How Much Larger Could the Budget Deficit be?

This one’s really going to throw everyone for a loop.  Now, I know all we can talk about these days is how to cut the budget deficit.  We need to tighten our belt so the government can live more responsibly and halt the risk of becoming the next Greece, right?  Wrong.  Let’s explain why.  But let’s remember a few things here first:

1)  I don’t care how you achieve a higher budget deficit if it’s necessary.  Depending on your politics you might want more spending.  Or you might prefer tax cuts.  I generally prefer tax cuts in this environment because we’re not going to get more spending (I am in favor of things like infrastructure spending or real investment, but that’s a different story).  But the point is, you don’t have to bring politics into all of this to understand my main points here.  A larger deficit can be achieved regardless of your politics.  Bush did it with tax cuts, Obama did it with spending.  So leave your politics at the door for a minute.

2)  The USA is not Greece.  It has no solvency risk as in “running out of money” because it harnesses its banking system and central bank to provide funding.  Yes, Primary Dealers are required to make markets in government debt so there is never a risk of bond auctions failing or yields surging due to solvency constraints (yes, yields can rise due to inflation constraints but that’s a different story).  In this regard, the US monetary system is arranged in a way that is totally opposite of Greece’s system which has a very real solvency constraint.  (This doesn’t mean inflation couldn’t result in currency and bond rejection!).  Click here for more details on this.  

3)  The USA remains mired in a balance sheet recession.  If you think of the monetary system like the human body you can imagine it like a system of flows (click here for a more detailed explanation).  Like blood moving through the body, money moves through an economy generating revenues, incomes, spending power, etc.  When the credit crisis hit that flow halted.  And the government turned it back on through their spending policies.  In a normal environment the private sector would do most of the heavy lifting. People would be borrowing, spending, investing, etc, but the borrowing mechanism is broken because the private balance sheets are not yet healthy enough to sustain a recovery on their own.  This is abundantly clear from the latest NY Fed Houshold Debt report which showed that borrowing is still very weak.  And it’s important to understand that in normal times the private sector increases its flow in accordance with borrowing (because loans which create deposits are the primary form of money in our monetary system).

4)  We know, from the situation in Greece and Spain that austerity during a balance sheet recession ravages an economy. It’s simple.  If the government won’t spend and the private sector won’t spend then the flow dries up.  The economy dies.  And you get 90% drops in equity prices, 50% youth unemployment and a modern day depression.  It’s not rocket science.  An economy needs spending.  Just like your body needs blood flow.  If it stops, you die.  Enough said.

We know the deficit is likely to fall substantially in 2013 and I keep saying this is probably a bad idea.  So, the question I always get is, if we need the government to help support the private sector then “how large can the budget deficit be”?  That’s not an easy question to answer, but we can provide pretty rough estimates.  Remember, this is the “dismal science” we’re talking about.  Okay, now for some rough math.

Let’s first remember that inflation becomes an issue when we spend in excess of productive capacity.  What’s our productive capacity?  We can use the output gap as a rough estimate of lost potential from the Great Recession.  If we use Okun’s Law we can assume that excess unemployment causes a ~2% output gap.  We currently have about a 7.5% output gap (potential GDP vs actual GDP) and 7.7% unemployment.   Let’s assume we’re going with full tax cuts and a multiplier of 1.  That’s pretty safe and conservative (in more ways than one).  Let’s also use the full employment rate of 4% as defined by the Humphrey Hawkins Act.

If it takes $320B in GDP (1% of current GDP is $160B) to close the unemployment rate by 1% then we need a deficit of about $1.2T to get us back to full employment and on the path to closing the output gap.  That means we’re currently headed in the wrong direction with the current budget proposals which are likely looking at something in the $500-$600B in deficits for next year.   In short, we either need the private sector to really pick up the slack here (and the outlook is improving, but still weak) or we need the government to pick up more of the slack (which it obviously isn’t going to do).

Welcome to the math on muddle through.  Enjoy your (unemployed) stay.

* To learn more about the modern monetary system please read here.  

** The math for my Elastic Deficit Targeting approach is: (unrate-unrate_target) * [(0.01*current_NGDP)*2] = $1.184T