Deficits and the Economy: All Deficits are not Created Equal

Abstract

Recent academic and popular discussions of budget deficits rely upon a simplistic and, in large part, false conception of their effects. The recent literature ignores the fact that deficit effects depend on their source and on private sector responses to them. It also matters whether budget changes arise passively through the workings of the business cycle and whether deficit-inducing policy actions are permanent or transitory. More often than not, deficits are associated with lower interest rates. One reason is that large movements in budget deficits are principally due to the business cycle. Recessions lower investment and interest rates and also lower capital inflows. The widely popular idea that current account deficits arise from budget deficits is also not correct. Current account movements are related to international capital flows that respond more to incentives for domestic investment than to budgetary developments. Not surprisingly, the key expectations of the simple theory now circulating, especially about interest rates, the current account deficit and the dollar, are precisely opposite to what modern theory and evidence indicate. Investment and asset allocation decisions that rely on the popular misrepresentations of why and how deficits matter do material damage to investor interest. About the Author: John A. Tatom is the Director of Research at Networks Financial Institute, part of Indiana State University, and Associate Professor of Finance at Indiana State University. He has published widely on international and domestic monetary and fiscal policy issues, especially inflation, capital formation, productivity and growth; the macroeconomics of supply, especially oil and energy price shocks; the relationship of exchange rate movements to international competitiveness, capital flows, trade, and international economic policy; and on financial innovations and their effects on monetary policy and the economy, among other areas.