The ratio of the deficit to GDP



My father was watching one of the talking-head shows on TV this past Sunday, and saw the Secretary of the Treasury, John Snow, talking about the deficit as a percentage of GDP, and wondered why he was doing that. He e-mailed me and asked. Then this morning I happened to be reading an article on the Morgan Stanley Global Economic Forum site, which mentioned deficits and the GDP. I'll be posting a link to this in a little bit. In the meantime, though, it’s time for a short economics lesson.

The theory is that as long as the deficit is small in relation to the GDP, it will not introduce distortions into the economy. For example, say you make 40,000, and have a deficit of 1,000. Your deficit/product ratio is 2.5 percent. Assuming that this threshold is 2.5 percent or less, you're ok. The true deficit/GDP threshold is harder to gauge, and subject to much interpretation, but my reading leads me to think it is in the 3% range. Higher than that, and you start to see "crowding out", where private investment is pushed aside to pay for public services. (As an aside, the International Monetary Fund sees deficits of 5% of GDP or higher in developing countries as a warning sign.)

What is this crowding out? The government finances its debt by selling government bonds on the market. These bonds compete with other corporate bonds, and the total bond market competes with other investments such as equities (stocks). When the government issues more bonds than it has in the past, interest rates have to increase for the bond market to clear. (Interest rates have to increase to make people want to buy bonds, which have a lower rate of return but more security, over equities, which have a higher rate of return but less security) This "crowds out" marginal investment by driving up the cost. For each percent of deficit to GDP, the long-term Treasury note interest rate is estimated to increase by 0.2 to 0.35 percent.

Right now investment isn't a big issue. On the contrary, current interest rates are historically low, held there by a lack of investment and the Federal Reserve trying to stimulate it. This is due to the peculiarities of this recession, which has been called an excess capacity recession. Basically, what it means is that we overinvested during the 90's boom, and now we're not using a lot of the manufacturing capacity we bought. Individual people are still spending money, but businesses aren't expanding. Hence, the mushy job market where jobs just aren't being created.

The point is, right now a higher than normal deficit/GDP ratio won't be a problem. But if we backload our tax cuts, so that most of the cuts in revenue occur later on down the road, we will only provide minimal stimulus to the economy in the here-and-now, and have less wiggle room in the future.

What should we do to stimulate the economy? I'll get to that shortly.

Popular posts from this blog

New post-convention poll Results look good to me. Now, we have to keep them coming. Further down in the article, there is discussion of how Kerry is gaining ground as a person who understands the needs of people, and a person of character. Key problem is going to be keeping these issues in front of voters, when the Kerry campaign will have a finite amount of cash to campaign on. Bush won't have a finite amount until the Republican convention at the end of August. Other people are going to have to step up and start hammering the Bush administration. Kerry Leads Bush in Post-Convention Poll (washingtonpost.com) : The new poll shows Kerry now claims the support of 50 percent of all registered voters, compared with 44 percent for Bush, with independent candidate Ralph Nader at 2 percent. On the eve of the convention, Bush led Kerry 48 percent to 46 percent. Among those most likely to vote, the race is tighter: Kerry holds a 2-point advantage over Bush in the current po...
Read more
Sometimes headlines just write themselves Like this one from the Washington Post today: Ex-FEMA Head Starts Disaster Planning Firm Michael Brown certainly has shown he can plan a disaster. Look at how awful Hurricane Katrina was. For preventing or fixing things afterwards, he's not so good.
Read more
Reading List It is a good thing to be married to a librarian. Our local system has a web-accessable catalog where I can put a book on hold. Depending on how many people are waiting for the book, in a few days to a few months, my wife comes home with the book I've requested. I was reading "A Mathematician Plays the Stock Market" by John Allen Paulos. It is the kind of book that makes mathematics of investing accessable to non-mathematical types (and some of us mathematical folks as well), even as he tells the story of his failed love affair with Worldcom stock. Of course, I set this aside as soon as I got in "Big Lies: The Right-Wing Propaganda Machine and How It Distorts the Truth" by Joe Conason. This book takes all of the distortions of the right-wing media, the Bush-Cheney administration, and the Republican "conventional wisdom", and proceeds to refute them, citing facts chapter and verse. I think this book is great. But I've g...
Read more