Deficits do matter, and maybe more than conventionally thought:
The U.S. federal budget is on an unsustainable path. In the absence of significant policy changes, federal government deficits are expected to total around $5 trillion over the next decade. Such deficits will cause U.S. government debt, relative to GDP, to rise significantly. Thereafter, as the baby boomers increasingly reach retirement age and claim Social Security and Medicare benefits, government deficits and debt are likely to grow even more sharply. The scale of the nation's projected budgetary imbalances is now so large that the risk of severe adverse consequences must be taken very seriously, although it is impossible to predict when such consequences may occur.
Conventional analyses of sustained budget deficits demonstrate the negative effects of deficits on long-term economic growth. Under the conventional view, ongoing budget deficits decrease national saving, which reduces domestic investment and increases borrowing from abroad.1 Interest rates play a key role in how the economy adjusts. The reduction in national saving raises domestic interest rates, which dampens investment and attracts capital from abroad.2 The external borrowing that helps to finance the budget deficit is reflected in a larger current account deficit, creating a linkage between the budget deficit and the current account deficit. The reduction in domestic investment (which lowers productivity growth) and the increase in the current account deficit (which requires that more of the returns from the domestic capital stock accrue to foreigners) both reduce future national income, with the loss in income steadily growing over time. Under the conventional view, the costs imposed by sustained deficits tend to build gradually over time, rather than occurring suddenly.
And it can be even worse than that:
The unfavorable dynamic effects that could ensue are largely if not entirely excluded from the conventional analysis of budget deficits. This omission is understandable and appropriate in the context of deficits that are small and temporary; it is increasingly untenable, however, in an environment with deficits that are large and permanent. Substantial ongoing deficits may severely and adversely affect expectations and confidence, which in turn can generate a self-reinforcing negative cycle among the underlying fiscal deficit, financial markets, and the real economy:
* As traders, investors, and creditors become increasingly concerned that the government would resort to high inflation to reduce the real value of government debt or that a fiscal deadlock with unpredictable consequences would arise, investor confidence may be severely undermined;
* The fiscal and current account imbalances may also cause a loss of confidence among participants in foreign exchange markets and in international credit markets, as participants in those markets become alarmed not only by the ongoing budget deficits but also by related large current account deficits;
* The loss of investor and creditor confidence, both at home and abroad, may cause investors and creditors to reallocate funds away from dollar-based investments, causing a depreciation of the exchange rate, and to demand sharply higher interest rates on U.S. government debt;
* The increase of interest rates, depreciation of the exchange rate, and decline in confidence can reduce stock prices and household wealth, raise the costs of financing to business, and reduce private-sector domestic spending;
* The disruptions to financial markets may impede the intermediation between lenders and borrowers that is vital to modern economies, as long-maturity credit markets witness potentially substantial increases in interest rates and become relatively illiquid, and the reduction in asset prices adversely affects the balance sheets of banks and other financial intermediaries;
* The inability of the federal government to restore fiscal balance may directly reduce business and consumer confidence, as the view of the ongoing deficits as a symbol of the nation's inability to address its economic problems permeates society, and the reduction in confidence can discourage investment and real economic activity . . .
The point is that while Krugman seems right on the politics for the short term, it is an unsustainable policy approach. At some point, good economic policy will be required. A Democratic President in 2008 is essential for this of course.
Perhaps that will be the signal Krugman is waiting for to endorse a return to sane economic policies.
