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CBO: Why Deficits Still Matter, Even Now

January 27th, 2009 . by economistmom

There’s a lot of new analysis on the economic recovery plan from the Congressional Budget Office (CBO) today.  Last night they released their official cost estimate on the bill, where, as explained on the CBO Director’s blog (in Director Doug Elmendorf’s first real post), they find:

In combining the spending and revenue effects of H.R. 1, CBO estimates that enacting the bill would increase federal budget deficits by $169 billion over the remaining months of fiscal year 2009, by $356 billion in 2010, by $174 billion in 2011, and by $816 billion over the 2009-2019 period.

In other words, around 64 percent of the total amount of deficit spending will occur between now and October 2010 (or more than a third will occur after then), even as CBO forecasts that the current recession (which began in December 2007) will end sometime in the second half of 2009.  They go onto explain why they believe that government purchases of goods and services will spend out more slowly than direct payments to individuals or tax cuts.

Speed of payout (or the incurring of the costs) does not necessarily correlate with the effectiveness of the policy (the economic benefits), however.  This morning Doug Elmendorf presented CBO testimony before the House Budget Committee, where he well outlined the main “criteria for effective fiscal stimulus”–including “timing” (economic effects during the recession or otherwise weakness), “cost-effectiveness” (economic impact per dollar of cost, or “bang per buck”), “consistency with long-run fiscal objectives” (avoiding persistent deficits–more below), and other considerations such as “who would be helped” (distributional concerns) and “what types of additional goods and services” would be produced (allocation of resources).  Regarding cost-effectiveness, Table 5 in the testimony (page 27) shows the cumulative impact on GDP of various policy options, ranked from most effective to least.  The effect is measured over “several quarters” and per dollar of spending; in other words, it’s a “bang per buck” (or “multiplier”) type of measure.  The policies shown as most effective are purchases of goods and services by the federal government, and transfers to state and local governments for infrastructure–even though these are the types of spending that CBO feels are slower to “spend out” (on the cost side) than are transfers to individuals or tax cuts.  In fact, the “tax-loss carryback” business tax cut provision is listed as the least effective policy in terms of “bang per buck,” even though the “bucks” would be spent almost immediately, in tax year 2009.  (The CBO evaluation of this particular provision seems more pessimistic than the Tax Policy Center’s view–see the TPC’s ”tax stimulus report card.”)

So the “spend out,” or budgetary cost, of the various proposals matter, but they should matter in terms of how the costs compare with the benefits.  In the short term (this period of cyclical “economic weakness”), the costs of this deficit spending should be compared to the benefits on GDP and employment.  In the longer term, whether deficit spending on longer-term initiatives is ”worth it” depends on whether the longer-term economic benefits of such spending outweigh the longer-term costs.  And with deficit financing of those longer-term initiatives, those costs include the adverse effects of deficits on national saving and economic growth, the costs of debt service that will be incurred (the compound interest), and even the risk that what appears to be an unnecessary increase in longer-term deficit spending could threaten the short-term stability of the U.S. economy as well.  As CBO puts it in their testimony (pages 22-23):

Because fiscal stimulus boosts aggregate demand through increases in government spending or reductions in taxes, such policies raise budget deficits in the short term. That effect is desirable for fiscal stimulus because it reflects the increased demand being delivered to the economy. Contemporaneous changes elsewhere in the budget—tax increases or cuts in spending—designed to offset those short-term effects on deficits would serve to reduce or eliminate the stimulative effect.

Those higher deficits, however, tend to slow economic growth in the long term if they are allowed to persist, because they tend to reduce capital accumulation and the upward trend in the economy’s capacity to produce. Given the large projected shortfall of federal revenues relative to outlays in the medium term and long term, any policy designed to provide short-term fiscal stimulus will have to reckon with long-term consequences. Increases in spending and decreases in taxes that are intended to be temporary may be difficult to reverse later. Moreover, even if taxes and noninterest spending return to their baseline levels, the additional debt service from the period of larger deficits will—unless offset by greater fiscal discipline later—crowd out some amount of future growth.

In addition to their negative long-term effects, policies that substantially worsen the fiscal outlook can have negative short-term effects as well. The nation currently benefits greatly from the fact that investors worldwide tend to flee to U.S. Treasury securities in times of trouble. That tendency provides an important advantage in times of crisis, helping to increase liquidity and decrease interest rates. If investors lost confidence in the government’s debt as a safe haven because of deterioration in the long-term fiscal outlook, the U.S. economy would lose that advantage, perhaps permanently.

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