Academic journal article Journal of Money, Credit & Banking

The Deficit Gamble

Academic journal article Journal of Money, Credit & Banking

The Deficit Gamble

Article excerpt

The historical behavior of interest rates and growth rates in U.S. data suggests that the government can, with a high probability, run temporary budget deficits and then roll over the resulting government debt forever. The purpose of this paper is to document this finding and to examine its implications. Using a standard overlapping-generations model of capital accumulation, we show that whenever a perpetual rollover of debt succeeds, policy can make every generation better off. This conclusion does not imply that deficits are good policy, for an attempt to roll over debt forever might fail. But the adverse effects of deficits, rather than being inevitable, occur with only a small probability.

The conventional wisdom holds that government budget deficits crowd out capital, reduce national income, and lead to lower living standards for future generations. Indeed, this is the standard critique of U.S. fiscal policy in the 1980s. According to this view, future historians looking back at the 1980s are sure to see a generation enjoying prosperity at the expense of their children and grandchildren.

This paper argues that a less prosperous future is only one possible consequence of a period of large budget deficits. Indeed, the probability of this outcome is low. With a much higher probability, temporarily profligate fiscal policy can raise the entire path of consumption above what it otherwise would have been. Future historians looking back at the fiscal policy of the 1980s may well see it as leading to a period of greater prosperity without any adverse long-run consequences.

More generally, we propose a new view of budget deficits. This view emphasizes the uncertainty about the future of the economy--in particular, the future of economic growth and of asset returns. In an uncertain world, deficits do not lead inexorably to future hardship. Instead, a deficit is a gamble. It is an imprudent policy because it imposes a significant burden on future generations in some realizations of history. But in most possible outcomes, the future effects of deficits are benign.

Our starting point in reaching these conclusions is the observation that the average return on government debt is below the average growth rate of the economy. The government can, therefore, most likely get away without paying for a period of budget deficits. After running a deficit for a while, it can forever roll over the debt and accumulated interest. Because the economy's income will likely grow faster than the debt will accumulate, the debt-income ratio will fall over time. In other words, a country with a large public debt can most likely grow itself out of its problem.

We document the probable success of such a policy in section 1. We call the policy a Ponzi gamble because it is an attempt at a Ponzi scheme--a perpetual rollover of debt--that is not certain to succeed. We consider a Ponzi gamble that starts with a debt-income ratio similar to the ratio in the United States today. If future economic growth turns out to be low relative to the return on government debt, the gamble will produce a rising debt-income ratio. In this case, the government will eventually be forced to raise taxes. But, using historical data on growth rates and interest rates, we estimate that the probability of this outcome is only about 10 or 20 percent. With a probability of 80 or 90 percent, a debt of the size inherited from the 1980s will never force the government to raise taxes higher than they otherwise would have been.

In section 2 we begin to examine the implications of Ponzi gambles for economic welfare. The framework we adopt is the standard overlapping, generations model of economic growth. In this model, there is a simple relationship between the success and desirability of a Ponzi gamble. If the path of history would allow a Ponzi gamble for government debt to succeed, then along that path it is possible to reallocate resources in a way that raises the welfare of all generations as of the time of their birth. …

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