Do Deficits Matter?

Updated on

Reagan proved deficits don’t matter. – Vice President Dick Cheney, 2004

Get The Full Ray Dalio Series in PDF

Get the entire 10-part series on Ray Dalio in PDF. Save it to your desktop, read it on your tablet, or email to your colleagues

Q1 2021 hedge fund letters, conferences and more

Are Federal Budget Deficits Good Or Bad For The Economy?

For almost the entire twentieth century, nearly all Republican politicians believed -- or at least claimed to believe -- that federal budget deficits were bad for our economy. But in the 1980s, in the wake of the worst economic downturn since the Great Depression, President Ronald Reagan and a compliant Congress sharply cut taxes and increased government spending.

The strategy worked quite well, fairly quickly restoring economic prosperity. But Reagan believed that tax rates should remain permanently low. This would enable Americans to keep more of their earnings and be incentivized to work longer hours, and thereby pay more taxes. And the icing on the cake would be a balanced federal budget.

Instead, the deficit rose and stayed high. But President Bill Clinton, a Democrat, working with a Republican controlled Congress managed to reign in spending, and in 1998 he presided over the first federal surplus since 1969. We continued running surpluses for the next three years.

But in 2001 our economy fell into a relative mild recession, and we began running federal budget deficits again – and have continued to do so ever since. By then, virtually all Congressional Democrats and a majority of Republicans accepted the need to run substantial deficits to bring our economy out of recessions.

How Large Deficits Should Be

With the advent of the Great Recession of 2007 – 2009, the only question was not whether or not to run substantial deficits, but how large they should be. President Barack Obama and the members of his slim Democratic majorities in the House and Senate, argued that we would need to run deficits of over one trillion dollars, while just a handful of Republicans thought they should be nearly that high.

With very little Republican help, the Democrats were able to pass budgets which incurred federal budget deficits that substantially exceeded one trillion dollars in fiscal years 2009 – 2012 (see accompanying table). Were such vast deficits necessary?

Hindsight tells us two things. First, had they not been that large, our economy might well have sunk into a full-blown depression. And second, considering our lagging recovery from the Great Recession, our economy had really needed the stimulus that would have been supplied by even greater deficits.

Federal Budget Deficits - Fiscal years 2008-2021

Year Deficit in $ billions
2008 459
2009 1,413
2010 1,294
2011 1,300
2012 1,087
2013 680
2014 485
2015 439
2016 585
2017 665
2018 779
2019 984
2020 3,013
2021 2,300*

Recovering From The Great Recession

Still, trillion-dollar federal budget deficits were quite alarming, especially during the years after we had finally fully recovered from the ravages of the Great Recession – until then, the worst economic downturn since the 1930s depression. A substantial minority of Congressional Republicans appeared to be getting back some of that old balance-the-budget religion. On the one hand, they criticized the Obama administration for the lagging economic recovery, while on the other, they insisted that the deficits were far too high.

But with the accession to the presidency of Donald Trump in January 2017, virtually the entire Republican majorities in the House and Senate did a complete 360-degree turn. Nearly every member would have agreed that President Reagan had indeed been correct: Deficits don’t matter.

In December of 2017, at the behest of President Trump, Congressional Republicans pushed through a ten-year $1.6 trillion tax cut. One might ask how much more economic stimulus was needed when our unemployment rate was just over four percent and falling.

As a consequence, you can see in the accompanying table that the federal budget deficit increased by over $100 billion in fiscal years 2018 and 2019. During a period that President Trump described as the most prosperous in our nation’s history, the last thing we should have been doing was running increasingly huge deficits.

From the spring of 2020 until the present, Congress has passed several massive economic stimulus packages totaling trillions of dollars to help ameliorate the economic effects of the coronavirus. The deficit jumped to over $3 trillion in fiscal year 2020, and will come in at well over $2 trillion in the fiscal year ending September 30th.

Limiting The Human And Economic Costs Of A Deficit

As long as the pandemic remains a deadly threat, there is widespread political agreement that these massive federal budget deficits will be a necessary byproduct of our effort of limit its human and its economic costs. Until then, the annual deficit will remain above the two-trillion-dollar mark.

Is there any limit to how much Treasury debt can be issued? Actually, there is. The only problem is that we have no idea how much it is.

As long as Americans, foreigners, and foreign governments are willing and able to keep buying up newly issued U.S. Treasury bonds, bills, and certificates, the federal government can not only keep running huge deficits, but ever increasingly larger ones.

Still, at some point, we’ll reach a limit at which buyers of the debt can’t afford to purchase additional Treasury debt. Or else, they might begin to fear that the U.S. government will be unable to pay them back, and the securities they’re holding will fall sharply in value, or even become worthless.

Are we nearing that point yet? Definitely not! Will we reach it within the current decade? If we keep running federal budget deficits in excess of $3 trillion, then default may become a very real possibility by the end of this decade.