We Shouldn't Cheer This Slipping Deficit

 | Feb 06, 2013 | 12:30 PM EST
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The Congressional Budget Office reported Tuesday that the federal deficit -- that is, the gap between spending and revenue -- will shrink below $1 trillion this year for the first time since President Obama took office. The projected $845 billion deficit would be about 5% of gross domestic product. That's the smallest deficit since 2008, when the gap was about 3.2% of GDP.

The deficit peaked in 2009 at just over 10% of GDP -- which, at the time, was the highest since 1945. But 1943 through 1945 saw annual deficits of 27%, 22% and 21%, in that order, due to heavy war spending -- and it resulted in a U.S. economic boom that hasn't been matched since.

With the economy growing so slowly -- or even contracting slightly, as we witnessed in the fourth quarter -- the shrinking deficit is worrisome. From the sectoral balances accounting identity, we know the government's balance, plus the domestic private sector's financial balance and the external balance (current account), must all sum to zero. This makes logical sense, because one sector's spending must equal another sector's income and savings. So if the government runs a deficit, it is equal to the private sector's surplus.

So, by definition, reducing the government's deficit reduces the private sector's income and savings. Either that, or the external deficit has to shrink by the same margin. But, with oil prices rising and the dollar steady to rising, it's unlikely the trade deficit will shrink enough to offset the drop in the federal budget deficit -- meaning that private sector balances (savings) will be reduced.

We saw the same phenomenon take place from 1997 to 2000, when the government's balance went from deficit to surplus. That swing corresponded with a large decline in private-sector savings, setting up for the market peak in 2000 and subsequent decline, and the economic recession that followed.

We saw this occur in 1937, as well, when President Franklin Roosevelt caved to demands to "balance the budget," and imposed austerity. That sent the U.S. into what would come to be known as the mini-depression of 1937. The economy stayed weak until 1943, when war spending ballooned the federal deficit to nearly 30% of GDP, thus causing the economy to boom.

More recently, the pre-crisis market top in 2007 saw the federal deficit shrink to 1.2% of GDP, sparking a concomitant drop in private-sector savings. With that ratio currently at 5%, it's still arguable whether the deficit is sufficient to keep things on a slow-growth path for the remainder of the year. Further, our $800 billion worth of nominal savings seems enough to provide a cushion -- perhaps. However, the budget trend is not our friend, as opposed to the period from 2009 to just recently.

It's ironic that the president and Congress are all calling for fiscal restraint, even as they see the result of austerity in Europe. Here they have a real-time laboratory that proves spending cuts result in rising unemployment, rolling recessions and higher deficits. In light of this, you would think they'd opt for the opposite policy.

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