something else that would necessitate a sudden, large deficit?

See Britain's big balance-of-payments crises from 48 til, hell, at least the 70s.

I think you could do something with a general rule that, barring a supremely-huge margin (2/3?) in both houses, the Budget should be balanced at least when initially submitted or something, but you pour concrete around the government's feet when you make it as ironclad as a Constitutional Amendment would be.
7.14.2005 6:05pm
Guest 1243,
You make a good point.
7.14.2005 6:08pm
Proud Generation Y Slacker:
Hmm, why do corporations have debt? Supposedly it's irrelevant in the absense of taxes, and the government doesn't pay taxes. The other reason is provide management the incentive to do well -- that is the old "equity is a pillow, debt is a sword" argument. This is basically the "starve the beast" approach, which, as we've seen, hasn't been effective. Either it just doesn't work, or the unstarved beast would be more terrible than we can imagine. I conclude that the reasons for debt in firm capital structures do not apply to the government.

It should be noted that I don't see what the balance of payments has to do with any of this. I sincerely hope nobody is trying to sneak in late through the side door with the decrepit "twin deficits" canard tucked under his arm.
7.14.2005 6:56pm
D. Oesy (mail):
With respect to your two "other" arguments for budget deficits, there are other persuasive reasons not explored. For instance, Newt Gingrich, who had ample practical experience in turning budget deficits into surpluses as Speaker of the House, said he learned to his surprise that deficits can work a certain discipline on Congress, which without such deficits, would go on spending binges. Those are not his exact words, but Newt is entitled to feel vindicated by the actions of future Congresses. The psychological need to cut spending to the level of forecasted revenues for a given fiscal year is an important leadership tool.

The second, more philosophical argument can look to accounting theory for support. An important principle of accounting is to match costs and benefits. Thus, a government might borrow to finance a project such as the War on Terror, and in that sense assign the upfront costs to a benefit period of, say, five years. The 1981 Israeli attack on the Iraqi nuclear facility at Osirak may have bought a benefit that extended for more than 20 years. The inherent assumption, which admittedly is difficult to enforce, is that the government will pay down the debt incurred ratably over the benefit period, commensurate with a cost amortization schedule. This theory is consistent with, and tends to bolster, the otherwise weak argument for intergenerational wealth transfer.
7.14.2005 7:21pm
I'm not an expert, but there may be some other possibilities.

1. Short-term debt is also used to smooth out timing differences in cash flow. Unless revenues and expenses are timed exactly, the difference creates a need for available liquidity, and maintaining access to credit can be more efficient than maintaining a large supply of cash.

2. Treasuries are an important chunk of the portfolio for banks and insurance companies in part because of their liquidity and "full faith and credit" guarantee. Corporate bonds or mortgage-backed securities don't have quite the same characteristics. Federal debt may therefore provide some benefit to society beyond simply financing government spending.

3. Corporations (arguably) only borrow when the financial return on the purchased assets is greater than the interest expense of the debt. The government could conceivably justify some level of debt as an efficient way to finance humanitarian projects even if it doesn't end up getting a direct financial return.

Of course, none of this removes the need for responsibility and fiscal discipline. Debt is not inherently evil, but proper debt structure is vital to a good loan regardless of the virtue of the intended use of funds. Although I admit I don't know the numbers, I would guess that nothing here could be used to justify the current deficit. And I suspect there's a lot in the budget that doesn't really qualify as a virtuous or profitable use of funds.
7.14.2005 7:59pm
Robert Schwartz (mail):
First: I am not sure that a balance sheet analysis fo government debt will work very well. What after all is the value of 12 carrier task groups? It is likely well above their acquisition and opperation costs.

Second from a cash flow view point, the debt and the deficit are both quite moderate. Interested readers should spend some time exploring the wonderful graphic analysis of the deficit at Steve Conover's excellent blog Sceptical Optimist.

Third: Beyond Hamilton's point. Federal Debt has 2 very important functions in the economy:

a.) our currency is Federal Debt, the assetts that back the federal reserve notes are Treasury Bonds. If they didn't exist, the Fed would have to invest in corporate or municapal issues, with the attendant risk of default and the political pressure to invest in the clients of the politically powerful. Imagine what the pressure would be like if GM were about to go bankrupt.

b.) The trading market in Treasury securities has a vital function in the financial system by providing market information on interest rates and inflation risk, which allow much more accurate pricing of corporate and municipal securities. The securities also provide investors with an opportunity to invest in securities that are default proof.

These are just some considerations to think about.
7.14.2005 8:00pm
Dilan Esper (mail) (www):
I am surprised nobody has mentioned the issue of interest rates. Government borrowing may have the effect of "crowding out" investment by increasing the demand for money and thus increasing interest rates. Thus, even if we assume the scenario Professor Zywicki posits where the funds generated by government borrowing are invested by private individuals or the government rather than consumed, at the same time the increase in interest rates may dilute this effect by constricting funds available for lending to individuals and businesses. And, of course, if Professor Zywicki's other scenario is operative, and the deficit is simply being consumed and not invested, it's even worse, because interest rates still go up and private investment still gets crowded out.

Many people believe that this is one reason why the predictions of some that the Clinton tax increases would lead to recession did not turn out to be accurate. The reduction of the deficit reduced long-term interest rates and increased investment, which under this hypothesis counterbalanced any contracting effect caused by the tax hikes.
7.14.2005 8:15pm
submandave (mail) (www):
Maybe I'm being obtuse or pedantic, but it seems we have some talking apples and some talking oranges here. The original question as I understood it concerned corporate and government debt, not perpetual deficit. While they are related, it seems to me that "are there benefits for a government to maintain a level of debt" and "are there benefits for a government to maintain a budget deficit" are two different questions.
7.14.2005 8:24pm
nlo (mail):
Yes, the accounting categories are messy with government since expenses and capital are not split out.

However, there is another point which seems to me to be pro-debt. Besides capital improvements there are human resource improvements (the hoary old "people are our greatest asset" saw). So, for example, effectively spent education expenses make people more valuable employees who can command higher wages that generate greater future tax revenue for decades.

Finally, there is another category of externalities. For example, companies (and individuals) used to dump sewage and smoke and all sorts of other trash into the environment because it was free. However, it turned out not to be free when things got so bad people were getting sick. Assessing the cost and value of the externalities is a political task and appropriate to government. Still, debt for a clean-up effort can be justified insofar as postponing clean-ups would only make the task more expensive.
7.14.2005 8:35pm
Zywicki (mail):
Robert Schwartz:
You're right, that skeptical optimist site is really interesting--and he has the best-looking graphics of any blog I've ever seen. Thanks for the tip.
7.14.2005 9:00pm
Greedy Clerk (mail):
Shorter Todd Zywicki: Deficits are good if a Republican President and Congress are the ones running them.
7.14.2005 10:00pm
Robert Schwartz (mail):
TZ: You are welcome. I really like Connover's blog.

Greedy: The party in power will always talk about the benefit of public debt, and the party out of power will awlways talk about the virtue of thrift. In the 60s, it was the Democrats who studied Keyens and the Republicans who complained. When the wheel turns, the parties will change places again.
7.14.2005 11:12pm
Steve Conover (mail) (www):
Thanks for the kind words about my blog, folks. Let me attempt a synopsis.

Economic growth, in a stable currency environment, overcomes the effect of a measured amount of debt. The key statistic is the ratio of debt-to-GDP: when it grows, the debt burden is growing; when it shrinks, the debt burden is shrinking. Note the important implication: even if debt is *growing*, the debt burden can be *shrinking* -- that happens when the economy (GDP) is growing faster than the debt is growing.

Private sector capitalists have always known that borrowing money to help fund good investments is sound financial practice ("leverage"). That is true for the federal government, too. Unfortunately, an old adage applies to the federal government: "Accountants count what's easy to count, not what counts." For example, in my book, national security is an asset -- but it's difficult to place a value on it, so we don't even try. Nonetheless, borrowing to help fund it is sound financial practice. (Economists on the left and right have confirmed that point, primarily because the math cannot be denied.)

It's a challenging concept to explain. I'm chipping away at it at my blog ( Also, my old website contains several essays that address the topic from several different angles (; the home page is a summary of the whole idea, for anyone interested in exploring the idea.

Best wishes!

Steve Conover, "The Skeptical Optimist"
7.15.2005 1:54am
William Spieler (mail) (www):
I'm adopting "no taxation without representation" as my rallying cry on this issue. Thanks, prof!
7.15.2005 9:57am
Anthony W. Hawks (mail):
Historically, the Balanced Budget Amendment (BBA) has been unenforceable because it misconceives how courts typically enforce our laws, to wit: courts do not enforce the laws themselves, they enforce the penalties for violating them. Since the BBA contains no penalty against Congress for deficit spending, it perforce has no enforcement mechanism.

I wrote on this issue at length in a September 2003 CATO Policy Analysis (No. 487), in which I argued that the best way to penalize Congress for budget deficits (in an institutional, non-partisan way) would be to give the President a "Balanced Budget Veto" (BBV). Under this proposal, the President would have item reduction veto power over any appropriations or funding authorization bill whenever the public debt increased in the prior fiscal year.

Congress would hate seeing its "power of the purse" diminished this way and, as a result, would actually get serious about curbing deficit spending. At the same time, since a BBV would not legally mandate a balanced budget (as the BBA does), you would not need supermajority votes for exceptions during times of war or other national emergency.

Finally, while a BBV would not give the President power to item veto entitlements, a BBV would still solve the problem of "off-budgeting" by forcing Congress itself to constrain entitlements in order to lower the public debt (and thereby terminate the President's BBV power and regain its power of the purse).

Of course, the political obstacles to adopting a constitutional amendment remain quite high, but suppose President Bush had asked for this temporary item veto power right after 9/11? I think that he would have stood a good chance of getting a BBV, and the deficits of the last four years would have been dramatically lower.
7.15.2005 10:48am
Zywicki (mail):
I'm not sure you read my post accurately--here's the introductory paragraph again in case you missed it:

The answer is yes, my view is that I think deficits could be ok but only under limited circumstances. In general, however, they are difficult to justify. Thus, it is likely that they are more defensible in theory than in practice. Whether the current budget deficits are defensible is an empirical question, I think, for reasons that I will elaborate, but that it is doubtful that much of recent budget deficits are justified.

I don't think that there is anything in the rest of the post that is inconsistent with my basic statement that they are "difficult to justify" and that "it is doubtful that much of the recent budget deficits are justified."

Could you point to exactly what I said that you think supports your characterization that I am saying whether deficits are good or bad has anything to do with the party in power as opposed to the ends to which the deficits are put? I'm not sure how my criticisms of the pork-ridden highway bill and the misdirection of "emergency" military funds to pork projects, for instance, are evidence of a pro-Republican bias in determining good v. bad deficits.
7.15.2005 12:02pm