Long-Run Effects of Deficits, Policy Mix-Deficits and Economic Growth

Long-Run Effects of Deficits:

The Policy Mix: Deficits and Economic Growth

Higher full-employment deficits initiate low investment. On the IS-LM figure a deficit--whether from more government purchases or else lower taxes shifts the IS curve to the right. In any run long sufficient for the full employment flexible price model to be relevant large full-employment deficits bring about higher real interest rates, lower total savings and lower investment.

In the flexible-price context the study of persistent deficits is straightforward. Such deficits decrease national savings. Flow-of-funds equilibrium therefore requires higher real interest rates and lower levels of investment spending.

Even in a sticky-price context it may perhaps well be that higher deficits reduce investment. The central bank can as well as probably will change monetary policy to neutralize the effect of the higher deficit on real GDP. The central bank prefers its baseline monetary policy in order to try to strike the optimum balance between the risk of higher-than-necessary unemployment and the risk of rising inflation. The central bank doesn’t want this balance disturbed by shifts in the IS curve therefore it is highly likely to use monetary policy to offset the effect of the deficit-driven shift in the IS curve on the level of real GDP and employment. The IS curve shifts out however interest rates rise leaving real GDP unchanged and investment lowered.

Low investment decreases capital accumulation and productivity growth putting the country on a trajectory to a lower steady-state growth path. Ever since the early 1960s economists have disagreed that economic growth is fastest and the economy is best off when the policy mix pursued by the government and the central bank is one of tight fiscal policy a government surplus and loose monetary policy a relatively low interest rate. Together this policy mix is able to produce, high investment, full employment and relatively rapid economic growth.

Over the course of time it has appeared that the U.S. government has the opposite partiality. Surely for a period of a decade and a half beginning with the Reagan tax cuts of the early 1980s the U.S. economy has had slack fiscal policy and tight monetary policy. Now the U.S. has a budget excess and relatively high investment. Partially these are a result of good luck however partly they are a result of politicians' taking economists' advice on the policy mix for the first time in more than a generation.

Higher Full-Employment Deficits Reduce Investment:

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If the deficit carries on for long they will begin to have an effect on the economy's capital intensity. The decrease in national savings as a share of GDP will reduce the economy's steady-state capital-output ratio which you will recall is equal to:

k* = s/(n + g + δ)
Long-Run Effects of Persistent Deficits on Economic Growth:

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A lower steady-state capital-output ratio entails a lower level of output per worker along the steady-state growth path for any given level of the efficiency of labor. Therefore policies of persistent shortfalls will as long as the rise in the deficit reduces national savings--reduce the level of output per worker in the long run below what it would otherwise have been. (This at least is the conventional analysis of the interaction among deficits and long-run growth. It has been confronted by a group of professors centered on Harvard's Robert Barro as is discussed below in the chapter on the future of macroeconomics.)

Debt Service, Taxation, and Real GDP:

However there is still more. A higher deficit signifies a higher debt which means that the government owes more in the way of interest payments to bondholders. Over time even if the level of the deficit is kept constant the rise in interest payment will require tax increases. And these tax raise will discourage entrepreneurship and economic activity. In addition to the decrease in output per worker resulting from the lower capital-output ratio there will be an additional decrease in output per worker- the increased taxes required to finance the interest owed on the national debt will have negative supply side effects on production.

The interaction of tax policy, macroeconomic policy, incentives for production and the level of real GDP deserves more space. No conversation of fiscal policy could be absolute without noting for instance a possible drawback of the progressive tax rates that create strong fiscal automatic stabilizers. The senior the marginal tax rate the greater the danger that at the edge taxes will discourage economic activity leading either to hordes of lawyers wasting social time executing negative-sum tax-avoidance strategies to a shift away from aggressive entrepreneurship toward more cautious less growth-promoting activities taxed at lower rates or to a depreciated exchange rate and therefore less power to purchase imports as capital flows across national borders to jurisdictions that have lower tax rates at the margin.

Opinion through these issues is complex. Are governments spending on basic research, infrastructure and other public goods themselves productive? Do they increase total output by more than the increased tax rates threaten to reduce it? And what is the government’s objective? Finally maximizing measured total output is the same thing as maximizing social welfare merely if externalities are absent and only if the distribution of total wealth corresponds to the weight individuals have in the social welfare function with the tastes and desires of the rich being given more weight.

These topics are conventionally reserved for public finance courses and aren’t covered in macroeconomics courses. However no one should think that an analysis of fiscal policy can start and end with the effects of discretionary fiscal policy and automatic stabilizers on the business cycle as well as the effects of persistent deficits on national saving. There is a lot more to be thought about.

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