06/03/2010 03:39 pm ET | Updated May 25, 2011

Selling the Deficit: When Austerity Matters

Over the past month, the blogosphere has born witness to a heated debate regarding the sustainability of fiscal deficits in the United States. On the left, economist Paul Krugman continues to defend the sustainability of US fiscal deficits, claiming that more deficit spending is needed to combat leftover cyclical unemployment from the global financial crisis. On the right, former advisor to President Bush Greg Mankiw argues that Obama's 2011 budget leads to deficits that grow faster than the economy. Mankiw cites the Congressional Budget Office, which forecasts the US' debt-to-GDP ratio will be approximately 80% by 2020 - the highest level since immediately after World War II. Ultimately, this debt overhang could lead to rising interest rates, a plummeting value of the dollar, and deep recession.

Depending on one's persuasion, the outcome of this debate is of paramount importance. Social liberals who prefer ever-extensive welfare provisions from the federal government see short-term deficits as a necessary cost to creating a morally just society. Staunch conservatives and libertarians see rising deficits as not only a road to economic ruin, but also as a force that could undermine individual liberty.

While the debate has been framed as whether or not deficits matter ever, I would argue that this is a false dichotomy. Instead, I believe that sometimes, deficits matter.

While this is a complicated debate, the sustainability of deficits hinges on one factor: the willingness of investors to finance them. As long as investors are willing to purchase the Treasury bonds, thereby lending to the government, the United States could theoretically refinance its debt ad infinitum, never having to worry about paying down the principal balance.

Prominent economist James K. Galbraith contends that a proxy for the United States' creditworthiness is the interest rate on long-dated Treasury bonds. If creditors, or buyers of Treasury bonds, were worried about the ability of the government to repay them, then they would demand a higher interest rate in exchange for lending to the United States. Galbraith shows that empirically, despite these rising deficits, interest rates have remained at historic lows.

The central divergence between deficit hawks and deficit doves depends on their belief of whether or not interest rates will remain low, despite rising total debt levels.

To answer the deficit question, it is necessary to understand who finances the US federal deficit. A report released by the non-partisan Congressional Research Service shows that 50% of outstanding federal debt is owned by private investors in the United States, while foreign holders own the other 50%. Of the foreign holders, China accounts for about 25%, Japan 21%, Oil exporters 6%, and the United Kingdom 5%. Thus far, these countries seem to have an insatiable appetite for US debt. The reasons for this are manifold: the dollar, as the global reserve currency, carries certain benefits for the United States. Countries who run large trade surpluses reinvest their earnings in dollar denominated debt, such as Treasury bonds, thereby keeping interest rates low.

So what could turn foreign sentiment against the United States, causing a rapid fall in Treasury prices? I see three potential reasons why this might occur:

1) Competition with the de facto reserve currency status of the dollar
Foreign governments are content to hold dollars as their foreign exchange reserve currencies. As long as this is the case, there will be little downward price pressure on Treasury bonds, since foreign central banks need dollars as a safety hedge to be used to stabilize the value of their own currencies. There are many determinants of reserve currency status, including political stability in the issuing country, foreign belief in the issuing country's central bank, and global economic dominance of the host country. There are theoretical threats to each of these planks, but the near-term threat to the dollar as the global reserve currency is remote. Still, electoral deadlock in the United States, the politicization of the Federal Reserve, or prolonged economic stagnation could lead to other central banks questioning the use of the dollar as a reserve currency. While the Euro poses no threat to the dollar, there are other potential long-term threats such as gold and the Chinese renminbi. Presently, competition is weak, but this could change over time.

2) Rampant inflation in the United States
Inflation erodes the nominal returns on assets denominated in that currency. If inflation were to rise, Treasury prices would fall, reflecting these lower real returns, thereby increasing financing costs for the federal government. Currently, inflation expectations are low, but could rapidly increase if the Federal Reserve fails to withdraw its massive post-crisis monetary stimulus in a timely fashion. Prolonged commitment to withdraw this stimulus is necessary to keep inflation expectations in check. If the Fed were slow to curtail its emergency lending provisions enacted during the crisis, expect inflation to pick up rapidly, thereby decreasing foreign appetite for US debt and raising long-term interest rates.

3) Continued fiscal profilgacy
If investors fear that the federal government is immune to austerity, even during periods of robust economic growth, they could demand higher nominal rates of interest from the government. This is why the United States desperately needs a deficit reduction plan for the long run, which would include some combination of lower spending and higher taxes. In order to keep foreign investor expectations in check, it is critical that the United States maintain credibility with its creditors. Thus, a solid plan of action to reduce the deficit in the long-term is a necessary aspect of running deficits today. Even if these are difficult political footballs, the United States has to get serious about reforming its entitlement program and decreasing its defense commitments abroad.

For all of its faults, the dollar still reigns supreme as the global standard of safety during times of economic distress. During periods such as immediately following the default of Lehman Brothers, or the flash crash of last month, Treasury prices soared, reflecting investor wariness of risky assets. But as I have argued, this will not always be the case. Ironically, the biggest near-term threat to running present deficits is the inability of the government to convince its creditors that it will be long-term austere. This is why the government must enact real changes to contain the deficit in the future, even if it chooses to run large deficits today.

Ultimately, there are many reasons why the United States is not like Southern Europe. These all come down to expectations. Because of this, the United States has a luxury of time for its structural adjustment that the embattled countries of Greece, Italy, Spain, and Portugal, among others, do not. Time will tell if this advantage will be exploited or squandered. Here's hoping to the former.

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