Sunday, July 09, 2006

Is the budget deficit destabilizing?

Hoping to avoid a descent into fiscal silliness, I am looking for reasons to be against the budget deficit. One possible reason is that the deficit has destabilizing effects on the international economy. It is surely true, to the extent that the deficit props up the dollar against floating currencies like the euro, that it sets up the dollar for a more precipitous fall – with more troublesome and unpredictable consequences – in the future.

On the other hand, the deficit may have a stabilizing effect on countries that (like China) effectively peg to the dollar or (like Japan) often intervene to keep their currencies weak. By pushing up US interest rates and thus making dollars more attractive to private investors, the budget deficit reduces the number of excess dollars that countries like China and Japan need to absorb. This presumably decreases the risk that such countries will eventually provoke instability by changing their minds about their massive dollar holdings.

So the answer to the question in the title of this post is only “maybe.” While it seems unlikely that the deficit has a net stabilizing effect (at least in today’s rapidly growing world economy), it is not clear that it has a net destabilizing effect.

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10 Comments:

Blogger Gabriel Mihalache said...

Maybe you could, on a related note, tell us what are your thoughts on Ricardian equivalence? I assume you're mostly against it.

Sun Jul 09, 05:13:00 PM EDT  
Blogger knzn said...

In most of my posts about the deficit, I’m assuming that Ricardian equivalence doesn’t hold. It makes a lot of sense theoretically, but a combination of introspection and casual empiricism leads to me to doubt that it has much relevance to the real world. Of course, if Ricardian equivalence does hold, then the deficit becomes a pretty trivial issue one way or the other: it turns into mostly a question of optimal taxation, which I suppose would suggest that larger deficits are better provided that the growth rate exceeds the interest rate.

Sun Jul 09, 07:02:00 PM EDT  
Anonymous Anonymous said...

Exactly how does a fed. gov. deficit prop up the dollar against the euro?

Shouldn't increasing the supply of "dollars" for sale on the market decrease it's value against the euro (requiring a greater interest rate to provide a proper return on the purchase of the asset)?

As much as "Short-term interest rates are determined by Fed policy," aren't there factors beyond "long-term interest rates are determined largely by anticipation of future Fed policy."
i.e. The actual expected underlying return on the investment?

I mean, at some point the rubber has to hit the road. Even if you perceive the risk to capital to approach zero, you still need some type of return.

As to the point of your second graph; "the deficit may have a stabilizing effect on countries that (like China) effectively peg to the dollar or (like Japan) often intervene to keep their currencies weak," why do they need a deficit to maintain the peg?
It might be harder, but it's certainly possible, and considering your own observation that they already have too many dollars, isn't their eventual reconsideration of maintaining their dollar peg through the accumulation of our government debt also destabilizing?

It seems to me that deficits are clearly destabilizing forces in that by increasing the size of the asset without increasing underlying utility they diminish return.



Sorry, forgot my blogger password.

Lindsey

Sun Jul 09, 09:44:00 PM EDT  
Blogger knzn said...

Lindsey (anonymous),

Exactly how does a fed. gov. deficit prop up the dollar against the euro?

In my other post (which you’ve apparently read), I made the argument by discussing what would happen if the deficit were reduced, why that would cause the dollar to decline. It might help to turn the whole argument upside down and talk about what would happen (just the opposite) if the deficit increases (e.g. if we go from zero deficit to a positive deficit).

Shouldn't increasing the supply of "dollars" for sale on the market decrease its value against the euro … ?

This might be the initial effect of an increase in the deficit, but if the Fed is determined to prevent the US economy from overheating, it will have to raise rates high enough to make dollars attractive again. If the Fed lets the value of the dollar drop, then US goods will become more attractive, and the additional demand will stress the US economy and cause additional inflationary pressure. If the Fed thinks the deficit is already causing inflationary pressure, it will have to offset this by making US goods less attractive, and the way to do this is to increase the value of the dollar. So no matter what interest rate investors require in order to keep the value of the dollar where it is, the Fed will offer a higher interest rate than that. (In theory, another possibility is to choke off enough private domestic demand to compensate for the fiscal deficit, but in practice, that doesn’t seem to be what happens. The dollar rises enough before the domestic demand dies.)

…aren't there factors beyond "long-term interest rates are determined largely by anticipation of future Fed policy." i.e. The actual expected underlying return on the investment?

Investors always have the choice of a fixed rate or a floating rate. The floating rate will follow Fed policy exactly, so the fixed rate cannot deviate too much from the expectation of future Fed policy; otherwise everyone would choose one or the other, and the market wouldn’t clear. Of course, for longer horizons, anticipating Fed policy mostly consists of anticipating the fundamentals that will determine the Fed’s action.

“…why do they need a deficit to maintain the peg?... isn't their eventual reconsideration of maintaining their dollar peg through the accumulation of our government debt also destabilizing?”

I’m not sure what you’re asking here. Paradoxically, reducing the deficit causes the PBoC to accumulate more US government debt. They can maintain the peg either way, but without the deficit, they have to eat more dollars to do it. Which means they’re more likely to get indigestion and will have more dollars to throw up if they do. The peg, and the possibility of its removal, is destabilizing with or without the deficit, but it’s more destabilizing without the deficit.

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