When do deficits matter?

Nervous financial markets and waves of fiscal austerity spreading across Europe raise an important question: when does a country’s budget deficit become a problem?

The easy answer, of course, is that a deficit is too large when it can no longer be financed. But by that time it’s too late, so it’s important to ask if there is a good way to tell before things get that bad.

Carmen Reinhart and Kenneth Rogoff, in a recent paper called Growth in a Time of Debt, found that when government debt reaches 90 percent of GDP, economic growth is seriously retarded.

But rules of thumb are by their nature imperfect, and it’s difficult to apply the 90 percent formula across the board. The U.S., for example, is not Greece—it’s closer to being the anti-Greece, in fact. Greece is a tiny, uncompetitive country that does not control its own currency. The business climate there is terrible. America is a vast, competitive, adaptable nation that not only controls its own monetary policy, but is blessed with the world’s reserve currency. The climate for business is favorable, abetted by large reserves of cultural and intellectual capital.

So we shouldn’t conclude that just because the Europeans are suddenly cutting public spending, we ought to as well. Since deflation looks more threatening than inflation, it seems sensible, for now at least, for America to borrow and spend. Washington’s cost of money is close to zero, and the multiplier effect (for which this blog is named) means that pumping funds into the economy is likely to pay growth dividends, especially if the money is directed at those likeliest to spend it.

Countries almost always run deficits and, despite the ardent wishes of fiscal conservatives, they probably always will. The problem, when debt accumulates, is that it can make you vulnerable to investors who may become impatient or even irrational. If these are the people who have the money you need to finance your deficit not in your own currency, you may find yourself in the position of several Eurozone countries now, who are forced to embrace austerity at the worst possible time. Perhaps the lesson is not to run up large deficits in good times, as Greece, Portugal, Spain and Ireland, so that in bad times you can get credit when you need it.