Deficits can matter, sometimes | financial times

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The writer is a financial journalist and author of ‘More: The 10,000-Year Rise of the World Economy’

Deficits don’t matter. This quote comes not from some spendthrift European socialist, but from the clearly conservative Dick Cheney, Vice President of the United States from 2001 to 2009.

According to an account by former Treasury Secretary Paul O’Neill, in 2002 Cheney cited the Reagan administration as evidence for his thesis; The national debt tripled under the watchful eye of the Republican in the 1980s, but the US economy boomed and bond yields fell sharply.

In the 20 years since Cheney’s comment, the US federal debt has roughly doubled as a proportion of GDP. But 10-year Treasury yields are no higher than they were two decades ago; in fact, they have spent much of the intervening period at much lower levels, even as debt has skyrocketed. The ongoing fuss over the US debt ceiling has nothing to do with the willingness of the markets to buy US debt, it has everything to do with the willingness of politicians to honor their government’s commitments.

However, Cheney’s sentiments have not always been borne out elsewhere. Over the last nine months, the UK government has discovered the problems that can occur when financing costs rise suddenly. And that has reignited the debate about the ability of governments to run prolonged deficits.

In one field are the spiritual descendants of Margaret Thatcher, the former British prime minister who sought to balance budgets, arguing that “good Tories always pay their bills.” Modern budget hawks often say that governments should not pass the burden of debt service on to the next generation. Many also argue that budget deficits are caused by excessive government spending and that reducing this spending is not only prudent but will boost economic growth. In the other camp are most economists, who argue that, unlike individuals, governments are immortal and can rely on inflation, or future generations, to pay off their debts.

They point out that government debt, as a proportion of gross domestic product, was very high (in both the US and the UK) after World War II. That debt proved to be no barrier to rapid economic growth. In addition, the aging of the population in the developed world means that there has been a “savings glut” as citizens set aside money for their retirements, making it easier to finance deficits.

But the freedom of governments to issue debt comes with a couple of caveats. First, a country must be able to issue debt in its own currency. Many developing countries have discovered the dangers of issuing dollar debt. If that country is forced to devalue its currency, then the cost of servicing the dollar debt skyrockets. Second, countries need a central bank that is willing to support their government by buying their debt. Quantitative easing programs for such purchases have certainly made it easier for governments to run deficits.

In the 2010-12 eurozone crisis, deficits mattered for countries like Greece and Italy. Yields on its bonds soared as investors feared indebted countries could be forced to leave the eurozone. This would have forced governments to default or try to redenominate the debt in their local currency. Greece turned to its neighbors for help, but found that other countries were unwilling to provide the required support unless Athens brought its budget deficits under control.

For many Eurosceptics, that demonstrated the folly of joining the single currency. Britain was free of such restrictions as it issued debt in its own currency and had a central bank that would handle QE. Given those liberties, last fall’s financial crisis, which followed the mini-budget proposed by the short-lived Liz Truss administration, was even more shocking.

As Truss tried to echo the Thatcher images, she refused the budgetary prudence of the Treasury as “abacus economics”. He argued that cutting taxes would lead to faster economic growth, so that the deficit would disappear on its own as government revenues increased.

However, the markets did not buy the argument. The mini-budget was followed by a spectacular sell-off of British and sterling government bonds. The latter may be due to leveraged bets made by UK pension funds on bonds. Even so, the Truss team’s economic analysis did not account for this possibility.

Investor confidence in British economic policy had already been shaken by the Brexit vote and the rapid turnover of prime ministers and chancellors. The problem has not disappeared. Data released this week showed Britain was still fighting to contain inflation and gilt yields returned to post-mini-budget levels.

So Cheney’s aphorism needs to be amended. Deficits don’t matter if the government borrows in its own currency, and it also has a friendly central bank, a constant inflation rate, and the confidence of financial markets. It also requires a continuation of the global saving excess. Those conditions mean there is plenty of room for future governments to get into trouble.