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Long-term Effects of Budget Deficits

Most people think that running a temporary deficit in a recession is necessary and/or unavoidable. Without the credit line of treasury debt, the federal government would be in the same position as many states: it would have to either raise taxes or lower spending at exactly the wrong time.
In the long run, however, deficits are not good. Government deficits tend to lower national savings, which can then lead to a lower level of investment.
So here’s the causal chain from econ101: government savings decreases –> national savings decreases –> interest rates rise –> investment falls –> national income lower than it would have been.
But wait; doesn’t the Fed and Alan Greenspan control interest rates? In other words, the Fed has the power to break the link between deficits and interest rates, and thus deficits and GDP, right?
Not quite. It turns out that investment is dependent upon long-term interest rates, since firms care more about 10 year rates than 3 month rates. The Fed, while it can control short-term rates rather well, has less influence on the longer-term rates. Furthermore, empirically, it does seem like deficits do have an impact on interest rates.
W. Gale and P. Orszag at Brookings lay out these arguments, examine some empirical evidence, and do some not-quite-back-of-the-envelope calculations on the impact of returning to long-run deficits.
If you ever plan on using the phrase “fiscal discipline,” you need to read this.

The Economic Effects of Long-Term Fiscal Discipline
Summary
Over the past two years, the long-term budget outlook has deteriorated markedly. Although many policy-makers and economists have expressed concern that this fiscal deterioration will reduce future national income and raise interest rates, Bush Administration officials and others have publicly denied the existence of such adverse effects. This paper examines the relationship between long-term fiscal discipline and economic performance, with two main results. First, as almost all economic research and standard textbooks suggest, declines in budget surpluses (or increases in budget deficits) reduce national saving and therefore reduce future national income, regardless of their effect on interest rates.
Second, simple correlations, careful empirical research, macro-econometric models, and the views of leading economists and policymakers all indicate that increases in expected future deficits raise long-term interest rates. Based on the literature, a reasonable estimate is that a reduction in the projected budget surplus (or increase in the projected budget deficit) of one percent of GDP will raise long-term interest rates by between 50 and 100 basis points. These findings suggest that the costs of increased deficits are significant over the long run, and need to be compared carefully to the potential benefits of the tax and spending programs that result in larger long-term deficits.

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