BY THOMAS FRISBIE, CFA
In April, the Congressional Budget Office released its “Budget and Economic Outlook”, which included 10-year projections on the size of the federal budget deficit. The report somberly predicted that, following passage of Donald Trump’s tax cuts, the deficit as a percentage of economic output will rise from 3.5% last year to 5.4% in 2022 and then stay stuck in the 5.0% range through 2028. The report notes that the long-term historical average of our budget deficits is only 2.9% of economic output. Some Democrats running in the mid-term elections are sure to seize upon these predictions to label Trump and the Republicans as “irresponsible” stewards of the public finances, but do large budget deficits really spell doom for our economy? Our economic history does not support that concern.
Three times in the past 100 years, our national deficit has ballooned for periods lasting several years, and all three times, prosperity, not penury, has followed. The first time the federal deficit “blew out”, much to the disapproval of Republicans, was during Franklin D. Roosevelt’s first term, when he sought to battle a depression brought about in part by reckless trade and tax legislation passed during the Herbert Hoover administration. FDR junked the standard economic playbook of always balancing budgets in favor of radical economic stimulus—devaluing the dollar by 50% against its substitute, gold, and ramping government spending in all ways imaginable to stimulate employment and private sector incomes. What resulted were four straight annual deficits between 1933 though 1936 averaging a scandalous (in those days) 4.9%. What also resulted was an enormous jump in economic output averaging 9.4% between 1934 and the end of 1937. It was only when the government began to taper its deficit spending in 1937 that the economy reacted with another downturn in 1938. The government’s spending was essential to fill the void in demand created by the massive destruction of private sector (workers’) incomes.
The second time in peacetime when federal deficits “blew out” was during the first term of Ronald Reagan’s presidency, much to the disapproval of Democrats. Reagan, like FDR, entered office in response to an economic crisis born during the tenure of his successor, Jimmy Carter. The problem this time was runaway inflation, and in 1979, Fed Chairman Paul Volcker began raising interest rates higher and higher with the goal of choking private borrowing and thereby private spending. Reagan’s first two years in office were marked by interest rates in the teens and a sharp downturn in the manufacturing output and employment. But inflationary pressures finally buckled, and Reagan stimulated a return to spending with a tax cut in 1981 and high levels of deficit spending. The result was five straight budget deficits between 1982 and 1986 that averaged 4.9% of output. However, economic output also jumped, hitting 7.3% in 1984 and then average almost 4% during his entire second term. Not only did inflation fall back to normal levels, but employment jumped and the purchasing power of the U.S. dollar compared to foreign currencies skyrocketed. Once again, America was back on its feet.
The third budget crisis fell upon Barack Obama, who inherited a massive financial crisis from the George W. Bush Administration, and which also infected European banks and their economies. Obama and his Fed chairman, Ben Bernanke, basically invoked the same crisis playbook, opening the floodgates of federal spending while the much larger private sector sought to recover its equilibrium. The Obama budgets produced deficits of 9.8% in 2009, 8.7% in each of 2010 and 2011 and another 6.8% in 2012. And the nostrum worked for the third time. Although the economic growth that followed was abnormally slow, inflation was essentially non-existent, the U.S. dollar soared against foreign currencies, and we escaped the much deeper downturns experienced by some of our European trading partners. For the third time, a fundamental breakage of the economic system was avoided.
Budget deficits may irritate some voters, but even historically high deficits of 5% of economic output means that the other 95% of output is being funded by somebody else. That “somebody else” is the combination of consumer spending, business spending and exports, and it is this “somebody else” that needs to be the constant focus of government policy makers. Without policies that reward investment, risk taking and the development of foreign markets for our goods, running deficits or surpluses will not matter.
The information provided is for illustration purposes only. It is not, and should not be regarded as “investment advice” or as a “recommendation” regarding a course of action to be taken. These analyses have been produced using data provided by third parties and/or public sources. While the information is believed to be reliable, its accuracy cannot be guaranteed.