NBER WORKING PAPER SERIES

WHAT DO BUDGET DEnCrrS DO?

Laurence Ball
N. Gregory Mankiw

Working Paper 5263

NATIONAL BUREAU OF ECONOMIC RESEARCH

1050 Massachusetts Avenue
Cambridge, MA 02138
September 1995

This paper was prepared for the Federal Reserve Bank of Kansas City Symposium on Budget
Deficits and Debt, in Jackson Hole, Wyoming. on August 31 - September 2, 1995. We arc
Foundation for
grateful to Michael Rashes for research assisthnce and to the National Science
financial support. This paper is part of NBERs research programs in Economic Fluctuations and
not those of the
Monetary Economics. Any opinions expressed am those of the authors and
National Bureau of Economic Research.

© 1995 by Laurence Bali and N. Gregory Mankiw. All rights reserved. Short sections of text.
full
not to exceed two paragraphs, may be quoted without explicit permission provided that
credit. including © notice, is given to the source.
 NBER Working Paper 5263
September 1995

WHAT DO BUDGEf DEFICITS DO?

ABSTRACT

This paper discusses the effects of budget deficits on the economy in four steps. First,

it reviews standard theory about how budget deficits influence saving, investment, the trade

balance. interest rates, exchange rates, and long-term growth. Second, it offers a rough estimate

of the magnitude of some of the effects. Third, it discusses how budget deficits affect economic

welfare. Finally, it considers the possibility that continuing budget deficits in a country could

lead to a hard landing" in which the demand for the country's assets suddenly collapses.

Laurence Ball N. Gregory Manldw

Department of Economics Department of Economics
Johns Hopkins University Littauer 223
Baltimore. MD 21218 Harvard University
and NBER Cambridge, MA 02138
and NEER
 No issue in economic policy has generated more debate over the

past decade than the effects of government budget deficits.

Politicians of various ideologies argue that deficit reduction is
critical to the future of the United States and other major
economies. Although the economics profession is more divided over

the issue, many economists share the view that deficits are
haruful, and perhaps even disastrous.
When economists and policymakers decry deficits, they cite

diverse reasons. Thus, despite almost unanimous concern over

deficits, there is considerable controversy about what effects

deficits have on the economy. The goal of this paper is to clarify

these effects. Do budget deficits reduce economic growth?

Threaten to create a financial crisis? Do deficits create winners

as well as losers? If so, who are they? How large are the effects

of deficits? Are deficits merely an chronic nuisance, or do they

threaten us with economic decay and, to use Benjamin Friedman's
(1988) ominous language, an upcoming "day of reckoning?"
To answer these questions, we proceed in several steps.
Section I presents a positive analysis of the effects of budget
deficits on aggregate economic variables such as GDP, exchange

rates, and real wages. The analysis follows the conventional

wisdom as captured, for example, in most undergraduate textbooks.

In our view, the conventional wisdom in this area is mostly On the

right track.
deficits, we take
After describing the qualitative effects of

1
a stab in Section II at quantifying the effects of recent deficits
in the United States. As usual in economics, theory is too
stylized to give precise estimates of the sizes of the effects.
But some simple calculations shed light on the orders of magnitude
involved.

Section III turns from positive analysis to a consideration of

deficits and economic well—being. Our theme here is that deficits

cause redistributions: some people lose from deficits, but others

gain. It is possible to justify the common view that deficits are

undesirable over all, but doing so is not as easy as one might
think.

section IV turns from the question of what deficits currently

do to what they might do in the future. We focus on the
possibility that continued high deficits in a country will trigger
a "hard landing" in which the demand for domestic assets collapses.

Both the likelihood of such an event and its effects are highly
uncertain. But the risx of a hard landing may be the most
compelling reason for reducing budget deficits.

I. Budget Deficits and the Economy

Suppose two countries are identical and initially both have

balanced budgets. Suddenly, for no good reason, one country starts

running a budget deficit, either by raising government spending or

by cutting taxes, while the other country keeps its budget
balanced. How will the evolution of these two economies differ?
In particular, how will budget deficits affect major economic

2
variables, such as GDP, investment, net exports, wages, interest

rates, and exchange rates?

The Immediate Effects of Budget Deficits

Budget deficits have many effects. But they all follow from

a single initial effect: deficits reduce national saving. National

saving is the sun of private saving (the after—tax income that
households save rather than consume) and public saving (the tax

revenue that the government saves rather than spends). When the
government runs a budget deficit, public saving is negative, which
reduces national saving below private saving.
The effect of a budget deficit on national saving is most
likely less than one—for—one, for a decrease in public saving
produces a partially.-offsetting increase in private saving. For
example, consider a one—dollar tax cut. This tax cut reduces

public saving by one dollar, but it also raises households' after—

tax income by one dollar. It is likely that households spend part

of this windfall but save part as well. This implies that national

saving falls, but by less than the fall in public saving.'

How does lower national saving affect the economy? The answer

can be seen most easily by considering some simple (and

irrefutable) accounting identities. Letting Y denot gross

Economists of the "Ricardian" school argue that consumers

that
save 100 percent of a debt—financed tax cut, which implies
economists.
deficits have no effect on national saving. Like most
we believe the added private saving is much smaller than the full
tax cut. For descriptions and critiques of the Ricardian position,
see Bernheim (1987) and Granlich (1989).
3
domestic product, T taxes, C consumption, and G government
purchases, then private saving is Y—T-C, and public saving is T-G.

Adding these yields national saving, 8:

S Y — C - G.

National saving is current income not used immediately to finance

consumption by households or purchases by the government.

The second crucifl accounting identity is the one that divides

GD? into four types of spending:

Y = C + I + C + NX.
Output I is the sum of consumption C, investment I, government
purchases C, and net exports mc. substituting this expression for
I into the previous equation f or national saving yields
S= I + MX.

This simple equation sheds considerable light on the effects of

budget deficits. It says that national saving equals the sum of
investment and net exports. When budget deficits reduce national
saving, they must reduce investment, reduce net exports, or both.

The total fall in investment and net exports must exactly match the

fall in national saving.

To the extent that budget deficits increase the trade deficit

(that is, reduce net exports), another effect follows immediately:

budget deficits create a flow of assets abroad. This fact follows

from the equality of the current account and the capital account.
When a country imports more than it exports, it does not receive

these extra goods and services for free; instead, it gives up

assets in return. Initially, these assets may be the local
4
currency, but foreigners quickly use this money to buy corporate or
government bonds, equity, or real estate. In any case, when a
budget deficit turns a country into a net importer of goods and
services, the country also becomes a net exporter of assets.
At first, some of these conclusions may appear mysterious.
Business firms choose the economy's level of investment, and
domestic and foreign consumers choose net exports. These decisions
may seem independent of the political decisions that determine the
budget deficit. If the government decides to run a deficit, what
forces induce fins - to invest less and foreigners to buy fewer

domestic products?
The answer is that these changes are brought about by interest

rates and exchange rates. Interest rates are determined in the

market for loans, where savers lend money to households and fins
who desire funds to invest. A decline in national saving reduces
the supply of loans available to private borrowers, which pushes up

the interest rate (the price of a loan). Faced with higher

interest rates, households and fins choose to reduce investment.

Higher interest rates also affect the flow of capital across

national boundaries. When domestic assets pay higher returns, they

are more attractive to investors both at home and abroad. The
increased demand fqr domestic assets affects the market for foreign
currency: if a foreigner wants to buy a domestic bond, he must
first acquire the domestic currency. Thus, a rise in interest
rates increases the demand for the domestic currency in the market

for foreign exchange, causing the currency to appreciate.

5
 The appreciation of the currency, in turn, affects trade in
goods and services. With a stronger currency, domestic goods are
more expensive for foreigners, and foreign goods are cheaper for
domestic residents. Exports fall, imports rise, and the trade
balance moves toward deficit.2
To sum up: government budget deficits reduce national saving,

reduce investment, reduce net exports, and create a corresponding

flow of assets overseas. These effects occur because deficits also
raise interest rates and the value of the currency in the market
-.

for foreign exchange.

2 At least since the 1960s, most economists have agreed that

budget deficits create trade deficits by causing the domestic
currency to appreciate. Yet, within the past year journalists and
policyinakers have argued that budget deficits cause a deoreciation
of the currency. In particular, the fall in the dollar in the
first half of 1995 was widely blamed on low national savings
arising from U.S. deficits. A New York Tipes headline proclaimed
"Save the Dollar: Encourage Saving."
Can one make sense of this recent view? As far as we can see,
the only channel through which budget deficits could weaken the
domestic currency is increased fear of the "hard landing0 discussed
in Section IV. A sharp fall in investor confidence could cause a
fall in the demand for domestic assets, outweighing the direct
effect of deficits. We are doubtful, however, that this is the
right explanation for the recent fall in the dollar. Early 1995
was a period in which the likelihood of a hard landing may have
fallen due to increased interest in budget—balancing by both
political parties.
We suspect, therefore, that recent views about deficits and
the dollar are simply fallacious. Since budget deficits are
generally viewed as irresponsible policies, it is tempting to blame
them for any undesirable event, even in the absence of a logical
connection. Note that if budget deficits weaken the dollar, they
also reduce rather than increase the trade deficit, an unappealing
implication that is ignored in recent discussions.

6
Budget Deficits in the United States
So far, our discussion of budget deficits has been
theoretical. Do the effects we have discussed occur in actual
experience? There is a large empirical literature that looks for
these effects, unfortunately, this work has neither refuted the

theories we have sketched nor convinced skeptics of their validity.

The main obstacle to convincing empirical work is the

identification problem. Countries do not run fiscal policies as

controlled experiments; instead, policies change over time in

response to changing econonic circumstances. It is difficult to

sort out the effects of budget deficits from their causes.

Nonetheless, it is useful to examine the U.S. experience over

the past dozen years. Table 1 provides some summary statistics.

While these data do not prove anything definitively, they show that

the U.S. experience can be explained by conventional theories. The

figures also offer a sense of the magnitudes involved.
As the top line of Table 1 shows, beginning in the early

l980s, the U.S. government switched from a policy of (inflation—

adjusted) budget surpluses to budget deficits. Public saving fell

by 2.4 percent of GDP. Rather than rising as one might expect,

private saving rates fell slightly, suggesting that the increased
impatience exhibited in fiscal policy also infected the private
sector. National saving fell by about 2.9 percentage points.
So far, this fall in national saving has been associated with
a fall in domestic investment of only 0.8 percentage points. As a
result, the U.S. trade balance went from a small surplus to a large

7
and persistent deficit, a fall of about 2.0 percent of GOP. These

trade deficits have, as is necessary, been financed by the sale of

domestic assets. In 1981. the U.S. stock of net foreign assets was

about 12.3 of GDP; in 1993 it was negative 8.8 percent. The

world's largest economy went from being a creditor in world
financial markets to being a debtor.

8
Table 1

The U.S. Experience

Averages as a percent of GDP

1960—1981 1982—1994 change

Public saving 0.8 —1.6 —2.4

Private saving 16.1 15.7 —0.4

National saving 16.9 14.0 —2.9

Domestic Investment 16.5 15.7 —0.8

Net Exports 0.3 —1.7 —2.0

Note: All variables are gross nominal magnitudes as a percentage of

nominal GD?. Public and private saving have been adjusted for the
effects of inflation: only the real interest on the national debt

is counted as expenditure by the government and income to the

private sector. Net exports here are measured as national saving
less domestic investment; it thus includes the net income from
domestically—owned factors of production used abroad.

source: U.S. Department of Commerce and authors' calculations.

9
Long-Run Effects of Deficits: Output and Wealth

The effects described so far begin as soon as the government

begins to run a budget deficit. Suppose, as is often the case,

that the government runs deficits for a sustained period, building
up a stock of debt. In this case, the accumulated effects of the

deficits alter the economy's output and wealth.

In the long run, an economy's output is determined by its

productive capacity, which in turn is partly determined by its
stock of capital. When deficits reduce investment, the capital
stock grows more slowly than it otherwise would, Over a year or
two, this crowding out of investment has a negligible effect on the

capital stock. But if deficits continue for a decade or more, they

can substantially reduce the economy's capacity to produce goods

and services.
The flow of assets overseas has similar effects. When
foreigners increase their ownership of domestic bonds, real estate,

or equity, more of the income from production flows overseas in the

form of interest, rent, and profit. National income——the value of

production that accrues to residents of a nation——falls when
foreigners receive more of the return on domestic assets.

Recall that budget deficits, by reducing national saving, must

reduce either investment or net exports. As a result, they must
lead to some combination of a smaller capital stock and greater
foreign ownership of domestic assets. Although there is
controversy about which of these effects is larger, this issue is

not crucial for the impact on national income. If budget deficits

10
crowd out capital, national income falls because less is produced;
if budget deficits lead to trade deficits, just as much is
produced, but less of the income from production accrues to
domestic residents.
In addition to affecting total income, deficits also alter
factor prices: wages (the return to labor) and profits (the return

to the owners of capital). According to the standard theory of

factor markets, the marginal product of labor determines the real

wage, and the marginal product of capital determines the rate of

profit. When deficits reduce the capital stock, the marginal

product of labor falls, for each worker has less capital to work
with. At the same time, the marginal product of capital rises, for
the scarcity of capital makes the marginal unit of capital more

valuable. Thus, to the extent that budget deficits reduce the

capital stock, they lead to lower real wages and higher rates of

profit.

Long—Run Effects of Deficits: Future Taxes

In addition to their effects on macroeconomic performance,

budget deficits have a more direct implication for the future: the

resulting government debt may force the government to raise taxes

when the debt comes due. These future taxes reduce hoUsehold
incomes in two ways——directly through the tax payments and
indirectly through the deadweight loss that arises as taxes distort
incentives. Alternatively, if taxes do not rise, the government
to free up
may be forced to cut transfer payments or other spending

11
funds to pay the debt.
By how much must taxes rise or spending fall to pay off a
country's debt? This question is more tricky than it seems, for
the answer depends on both policy choices and luck. One surprising
fact is that the government may never need to raise taxes or cut
spending at all. Instead, it can simply roll over its debt: it can

pay off interest and maturing debt by issuing new debt. At first
this policy might appear unsustainable, because the level of debt
increases forever at the rate of interest. Yet as long as the rate

of GDP growth is higher than the interest rate, the ratio of debt
to G' falls over time. With the debt shrinking relative to the
size of the economy, the government can roll over the debt forever

even as its absolute size grows. That is, the economy can grow its
way out of the debt.

History suggests that a government is likely to get away with

running such a Ponzi scheme. In many developed economies, the
average growth rate over long periods has exceeded the average
interest rate on government debt. In the United States, for
example, average growth of nominal GDP from 1871 to 1992 was 5.9

percent, and the average interest rate on debt was 4.0 percent. If

these trends continue, a policy of rolling over the debt (and using

taxes to pay for current government services) will cause the debt
to grow more slowly than GDP. The debt will eventually become
negligible relative to the size of the economy, even with no tax
increases -
Does this scenario sound too good to be true? It may be. The
12
catch is that the future paths of interest rates and GD? are
uncertain. Although interest rates on government debt have usually

been less than the growth of GDP, these variables fluctuate. It is

possible, although not especially likely. that the economy will

experience a run of bad luck——Say a major depression——in which the
growth rate drops below the interest rate for a sustained period.
In this case, a policy of rolling over the debt will cause the debt
to rise faster than national income. Eventually, the debt may
become so large relative to the economy that the government has
difficulty selling it, forcing a tax increase or spending cut.
Moreover, these adjustments are especially painful: they are large,

and they come when the economy is already suffering from a problem
that has caused the debt—income ratio to rise.'

Thus a policy of rolling over the debt is a gamble: the

government is likely to avoid any tax increase or spending cut, but
it risks large and painful ones. Faced with this risk, the
government may choose to reduce the deficit while the debt
is still
moderate and the economy is healthy. By raising taxes or cutting
spending initially, the government can reduce the risk of more
difficult fiscal adjustments later.
By how much must the government raise taxes to ensure that the
debt—income ratio does not explode? One natural, safe policy is to
raise taxes enough to stabilize the real value of the debt. As

'Ball, zlDaendorf, and Nankiw (1995) use the historical behavior

of growth rates and interest rates and estimate probability
the
debt-
of
this event at 10 to 20 percent, under the assumption that the
income ratio begins at roughly it current level.
13
long as economic growth does not stop entirely, this policy will
ensure that the debt—income ratio falls over time. Thus, a
permanent tax increase equal to the real interest on the debt is an

upper bound on the future tax burden arising from past budget
deficits, assuming the government chooses to play it safe.

II. THE SIZE OP THE EFFECTS

we now turn from the qualitative effects of budget deficits to
their quantitative importance. Are the effects of deficits on
variables such as GDP and wages large or small? And how important
are these effects compared to other phenomena, such as the
worldwide slowdown in productivity growth? We focus on deficits of
the size experienced in the United States, which has to date
accumulated a debt of about one—half of annual GDP.

A Parable

we have discussed, government debt reduces the growth of

As
GDP because it crowds out capital. To see how different the U.S.
economy would be if there were no debt, consider the following
thought experiment. Suppose that the crowding—out process is
magically reversed. One night, the fairy travels around and
debt
replaces every U.S. government bond with a piece of U.S. capital.
Row different would the world be the next morning when everyone
woke up? After answering this question, we argue that it provides
a good guide to the actual effects of deficits in the United

States.
14
 The debt fairy's actions would affect four key variables: the
burden of debt service, the level of GD?, the real wage, and the

return to capital. The simplest calculation is the reduction in

the debt service.In real terms, the government has to make
interest payments of rID, where D is the debt and r is the real
interest rate. These interest payments must be financed with
In the United
taxes, spending cuts, or additional borrowing.
States, the average real return on government debt is approximately
2 percent. Because debt is about half of GD?, the debt fairy's
generosity would eliminate a debt service of about 1 percent of

GDP.
The replacement of debt by physical capital would also raise

output.
Since the capital stock rises by the level of debt D,

output '1 rises by MPKXD, where MPK is the marginal product of

capital. proportionately, output rises by MPKxD/Y. In the United
States, the capital share is about 30 percent, and the capital—
income ratio is about 2.5, which implies an IIPK of 12 percent.

Thus, the creation of capital by the debt fairy raises gross

domestic product by about 6 percent.4

netermining the effects on real wages and the returns to

capital requires some information about the ton of the aggregate

production function. A standard view is that the production
function is roughly cobb-Douglas. For this production function,

1These calculations ignore the tact that the marginal product

of capital would fall as the level of capital rises. Formally,
this means that our numbers are first—order approximations to the
effects of raising the capital stock.
15
the marginal product of labor, which determines the real wage, is

proportional to output per person. Because output rises by 6

percent and the labor force is unchanged, the real wage rises by 6

percent as well. -

Finally, for a Cobb—Douglas production function, the marginal

product of capital is proportional to the output—capital ratio. As

we have discussed, output rises by 6 percent. For a debt—income

ratio of 0.5 and a capital—income ratio of 2.5, the debt fairy's
intervention raises the amount of capital by 20 percent. Thus, the

output—capital ratio falls by about 20 — 6 = 14 percent, implying

a similar fall in the return to capital. Because the return to
capital is about 12 percent per year, it falls to about 10.3
percent per year. In the longer run over which real interest rates
are tied to the return to capital, real interest rates also fall by

about 170 basis points.

Is This the Right Calculation?

Our goal is to estimate how the U.S. economy would be
different today if the government had always run a balanced budget.

Does the debt-fairy experiment answer this question? The

experiment is exactly right under two assumptions: the economy is

closed, and fiscal policy does not affect the path of net private
saving. With constant saving, the sale of government debt does not
alter the level of private wealth. Each dollar of government debt
in savers' portfolios crowds out a dollar of capital, and there is
no inflow of capital from abroad. Fiscal policy simply substitutes

16
government debt for capital, and the debt fairy reverses this

process.
That if we relax the obviously false assumption of a closed

economy? In an open economy, capital inflows partly offset the

crowding-out of capital by debt. These inflows mitigate the
effects of debt on GDP, the real wage, and the profit rate. For
example, if one—third of the fall in national saving is financed

with a trade deficit (a typical estimate), the fall in the capital

stock is only two—thirds as large, implying that the impacts on GOP

and factor prices are only two—thirds as large as estimated above.5

yet, as discussed earlier, this issue is not important for
calculating the effect of deficits on gross national product.
Because GNP rather than GDP determines the living standards of a
country's residents, the impact on living standards is not much

altered by the capital inflow induced by budget deficits.

It is difficult to evaluate the assumption that private saving

is invariant to fiscal policy. As we have discussed, private

saving probably responds somewhat to public saving, and this effect
reduces the impact of budget deficits. Unfortunately, there is no
consensus on the magnitude of the effect. The Council of Economic

Feldstein (1992) suggests that about 25 percent of a budget

deficit is typically financed by a trade deficit, while the Council
of Economic Advisers (1994) suggests 40 percent. At first glance,
the U.S. experience summarized in Table 1 suggests a larger number,
since most of the fall in national saving after 1982 was financed
by a trade deficit. Yet there are probably other factors that
boosted investment and raised the trade deficit over this period.
The fact that the stock market boomed during a period of high real
interest rates suggests increased investor confidence about future
profitability.
17
Advisers (1994) argues that the offset is close to zero on the
basis of the experience of the 19805: because private saving was
low in the presence of large budget deficits, it is hard to believe
it would be much lover in the absence of deficits. On the other
hand, studies of countries with deficits of varying sizes suggest
a private—saving offset closer to one half (Bernheim, 1987). In
light of this uncertainty, we view the results of our debt—fairy
experiment as an upper bound on the effects of the U.S. debt on
national income, Our best guess for the actual effect is somewhere

between the debt—fairy figure of 6 percent and half of that level.

Are These Effects a Big Deal?

Do the numbers we have presented suggest that budget deficits
are a major economic problem or a minor one? Our subjective
assessment is somewhere in between. Our upper bound for the
effects of past U.S. deficits on current national income is 6
percent. One way to interpret this number is to remember that
average real growth in income per capita in the United States is
about 2 percent per year. Thus reducing GNP by 6 percent is like

giving up three years of growth. In the absence of debt, the

United States would have achieved its 1995 level of income in 1992.

These numbers are certainly significant: 6 percent of current GNP

is about $400 billion. But waiting an extra three years to achieve
any level of income is hardly a disaster.

Another way to gauge the importance of deficits is to compare

their effects to those of other economic phenomena. The United

lB
States and most other industrialized nations have experienced slow
growth for the last 20 years, relative to the previous three
decades. This slowdown in growth is behind the widely publicized
stagnation in living standards for many workers and the resulting
public concern that something is wrong with the economy. The

slowdown in output growth has been caused mainly by slower growth

in total factor productivity. Productivity growth has fallen by
about 1 percent per year, resulting today in a total shortfall
relative to the past trend of about 20 percent. By comparison, the
3 to 6 percent fall in income due to government debt can viewed as

only a moderate problem.

III. DEFICITS AND ECONOMIC WELL-BEING

Having presented a positive analysis of the effects of budget
deficits on aggregate economic variables, we now turn to the
normative questions of whether and why deficits are undesirable.
Popular discussions of deficits usually take it for granted that
deficits are bad for the economy, and perhaps even irimoral.
Although this view can be defended, its justification is less
obvious than one might think.
Economists are often tempted to use GNP as a shorthand measure
of economic well—being. As we have already discussed, budget
deficits do not affect GNP initially and, in the long run, reduce

GNP. 'thus, by the measure of GNP, deficits are unambiguously

harmful. Yet this analysis of deficits is misleading, for economic
well—being depends eli consumption rather than GNP. while deficits

19
do not raise GNP, they do raise consumption in the short run by
lowering households' tax burden.
If one focuses on consumption as the proper measure of well-
being, budget deficits come to look like a particular policy of
income redistribution. Redistributions occur because of the change

in the timing of taxes and because of changes in factor prices.

These redistributions do not harm everyone; instead, some people
gain at the expense of others. The gains and losses sum to zero,
so it is not obvious that deficits are good or bad overall.

Who Wins and Who Loses?

An analogy may be helpful in thinking about the desirability
of deficits, Suppose that Californians become powerful in Congress
and pass a law that reduces taxes in California and raises them in

New York, leaving total taxes unchanged. This law does not benefit

or han the economy as a whole; it merely redistributes income

among people. The direct effect is to benefit Californians and
hurt New Yorkers. There are also likely to be general-equilibrium

effects on the incomes of various groups. For example, the shift

in the tax burden from California to New York will raise the demand

for surfboards and reduce the demand for opera, leading to higher
profits for surfboard manufacturers and lower wages for singers.

These effects are called pecuniary externalities. Assuming that

markets are competitive, these pecuniary externalities sum to zero,

like the direct effects of the tax change.

A policy of running deficits is similar to a pro—California

20
tax refonu: it shifts taxes between groups. Here the shift is not

between taxpayers in different places but between taxpayers at

different times. When the government runs a deficit, it

accumulates debt that it must pay back through future taxation.

Such a policy just shifts the burden of taxes: current taxpayers

gain, and future taxpayers lose.' -.

Like any shift in tax burdens, deficits have general-

equilibrium effects. Here the key effects follow from the crowding

out of capital. The fall in the capital stock affects factor

prices: wages fall, harming workers, and the returns on capital

rise, benefitting capital owners. Like the effects on the

surfboard and opera industries when Californians gain power, the
changes in wages and profit rates are pecuniary externalities. The
losses to workers from lower real wages are balanced by the gains

to the owt,ers of capital from higher rates of profit.

Thus, the winners from budget deficits are current taxpayers
and future owners of capital, while the losers are future taxpayers

and future workers. Because these gains and losses balance, a

policy of running budget deficits cannot be judged by appealing to
the Pareto criterion or other notions of ecønomic efficiency.

As discussed earlier, it is possible that a government might

attempt to run a Ponzi scheme by forever rolling over its debt and
accumulating interest. If such a scheme succeeds, then deficits do
not lead to higher future taxes. In this case, a policy of running
deficits can yield a Pareto improvement, for current taxpayers
benefit without any loss to future taxpayers. This possibility,
however, should not be construed as an argument in favor of budget
deficits, f or an attempted Ponzi scheme may fail, in which case the
future tax increases are especially large and painful. For further
discussion of these issues, see Ball, Elmendorf, and Mankiw (1995).
21
Instead, the key issue is whether we approve of the direction of

the redistributiOns that this policy implies.

Are the Redistributions Desirable?

Economists are not good at judging redistributions of income.
Indeed, they often claim that this issue is outside of the sphere

of economics altogether. It is, therefore, somewhat surprising

that economists decry budget deficits with such consensus and
assurance.

One widely accepted standard for judging redistributions is

the ability—to—pay principle: redistributions of income are
desirable if they go from better—off to worse—off people. By this

criterion, the redistributions arising from changes in factor

prices are undesirable. Many people hold little wealth and consume

the income from their wages, while a small part of society holds
most of the economy's wealth. When crowding—out raises the returns
on capital and reduces wages, the wealthy gain at the expense of

the less wealthy.

Yet, from the standpoint of the ability—to—pay principle, the

direct effect of budget deficits——the change in the timing of

taxes——is harder to reconcile with the conventional view that
deficits are undesirable. Because of technological progress, the
income and consumption of a typical individual in the economy rises
over time. Because budget deficits shift taxes forward in time,

they benefit relatively poor current taxpayers at the expense of

relatively rich future taxpayers. If reducing inequality is a goal
22
of policy, shouldn't budget deficits be applauded?
One way to answer this question is to go beyond neoclassical

economic theory. Although standard models assume that people

desire to smooth consumption evenly over time, popular discussions

of economic policy presume that consumption should rise over time.

Politiciansoften assume a moral imperative that the current

generation sacrifice to ensure that future generations enjoy a
substantially higher standard of living. This view suggests that
it is undesirable to shift a tax burden onto our children, even
though our children will be better able to shoulder that burden

than we are.
Another possible answer is that levels of taxation should be

based on the benefits principle, which holds that people should pay

for the government benefits that they receive. For example, the

use of a gasoline tax to pay for road repair is not based on the
abilities to pay of drivers and non—drivers; instead, it is
justified on the ground that drivers should pay for roads because
they benefit from them, Similarly, one might argue that each
generation should pay for the government it provides itself,
regardless of its level of income.
These issues are not easily resolved. Yet one point is clear:
saying whether and why deficits are undesirable requires judgeaents
that are more philosophical than economic.

Should You Worry About Deficits?

A related question is whether an individual needs to rely on

23
politicians to avoid the future suffering caused by budget
deficits, suppose you are worried about the effects of deficits on
your children, and aren't confident that Bill Clinton and Newt
Gingrich will take care of the problem by balancing the budget.
You can eliminate your worries simply by saving and leaving a
larger bequest to your children, so that they can bear the burden

of future taxes without reducing their consumption.

Some economists——advocates of Ricardian equivalence——claim
that people do in fact behave this way. If this were true, private
behavior would fully offset the effects of public dissaving.
Although we doubt that most people are so far—sighted, some people
probably do act this way, and anyone could. Deficits give you the
chance to consume more at the expense of your children, but they do

not require it.'

Indeed, if you are forward—looking and care about your
children, deficits can benefit your family. You can insulate

yourself from the effects of tax shifting through a larger bequest.

And, since you are accumulating more capital than the typical
family, you and your children are among the winners from deficit—

induced changes in factor prices. That is, you benefit from the
higher rates of return that deficits cause.

so why should you the reader——a person who we assume both

loves his children and understands the effects of deficits——worry

about balancing the budget? Once again, answering this question

requires going beyond standard economic theory. One possible

Herschel Grossman (1995) makes a similar argument.

24
answer is paternalism. You can protect your children from
deficits, but you know that some irresponsible parents will exploit
their children to raise their own consumption. You may care about
protecting these children's standard of living even though their

own parents do not.

Alternatively, there may be externalities from the effects of

deficits that do not appear in standard economic models. Paul

Romer (1987) and, more recently, Bradford Detong and Lawrence

summers (1991) have suggested that the accumulation of capital
stimulates technological change and increases economy—wide

productivity. If so, then the crowding—out caused by deficits

depresses national income by more than our calculations above
suggest. In addition, no single family can insulate itself from
these effects through higher private saving.
Another possible externality may arise from the distribution

of income. As discussed earlier, deficits redistribute income from

wage—earners to capital owners, creating greater dispersion in

wealth and income. Perhaps widening inequality is undesirable even

for the rich. A large poor population might raise crime rates and
otherwise threaten the living standards of the wealthy. The fact
that most people——both rich and poor—-prefer to live in rich
communities suggests that people care about their neighbors' living

standards for not entirely altruistic reasons.

A related consideration is that people often care about the
incomes of their fellow citizens relative to citizens of other

countries. If large deficits reduce the U.S. growth rate, the

25
average American standard of living may fall behind that in Japan.

It is not obvious why this matters——why we do not care just about

our own standard of living. Perhaps a nation's relative income
matters because it affects some sense of national prestige.
Perhaps it matters because it affects national power in world

politics. Again, judging the desirability of deficits leads to

questions that economists are not particularly qualified to
address.

IV. A HARD LANDING?

Numerical results suggest that the effects of budget deficits
are moderate in size. Moreover, since there are winners as well as

losers, it is not obvious that deficits are undesirable overall.

These conclusions suggest that popular concerns about budget

deficits are overblown, at least when the national debt is at its

current U.S. level relative to national income.

Matters start looking more serious if one looks ahead to
future fiscal policy. There are reasons to worry that debt—income

ratios are headed upwards around the world. Many countries,

including the United States, project large deficits because of
growing expenditures on programs for the elderly, such as Social

Security and Medicare. According to some projections, under

current programs, the U.S. debt—income ratio will reach five in
2025! Of course, the future is uncertain: we may be saved from
rising debt—income ratios by fiscal tightening or by good luck such
as high growth in income or containment of medical costs. But what

26
if the debt—income ratio does keep rising?
Part of the answer is clear: the effects we have already

discussed are magnified. We have calculated that past U.S.

deficits——which have produced a current debt—income ratio of about
one—half—-redUce current gross national product by 3 to6 percent.
If the ratio rises to one, the effect will rise to 6 to 12 percent.

Yet, if the debt—income ratio continues to rise, there may

also be additional effects which are qualitatively different from
those the economy is now experiencing. In particular, a rising
debt—income ratio in a country may at some point lead to a sharp
decrease in demand for the country's assets arising from a fall in
investor confidence. In this section, we discuss how such a "hard

landing" night come about and the possible effects on the economy.

our discussion is necessarily speculative. As far as we know, no

major industrialized country has ever experienced a hard landing of

the sort we will describe. But keep in mind: no major

industrialized country has persistently run large budget deficits

in peacetime——until recently.'

How a Hard Landing Might Occur

Why the demand for a country's assets fall? There are
might
two distinct but complementary stories about how a rising national
debt could lead to lower demand for domestic assets.

The first story emphasizes the effect of deficits on a

Here we draw on previous discussions of hard landings by

Icrugman (1991, 1992) and Summers (1991).
27
country's net—foreign—asset position. As we have discussed, budget
deficits tend to produce trade deficits, which a country finances
by selling assets abroad. Yet there may be limits to the quantity

of domestic assets foreigners are willing to hold. For various

reasons (such as lack of information, exchange—rate risk, or sheer
xenophobia), international diversification is far from perfect.
This fact is consistent with the finding of Feldstein and Horioka

(1980) that a country's saving roughly balances its investment over

long periods. As a country's net—foreign—asset position

deteriorates, foreign investors may become less and less willing to

purchase additional domestic assets.

A second story is that a rising level of government debt makes

investors fear government default or a similar policy aimed at
holders of domestic assets. Unlike the first story, this story is
relevant even if a country has not reached a negative net—foreign
asset position. And in this story, domestic as well as foreign
investors flee domestic assets.
In speculating about a loss of investor confidence, one is
naturally led to draw on the experience of the debt crisis in less

developed countries during the 1980s. (The case of Mexico in 1994

is less relevant, because it involves imprudent monetary and

exchange—rate policy as well as debt.) In the LDC debt crisis,
capital inflows in the f on of bank loans dried up when countries

began having trouble servicing their debts, leading to fears of

widespread default. It is tempting to imagine that this experience
is not relevant to countries like the United States——that rich

28
countries would never default. But Orange County, California is
even richer than the United States, and it is about to default on

its debt. Orange County voters, turning down a tax increase needed
to honor the debt, appear to reject the idea that they should pay

for their government's mistakes. It is easy to imagine such

arguments at the national level——or at least a fear on the part of

investors that such arguments will arise.

There is, however, a reason that the IJDC debt crisis is an
imperfect guide to hard landings in the United States or European
countries. The Latin American debt was external: it was owed to

foreigners. Thus the direct effect of default was a loss to

foreigners, making default a relatively attractive way out of a
fiscal crisis. The same is true for Orange County: most of its
debt was owned outside of the county. In the United States, by
contrast, most of the national debt is owned by American citizens.

Since an internal debt makes default less tempting, it is

likely to delay a hard landing: it takes a higher level of debt to
spook investors. The fact that a debt is internal also affects the

nature of the prospective policies that might spark a hard landing.

If the debt—income ratio spins out of control, something must be

done or default is unavoidable. And it might remain impossible
politically to raise income taxes sufficiently. One possible

outcome is a general tax on wealth. The government might require

owners of its bonds to "share in the sacrifice" through partial

default, but it would also tax the holders of other assets. The
tax could extend to foreign owners of domestic assets to reduce the

29
burden on domestic citizens.

An unsustainable path of debt and a worsening net foreign

asset position could lead investors to fear other unpleasant
consequences as wall. Extensive foreign ownership of u.s. assets
could lead to restrictions on capital outflows. Perhaps as debt
grows and wages fall relative to those of other countries,
political outrage will produce a government that increases
interference in the economy. Many U.S. politicians, for example,
are tempted to blame domestic problems on Japanese trade practices;
a trade war is not an unthinkable result of a general decline in

living standards. Similarly, many less developed countries have

unhappy histories in which economic problems create political
pressures for policies that discourage investment and make the
problems even worse. Fear of these outcomes——or just a belief that

something bad must happen if debt continues to grow——could lead to

a fall in the demand for domestic assets.

In principle, the decrease in demand for domestic assets could

be gradual, with the assets slowly becoming less popular as the

fiscal situation deteriorates. The history of financial markets
suggests, however, that shifts in investor confidence can be
sudden, with the timing driven by self-fulfilling expectations. A
flight from domestic assets could occur at a seemingly arbitrary
point in time, much as the 1987 stock market crash did. Or a hard

landing could be triggered by adverse events. In the Latin

American case, the worldwide recession of the early 1980s caused
investors to revise downward their expectations of growth and,

30
hence, the likelihood of repayment. similarly, a crisis in the
United States might be triggered by bad news about income growth,
which would imply higher debt—income ratios for given fiscal

policies.
since a hard landing involves the psychology of markets, it is

hard to judge when it might occur. The debt crisis hit Latin
jnerican countries with debt—income ratios below the current U.S.

level of one halt, but these countries had external debts and hence

a greater temptation to default. In addition, interest rates were

much higher for the Latin debt than for the U.S. debt, so the path

of debt was potentially more explosive. High debt—income ratios in

developed countries have previously occurred only in wartime, when

they were clearly temporary. Recent peacetime increases in the

ratio are taking the United States and other countries into
uncharted territory, so it is impossible to say whether a hard
landing is around the corner or still far off.

The Costs of a Hard Landina

If confidence in a country's assets collapses, what happens to

the economy? Theory and the experiences of LDCs gives some guide
as to the effects. The decline in the demand for domestic assets
leads to a sharp fall in the prices of these assets, including a
fall in the stock market. Interest rates and other asset yields
rise. The value of the domestic currency falls as investors sell

the currency they acquire from selling domestic assets. As the

currency depreciates, the trade balance turns sharply toward

31
surplus, and capital flows out of the country.
Such a hard landing potentially hans an economy in many ways.
Most obviously, wealth falls because of the decline in asset
prices. The lack of investor confidence and higher interest rates

lead to lower levels of physical investment1 and eventually a lower

capital stock. This effect exacerbates the decline in real wages

caused by budget deficits.

A number of other consequences might follow as well. Indeed,
hard landings are hard to think about because things can go wrong
in such a rich variety of ways. First, the rise in interest rates

during a hard landing would likely exacerbate the fiscal crisis by

causing the debt to grow rapidly. To avoid a greater disaster, the

government would have to shift abruptly to primary budget
surpluses, causing a sharp fall in consumption. That is, high
interest rates would eliminate the possibility of growing out of a

debt or paying it off slowly.

Second, the Latin American experience suggests that the shift

in the trade balance towards surplus would be a major sectoral

shock. The debt—crisis countries experienced a large shift from
non—tradeables to tradeables, causing high unemployment in non—
tradeables. According to some observers, the sectoral shock
brought growth to a standstill for a decade. (Sachs and tarrain,

1993)
Third, the hard landing could lead to inflation through two
distinct channels. The drop in the domestic currency would
directly push up the prices of iriports, which could trigger

32
continuing inflation if monetary policy is accommodative. And, in
response to the fiscal crisis, the monetary authority may feel
increased pressure to raise revenue through money creation. Both
these effects were important in producing high inflation in Latin

America after the debt crisis. We can hope that the central banks

of developed countries would hold the line against inflation even

in a crisis. But if the crisis brings extremists to power, who
knows?
Finally, a hard landing could trigger a general financial
crisis. Declines in asset prices and increases in fins' interest

burdens would increase bankruptcies. Bankruptcies of firms could

trigger financial distress for the banks that to then. In the
lend

worst case, these problems and the resulting contraction of credit

would build on each other and financial intermediation would break
down. As in the 1930s, the economy could plunge into a Depression.

A Call for Prudence

Previous sections of this paper have described well—understood

and quantifiable effects of budget deficits, such as crowding—out
of capital and intertemporal shifts in tax burdens. By contrast,
this section has been highly speculative. We can only guess what
level of debt will trigger a shift in investor confidence, and
about the nature and severity of the effects. Despite the

vagueness of fears about hard landings, these fears may be the most

important reason for seeking to reduce budget deficits. If the

main effects of deficits are moderate redistributions across

33
generations and groups of people, perhaps they should not be a
central concern of policyrnakers. But as countries increase their
debt, they wander into unfamiliar territory in which hard landings

may lurk. If policyrnakers are prudent, they will not take the
chance of learning what hard landings in G7 countries are really

like.

34
References
Bali, Laurence. N. Gregory Mankiw, and Douglas W. Elmendorf, "The
Deficit Gamble," NBER Working Paper No. 5015, February 1995.
Bernheim, B. Douglas, "Ricardian Equivalence: An Evaluation of
Theory and Evidence." NBER Macroeconomics Annual 2 (1981),

263—304.
council of Economic Advisers, Economic Renort of the President,

1994.

Detong, J. Bradford, and Lawrence H. Summers, "Equipment Investment

and Economic Growth,' Ouarterlv Journal of Economics 106

(1991), 445—502.
Feldstein, Martin, "The Budget and Trade Deficits Aren't Really
Twins," NBER Working Paper Mc. 3966, January 1992.
Feldstein, Martin, and Charles Horioka, "Domestic Saving and
International Capital Flows," Econonic Journal 90 (1980), 314—

29.

Friedman, Benjamin M., Day of Reckoning: The Conseauences of

American Economic Policy Under Reagan and After, Random House,

1988.

Gramlich, Edward M., "Budget Deficits and National Saving: Are

Politicians Exogenous?" Journal of Economic Perspectives 3
(spring 1989), 23—35.
Grossman, Herschel I., "American Fiscal Policy in the 1990s," NBER
Working Paper No. 5109, May 1995.
Erugman, Paul "Financial Crises in the International Economy," in

35
 Martin FeldstCifl, ed., The Risk of Economic Crisis, The
University of Chicago Press, 1981.

Krugman, Paul, The Age of Diminished Expectations: U.S. Economic

Policy in the 1990s, MIT Press, 1992.

Romer, Paul, "Crazy Explanations of the Productivity slowdown,"

NBER Macroeconomics Annual, 2 (1987), MIT Press.

Sachs, effrey D., and Felipe Larrain B., Macroeconomics in the

Global Economy, prentice Hall, 1993.
Suriuners, Lawrence H.,"Planning for the Next Financial Crisis," in

Martin Feldstein, ed., The Risk of Economic Crisis, The

university of Chicago Press, 1981.

36