US Capitol Building from New Jersey Ave.

When will the US budget deficit be a real problem?

Finance and economics professor Farrokh Langdana explores when the US budget deficit could become non-sustainable

By Farrokh Langdana, Director, Executive MBA Program & Professor of Finance and Economics  

Faculty Blog:

The US government has been running a budget deficit every year for all but four years (1998-2001) since 1970. A budget deficit is (G –T) > 0.  Here, G is government spending and T is all tax revenues.  So, a deficit is (G-T) > 0, and a budget surplus is < 0 but there will be no need to even discuss a surplus right now.

So when is a budget deficit problematic?

Simply put, when the US cannot finance it. Responsible deficit financing is when the US Treasury borrows funds by issuing (selling) government debt; these are Treasury bills and bonds, also known as “sovereign debt.”

As long as this can be done, and as long as the US can keep continuously borrowing to “roll over” the debt –  that is, to sell more bonds to pay back domestic and foreign lenders, the deficit is said to be sustainable. Usually the US deficit is sustainable when the deficit/GDP ratio is under 5%.  (This ratio stems from the Dornbusch model of sustainability, referenced below.)*

When lenders stop lending to Uncle Sam, that is, when the ratio exceeds 5%, the deficits become non-sustainable and we have a problem.  At this point the only recourse is to “monetize” the deficit, which is a fancy word for “printing money like crazy.”  In the past, rampant deficit monetization has led to mind-numbing hyperinflations (Zimbabwe recently, Germany following WWI.)

But then when we had almost 10% deficit/GDP ratios in the recent Great Recession, how come the deficits did not become non-sustainable?

The 5% ratio becomes scary and applies only when there is another “safe haven” for lenders to rush to. In the recent global subprime crisis, and really since 9/11, there have been no other safe options – the US has been (and still is) the safest harbor, the safest “cave” on the planet.  So, miraculously, the US got away with it! 

But now with a resurgence in global growth, there will soon be other options for global capital to fly to. So, deficit hawks, time to wake up!  If the Trump tax cuts misfire and the budget deficits bloom, we will have to revisit the scary non-sustainability drama.

*Dornbusch non-sustainability ratio has to do with the real interest rate paid on government debt relative to the rate of growth of the economy and the rate of growth of the debt/GDP ratio. For more technical details, see Monetary and Fiscal Policy: Demystifying Macroeconomic Policy by Farrokh Langdana, (Edition3, 2016) and also International Trade and Global Macro Policy, by Farrokh Langdana and Peter Murphy, 2014, for a detailed discussion of Dornbusch sustainability.

Hpyerinflation in the Weimar Republic
Non-sustainable budget deficits could lead to hyperinflation similar to what the Weimar Republic experienced after World War I.

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