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.