How Real is the Federal Deficit?

HOW REAL Is the Federal Deficit?

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This book is a work of fiction. Any references to historical events, real people, or real locales are used fictitiously. Other names, characters, places, and incidents are products of the author’s imagination, and any resemblance to actual events or locales or persons, living or dead, is entirely coincidental.

Copyright © 1986 by The Free Press

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Library of Congress Cataloging-in-Publication Data

Eisner, Robert.

How real is the federal deficit?

Bibliography: p.

Includes index.

1. Budget deficits—United States.  I. Title.

HJ2051.E37  1986   339.5′23′0973   86-1076

ISBN 0-02-909430-5

ISBN-13: 978-0-0290-9430-3

eISBN-13: 978-1-4391-3859-5

You and I, as individuals, can, by borrowing, live beyond our means, but only for a limited period of time. Why then do we think that collectively, as a nation, we are not bound by that same limitation? For decades we have piled deficit upon deficit, mortgaging our future and our children’s future for the temporary convenience of the present. To continue this long trend is to guarantee tremendous social, cultural, political and economic upheavals.

—Ronald Reagan, Inaugural Address, January 20, 1981

For every buyer there must be a seller, and for every lender a borrower. One man’s expenditure is another’s receipt. My debts are your asset, my deficit your surplus.

—James Tobin, Nobel Laureate in Economics, in National Economic Policy, 1966

Blessed are the young, for they shall inherit the national debt.

—Herbert Hoover

Contents

Tables and Figures

Preface

Acknowledgments

1. Debt and Deficits: Curse, or Blessing in Disguise?

2. Tricks Played by Inflation

3. Capital Budgeting or Its Lack—and the Nation’s Wealth

4. A Variety of Deficits

5. Deficit, Deficit, Who’s Got the Surplus?

6. Deficits and the Economy: The Theory, Part I

7. Deficits and the Economy: The Theory, Part II

8. Deficits and the Economy: The Facts

9. More Facts: A Statistical Analysis

10. Deficits and the Rest of the World

11. The Deficit, the Cost of Capital, and Wall Street

12. Implications for Policy: Past, Present, and Future

13. Implications for the Disarray in Macroeconomics

14. Where It All Gets Us: A Summing Up

Appendices:

A. Appendix to Chapter 7

B. Additional Tables

C. Sources and Methods

Notes

References

Index

Tables and Figures

2.1 Market-to-Par Indices

2.2 The Budget Deficit, Gross Public Debt, and Market Value of Net Debt, 1980, 1984

2.3 Federal Budget Surpluses and Deficits, and Gross Federal Debt, Fiscal Years 1929-84

2.4 Federal Government Net Debt, Market Values

2.5 The Real Value of Federal Debt, 1945-84

2.6 Federal Budget Surplus or Deficit and Change in Real Net Debt

3.1 Assets, Liabilities, and Net Worth, General Motors and IBM, 1970, 1980, and 1984

3.2 Federal and Other Debt as Percentage of GNP

3.3 Federal Government Net Debt and Net Worth

3.4 Current and Capital Federal Accounts, 1984

4.1 Federal Government Receipts, Expenditures, and Surplus or Deficit, National Income Accounts, 1980-84

4.2 Federal Liabilities and Contingency Obligations

5.1 Gross Public Debt of U.S. Treasury by Holder

5.2 Surplus and Deficit (−) by Sector, 1945-84 (Billions of Dollars)

5.3 Surplus and Deficit (−) by Sector, 1945-84 (Percent of GNP)

6.1 Burden of the Debt: Earnings

6.2 Burden of the Debt: Saving

7.1 The Debt and Aggregate Demand

7.2 Burden of the Debt: Future Taxes

8.1 Federal Receipts and Outlays, and Surplus or Deficit as Percentage of Outlays and GNP, Fiscal Years 1929-84

8.2 Actual and High-Employment Federal Budget Surpluses and Deficits on National Income Account, 1955-84

8.3 High-Employment Surplus as Percentage of GNP, 1955-84

8.4 High-Employment Surpluses and Deficits, and Growth in GNP, 1967-84

9.1 High-Employment Budgets and Changes in Real GNP and Unemployment

9.2 High-Employment Budgets and Changes in Real GNP and Unemployment, Distributed Lags

9.3 High-Employment Budgets, Changes in Monetary Base, and Changes in GNP

9.4 High-Employment Budgets, Interest Effects, and Changes in Monetary Base and GNP

9.5 High-Employment Budgets, Price Effects, Delayed Interest Effects, and Changes in Monetary Base and GNP

9.6 High-Employment Budgets, Interest Effects, and Changes in Monetary Base and Unemployment

9.7 High-Employment Budgets, Price Effects, Delayed Interest Effects, and Changes in Monetary Base and Unemployment

9.8 High-Employment Budgets, Changes in Monetary Base, and Changes in Components of GNP

9.9 High-Employment Budgets, Changes in Monetary Base, and Changes in Five Components of GNP

10.1 General Government Net Financial Assets (+) or Debt(−), 1970, 1982

10.2 Price Effects on Government Financial Assets (+) or Debt (−), 1970-82

10.3 Measures of the General Government Surplus or Deficit (−), 1970-82

10.4 Own High-Employment Budgets, Unadjusted and Price-Adjusted, Time Series

10.5 U.S. High-Employment Budgets, Unadjusted and Price-Adjusted, Time Series

10.6 U.S. and Own High-Employment Budgets, Unadjusted and Price-Adjusted, Time Series

10.7 Own and U.S. High-Employment Budgets, Unadjusted and Price-Adjusted, Pooled Cross Sections and Overall Regressions

10.8 Own and U.S. High-Employment Budgets, Unadjusted and Price-Adjusted, Pooled Time Series Excluding U.S.

10.9 Unadjusted and Price-Adjusted High-Employment Budgets and Real Rates of Growth of GNP, Means and Standard Deviations by Country and Year, 1971-76

11.1 Deficits and the Dow Jones

11.2 Deficits, Interest Effects, and the Dow Jones

12.1 Projected High-Employment Budget Surplus or Deficit, and GNP Without Deficit Reductions, 1985-90

12.2 Projected High-Employment Budget Surplus or Deficit and GNP, on Basis of Fiscal 1986 Congressional Budget Resolution, 1985-90

12.3 Projected High-Employment Budget Surplus or Deficit and GNP, on Basis of Gramm-Rudman

B.1 Assets, Liabilities, and Net Worth, Total Government, 1945-84

B.2 Assets, Liabilities, and Net Worth, Federal, 1945-84

B.3 Assets, Liabilities, and Net Worth, State and Local, 1945-84

B.4 Assets, Liabilities, and Net Worth, Total Government, Current Dollars Divided by GNP Price Deflator, 1945-84

B.5 Assets, Liabilities, and Net Worth, Federal (Current Dollars Divided by GNP Price Deflator), 1945-84

B.6 Assets, Liabilities, and Net Worth, State and Local (Current Dollars Divided by GNP Price Deflator) 1945-84

B.7 Actual Budget Surplus, 1955-84 (Billions of Dollars)

B.8 High-Employment Surplus, 1955-84 (Billions of Dollars)

B.9 Actual Budget Surplus, 1955-84 (Billions of 1972 Dollars)

B.10 High-Employment Surplus, 1955-84 (Billions of 1972 Dollars)

B.11 Actual Budget Surplus, 1955-84, as Percentage of GNP

B.12 Federal Government Net Worth, 1945-84

B.13 State and Local Government Net Worth, 1945-84

B.14 Market-to-Par Indices: Treasury Bills, Notes, and Bonds; Mortgages; and State and Local Bonds

B.15 Percentage Changes in Dow Industrials and Changes in Budget Surplus as Percentage of GNP, 1956-84

B.16 Monetary Base, GNP, and Unemployment, 1955-84

8.1 Official and Price-Adjusted High-Employment Budget Surplus

8.2 Lagged Price-Adjusted High-Employment Deficit and Change in GNP

8.2A Lagged Price-Adjusted High-Employment Surplus and Change in GNP, 1967-84, Scatter

8.3 Lagged Price-Adjusted High-Employment Surplus and Change in Unemployment

11.1 Changes in Dow Industrials and Price-Adjusted Deficit

11.2 Changes in Dow Industrials and Two-Year Mean Price-Adjusted Deficit

11.3 Changes in Dow Industrials and Price-Adjusted High-Employment Deficit

Preface

Popular perceptions of governmental deficits reflect more in the way of personal predilections and political posturing than scientific insight. But economists are human, and we too have been influenced by private and political passions. Misled or ill-armed by our own figures and data, we have too often misapplied theoretical economic analysis, or abandoned it.

While this work builds on the Keynesian model of the determinants of income and employment, it infuses that model with the traditional neoclassical emphasis on the role of real wealth and abhorrence of money illusion. It is aimed at economists and noneconomists of all schools and political persuasions.

The pages that follow support old theory with new data, or with new, corrected measures of old data. They will give comfort to those who, if only in the closet, have continued to identify themselves with established formulations. They should give pause to those who have marched to new drummers.

Robert Eisner

December 1985

Acknowledgments

A series of grants from the National Science Foundation have offered critical support to the research on which this book is based. Initial estimates of real budget deficits were prepared for the Council of Economic Advisers in 1981 and were incorporated in the Economic Report of the President February 1982.

A great deal of my research on this subject has been done in collaboration with Paul J. Pieper. I am most indebted to him for his contributions to our joint work as well as to this current effort. And I am grateful to the American Economic Review, The Public Interest, the Journal of Macroeconomics, and the North-Holland Publishing Company for permission to incorporate parts of my own papers and the articles that I have co-authored with Professor Pieper. Sang-In Hwang has been an indefatigable and extraordinary research assistant along the entire path from computer to tables to text. I am also indebted for assistance along the way from Steve Zimmer, George Houlihan, and John Keating. Molly Fabian has done her usual superb job in typing the manuscript and myriad tables.

I have received most useful, detailed comments from Alan Blinder and useful comments as well from Gardner Ackley, Michael J. Boskin, Mary Eccles, Edith C. Eisner, Robert Heilbroner, Paul McCracken, Joseph Pechman, Frank S. Russek, Mary Alice Shulman, Lester Thurow, James Tobin, and Murray Weiden-baum. Credit for help or comments with regard to earlier papers and articles is due to Lawrence Kotlikoff; Elizabeth Fogler and John Musgrave; John J. Seater, W. Michael Cox, and Eric Hirsch-horn; Otto Eckstein, H. S. Houthakker, and Allen Sinai; and Moses Abramovitz, E. Cary Brown, Paul Evans, Benjamin Friedman, Robert J. Gordon, Bert G. Hickman, Frank de Leeuw, Frederick Mishkin, Dale T. Mortensen, and George Neumann; and to anon-ymous referees. I am especially indebted to copy editor Ann Hirst and Edith Lewis of The Free Press for their fine and painstaking work in editing final copy.

And my thanks finally to Grant Ujifusa of The Free Press for convincing me of the value of presenting my formulations and findings in this forum, and helping me do it.

In particular, NSF grants SES-7717555 and SES-8200324 for the development of expanded measures of national income (the Total Incomes System of Accounts) and, currently, grant SES-8409793 to examine Inflation and the Adjustment and Impact of Fiscal Variables. The National Science Foundation is, of course, in no way responsible for the particular contents of this book or the views I express therein.

1

Debt and Deficits: Curse, or Blessing in Disguise?

THERE HAS ALWAYS BEEN a certain amount of hysteria surrounding the federal debt and deficits. Politicians and pundits compete in their proclamations of future disaster and the attribution of its causes.

Meanwhile, for most of the American public, debt and deficits are like sin: morally wrong, difficult to avoid, but not easy to keep track of. Our federal deficits have each year been adding huge, $200 billion chunks to the national debt. The sheer magnitude of that debt, currently approaching $2 trillion, suggests to some the danger of national bankruptcy.

Yet, election after election, from the early days of Franklin Roosevelt’s presidency on, Republicans have traditionally cried out against budget deficits with little apparent success, either substantively or politically. Walter Mondale tried to reverse field and lead Democrats in a similar crusade in 1984. His failure is well-remembered recent history.

A few short years before, the Carter Administration, faced with seemingly explosive inflation, reacted sharply to the then supposedly large federal deficits believed responsible. It tightened fiscal policy and encouraged tight money as well. Carter thus further weakened a sluggish economy and contributed to his own demise.

Those Carter policies, we shall show, were based on false intelligence, misread by friend and foe alike. They were unnecessary and misguided. In fact, we did not have real federal budget deficits from 1977 to 1980.

The new Reagan Administration in 1981, in the name of combatting inflation, continued the Carter policies. But it did so with sufficient dedication and efficiency to bring on the worst recession since the Great Depression of the 1930s. Business investment and profits plummeted, and unemployment rose to a post—World War II record of 10.7 percent of the labor force. We counted almost ten million Americans unsuccessfully looking for jobs, and millions more too discouraged to look further, or only partially employed for economic reasons.

And then came an economic miracle. We began to run really huge budget deficits, and the economy recovered sharply. A new Reaganomics and hitherto unheralded preachers of a supply-side gospel claimed credit.

But what really happened? Did the recovery take place despite the great move to very large deficits, as traditional budget balancers might insist? Were the deficits essentially irrelevant, as monetarists tell us? Or is there something else to the story—something basic and fundamental?

The real story is that federal budget deficits can have great consequences for the economy. Startling as this may seem, these may be good as well as bad. And deficits can be too small as well as too large. We cannot begin to know the consequences of deficits until we measure them correctly.¹

And because we have not measured deficits correctly, we have confused economic analysts, turned economic theory on its head, and committed grievous errors in economic policy. If we continue to act this way, we court future disaster.

When World War II brought us an early bout with inflation, a popular song had it that A dollar ain’t a dollar any more. The refrain in recent years could be put another way, that A deficit ain’t a deficit any more.

Why? Because inflation plays many tricks, and one of its biggest has been largely overlooked in the mounting rhetoric over budget deficits. That trick, simply enough, is that as inflation wipes out the value of money, it also wipes out the value of debt. As it does that, it profoundly alters the significance of conventional ways of measuring the deficit.

Accordingly, meaningful correction for inflation can cause a dramatic shift in understanding. Deficits which have appeared to be enormous can turn out to be moderate. Moderate deficits may even be converted into surpluses!

Mismeasuring deficits, we have confused economic policy and theory alike. We think we have deficits when we do not, and take counteractions that cause recessions. We further see consequences of what we call deficits belying the predictions of economic theory, and question and repudiate our theory.

Inflation, however, is not the only source of our confusion about the deficit. The federal government has a strange accounting system. It differs not only from that of private business, but also from that of state and local governments. Every large corporation, just like the State of California under Ronald Reagan, distinguishes between current and capital expenditures. Every individual sensibly managing his own finances must so distinguish. Our official measures of the federal deficit do not.

Why make the distinction? Because it makes a difference whether a family’s outgo exceeds its income—a deficit—because of gambling losses in Las Vegas or the purchase of a new home. Business investment in excess of retained earnings is applauded as contributing to economic growth. But by federal government accounting practice, AT&T, General Motors, IBM, and many other companies would be guilty of deficit financing. And so, indeed, would most of our state and local governments, which by their own accounting generally show balanced budgets or tidy surpluses.

The reason for all of these anomalies? The federal government, alone, does not differentiate between capital and current expenditures.

There is much more to the story that too often escapes public understanding. For example, for every borrower there must be a lender. In other words, the federal deficit is someone else’s surplus. If the government can be viewed as getting poorer by going into debt, then the individuals, businesses, and state and local governments that acquire the debt are getting richer. This has profound effects on private spending and saving and on the health of the economy. But again, to know the effects, we have to make our measures correct.

As the federal government runs deficits, it presumably increases its debt. But construction and analysis of federal balance sheets yield some anomalous findings. With all the deficits, the general trend of real federal debt—the debt adjusted for inflation—has been downward. On a per capita basis it has indeed gone down very sharply over most of the last forty years. And the government’s net worth, the difference between its assets—financial and real—and its liabilities, has moved from red to black.

All of this illuminates a fiscal landscape substantially different from that portrayed by today’s headlines. The struggles of Administration and Congress, the battles of former budget chief David Stockman and chief economic advisor Martin Feldstein appear in a different light. And so too do the clashing positions of presidential hopefuls, Senate Majority Leader Robert Dole and Congressman Jack Kemp.

Corrected measures of debt and deficits also demand major revision of recent economic history. The indictment of twenty years of economic mismanagement leveled by this Administration at its predecessors proves wide of the mark, but other crucial policy errors come to light. The initial economic failures and subsequent recovery of Ronald Reagan’s first term get new explanations, at considerable variance from official interpretation.

Revising our view of the past, we gain new insights into what to do about the future. Corrected perceptions of our true budgetary posture suggest the need for policies sharply different from those most loudly advocated in Washington and on Wall Street.

As a basis for a new approach, we develop corrected measures of government debt and deficits. Conventional, official accounting deals in nominal and par values, regardless of what securities are really worth. We correct this accounting for changes in market values of assets and liabilities due to changing interest rates and changes in real values due to inflation. We thus derive real market measures relevant to the course of the economy.

We can then see the implications of a consistent set of federal accounting rules, distinguishing between expenditures for current consumption and those that entail investment in the nation’s future. This leads beyond capital budgeting to a broad view of all public assets and liabilities, long-term as well as short-term, financial and real, tangible and intangible.

Such new measurement lays the groundwork for new analysis. After reviewing the state of economic thinking on the effects of debt and deficits upon the economy, we can look at the facts. A statistical study confirms that deficits are very important, more important than our old, faulty measures indicated. And as a consequence of all this, our analysis has import for much of the disarray in modern macroeconomic theory. Correct measures of debt and deficits clear a path through the thickets of confusion shaped by the varying claims of monetarists, supply-siders and the apostles of market-clearing rational expectations. In so doing, they open the way to a new Keynesian-neoclassical synthesis.

To know how deficits matter we not only have to measure them correctly. We also have to understand their real role in the economy.

Of fundamental importance to this understanding is the notion that the federal debt, however frequently viewed as a burden to the government or to future taxpayers, is wealth to those who own it. Whatever their concerns for the government’s fiscal responsibility, the holders of all those deficit-financing Treasury notes, bills, and bonds feel richer for having them. And the richer they feel, the more they try to spend now and plan to spend in the future.

Since federal deficits add to federal debt, which thus adds to private wealth, they can be expected to increase aggregate demand, or spending. If the economy is booming along at full employment of its resources, further increases in demand raise prices and encourage inflation. But if there is slack in the economy, deficit-induced demand stimulates output and employment.

But for deficits to matter they must be real deficits. A real deficit is one which increases the real net debt of the government to the public and hence increases the public’s perception of its own real wealth. Thus the vital importance of the inflation correction. For inflation in effect generates an inflation tax, eating away the value of the public’s holdings of those Treasury notes, bills, and bonds, or the cash which they back.

We all know that inflation accelerated sharply in the Water-gate Nixon years from 1972 to 1974, and again from 1977 to 1980, during the Carter Administration. In each case, associated higher interest rates reduced the market value of outstanding Treasury securities and higher prices further cut their real worth. The precipitous decline in real market value of the debt