When it comes to fiscal policy and especially budget deficits, your basic DC policymaker walks around thinking, "Deficits bad, surpluses good." Virtually every Republican currently running for president — and more than a few congressional Democrats — have endorsed amending the Constitution to force Congress to balance the budget each year.
Even those who recognize that there are rare times when it makes sense for the government to temporarily spend more than it takes in tend only to defend deficits as a necessary evil.
We think this is wrong. Budget deficits, properly managed, are not only not evil — they’re downright good. The long historical record shows that their use has led to smoother and stronger growth.
In essence, they’ve worked like shock absorbers, smoothing out bumps along the growth path. To eschew their use, as so many policymakers espouse, would mean growth that was both more volatile and somewhat slower.
Thanks to a new, long time series of historical data, we’re able to show you what we mean. Consider two time periods, which we’ll call BD (before deficits) and AD (after deficits; meaning after deficits started to be more commonly employed in their shock-absorber role). In this analysis, BD runs from 1870 to 1929 and AD from 1950 to 2015 (see data note).
The BD period is a deficit hawk’s dream. The deficit-to-GDP ratio flatlines in the figure through boom and bust alike, averaging a slight surplus (!) of 0.4 percent over the period. Over the AD period, deficits average -2.2 percent of GDP.
Importantly, deficits are also a lot jumpier in the latter versus the former period. The standard deviation — a measure of dispersion around the average — is 0.5 percent BD and many times that much, 2.4 percent, in the AD period.
So deficits were both a lot larger and a lot more varied in the latter period.
What about growth? Real per-person income growth is faster in the AD period, though not too much: 2.0 percent annually versus 1.8 percent in the BD period. Still, this extra growth adds up over time: With AD growth rates, the economy doubles every 35 years, but with the slower BD growth rates, it takes an additional four years to double.
And just eyeballing the figures, you can see how much jumpier income growth was in the earlier BD period; recessions were far more frequent and far more severe. The standard deviation of income growth was 5.0 percent in the BD period and less than half that — 2.3 percent — in the AD period.
In other words, the shock absorber of deficit spending is one reason the growth ride has been smoother post-1950, and very likely has contributed to faster overall growth, as well, since it is easier to maintain speed on smoother pavement.
How does it work? What we’re calling "bumps in the road" are contractions in private sector economic activity, caused by one sort of shock or another, like the bursting of a housing bubble or the sharp disruption of a key input, like oil. To offset these shocks, the government borrows from the future to spend more today, which is just what the economy needs during bad times, when ordinary citizens are losing income (and jobs) and investors have few useful opportunities anyway. When the private sector is back up and running at full strength, that’s the time for deficits to fall or turn to surplus.
To be sure, using deficits as shock absorbers is by no means the sole explanation for the smoother and stronger growth in the AD period. Another candidate is increased globalization, since the increased flows of goods and capital helps avoid volatile supply disruptions. The Federal Reserve also has gotten better at macro-management over time.
Of course, the fact that deficits can be good if wisely managed does not mean that deficits are always wisely managed. For instance, it’s problematic to see rising ratios of debt to GDP in strong economies. As Keynes himself said, "The boom, not the slump, is the right time for austerity…"
Unfortunately, a glance at fiscal policy around the globe suggests we are in the midst of relearning this lessons. Greece is the poster child, but most European countries that went the austerity route following the Great Recession are still mired in slow growth and high unemployment. (Real GDP in the eurozone has been growing around 1 percent annually, and unemployment is 11 percent.) In other words, there are a lot of hapless passengers in other countries getting an awfully slow and bumpy ride.
Data note: It’s important to leave large wars out of the picture, as they create unusual fiscal dynamics, so the BD period starts after the Civil War and leaves out 1918-'19, and the AD period starts after World War II. But the data goes all the way back to 1792, and different endpoints yield similar results.
The growth measures are real economic growth per person. Accounting for population growth deals with the fact that the population has grown faster or more slowly during different periods in history. Economic growth is measured over calendar years, deficits over fiscal years.