The Treasury Department is expected to report that the federal budget deficit for FY19 (which ended in September) fell short of $1 trillion. That’s a lot of money, especially with an economy running full tilt. However, the government currently doesn’t have any problem borrowing. Some will worry that the deficit will become a crisis, but that’s unlikely. The greater concern is that the deficit will constrain our ability to respond to the next recession and well-meaning efforts to reduce the deficit will either worsen the downturn or restrain the recovery.

The nonpartisan Congressional Budget Office estimates that the FY19 deficit was $984 billion, 26% higher than in FY18 and 68% higher than in FY16. Outlays rose about 8% (Social Security +6%, Medicare +6%, Defense +8%, Interest +14%), and receipts were up 4% (individual taxes +2%, payroll taxes +6%, corporate taxes +12%). While corporate tax receipts improved from FY18, they were still 23% lower than in FY17. We have run larger budget deficits before. The deficit ballooned to $1.4 trillion in FY09 (or 10% of GDP), reflecting the magnitude of the economic downturn. Recession-related spending (unemployment insurance, food stamps, aid to the states) rose, while tax receipts dried up. As the economy recovered, the recession-related spending went away and tax receipts picked up. By FY15, the deficit had fallen to just 2.4% of GDP. While smaller than in FY09, The FY19 deficit comes with an economy near full employment. If we were to fall into a recession, the deficit would climb.

Scott Brown
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Recessions are fought through a combination of fiscal policy (tax cuts and spending increases) and monetary policy (cuts in short-term interest rates). Fiscal policy stimulus is generally difficult to implement, but has a relatively quick effect on the economy. In contrast, monetary policy changes can be taken quickly, but the impact on the economy may not be felt for a year or more. In a typical recession, the central bank lowers the federal funds target rate by 500 basis points. The scope for monetary policy stimulus is more limited now and the proximity to the zero lower bound on interest rates means that action should be taken quicker. With the deficit trending higher, there is likely to be less scope for fiscal stimulus as well. Moreover, we may see efforts to reduce the deficit (tax increases or spending cuts), which would dampen the recovery. That was the case in Europe during the recovery from the financial crisis. The European economy slowed, leaving deficit improvement short of expectations. The U.S. also went through a brief period of austerity, but on a much smaller scale. There are few signs that politicians learned anything from that.

It’s well known in Washington that the deficit only matters when the other party occupies the White House (even though the budget responsibility is shared with Congress). Heading into an election year, the budget is expected to be a key issue.

There’s a growing debate among economists about deficits. Much of it centers on Modern Monetary Theory (MMT), which has been embraced by Alexandria Ocasio-Cortez (D-NY). Stephanie Kelton, MMT’s main proponent, is an advisor to Bernie Sanders. A key problem with MMT is defining precisely what it is. Countries that borrow in their own currency cannot default. The U.S. is not going to go bankrupt. No argument there. MMT followers argue that high budget deficits should not be a constraint on spending. We can run much larger deficits, although most admit that won’t be true at some level (well above where we are now). MMT suggests that fiscal policy should target inflation not monetary policy (this is where MMT loses most economists).