Debt vs. Deficit

I know a bit about economics.  I’ve taught it to undergrads at San Francisco State and Stanford, and I’ve created five online economics courses (including one for Dartmouth and two for the University of Chicago).  So Rachel Maddow is killing me every time she says extending the Bush tax cuts to the richest segment of our population will add $700 billion to the deficit. She says it in this clip, about 45 seconds in:

Rachel is mixing up the deficit with the debt. That’s a big mistake — and a rookie mistake, at that:

  • The deficit is the amount government spending exceeds revenue in a given year.
  • The debt is the total accumulation of annual deficits (and surpluses) over our nation’s history.

Suppose a country had been around for just five years.  If it ran deficits of $100 million in each of those five years, it would now have a debt of $500 million.

Extending Bush’s tax cuts for the rich is projected to increase our national debt by $700 billion over the next ten years.  When Rachel said deficit instead of debt, though, she was saying that’ll happen in a single year.  And since the tax cut would be ongoing, people might think it would add $700 billion to the deficit year after year, increasing our national debt by $7 trillion over the next decade.

That would be wrong.

It’s important to get this right.  I favor extending the tax cuts for the poor and middle class, but not for the rich, and here’s why:

1. Deficit spending makes sense during a recession, especially a severe one.

  1. Tax revenues fall during a recession (because personal and corporate income has fallen, which leads to less income tax revenue).
  2. Right now we need people out there buying things, so businesses have reason to hire more employees.
  3. If the government lowered spending to match its lower revenues, we’d end up with even fewer things being bought, which would worsen the recession.
  4. That’s why the government increases spending in bad times — more purchases means higher employment, and then those newly-employed workers start purchasing more stuff themselves, which means still higher employment, and we find ourselves in an upward economic spiral instead of one going down.
  5. Thus, lower taxes and higher spending make sense during (some) recessions.

2. The deficit is now dangerously high.

  1. Yes, we need to be running a substantial deficit now, but we don’t want to keep doing that when the economy is stronger.
  2. A high deficit means the government is borrowing lots of money that year.
  3. In order to raise more and more money, the government has to pay higher and higher interest on the money it borrows, which raises interest rates across the whole economy.
  4. This make it harder for businesses to borrow the money they need to expand production and employment.
  5. That’s not a problem right now, but it will be once the economy starts to recover and businesses want to invest.
  6. High interest rates also discourages consumers from buying big-ticket items like cars, homes, and major appliances.
  7. Yet it looks like our deficit will just go on and on and on, especially if we implement long-term tax cuts.

3. Because the deficit is so big, we should only increase it if the economic pay-off is huge.

  1. When does giving money back to consumers has the biggest economic impact?  When those people go out and spend it on goods and services rather than banking it.
  2. This is especially true in a recession, when businesses are reluctant to borrow investment capital from banks even at low interest rates.
  3. That’s why extending employment benefits has such a huge impact on the economy:  such money is almost entirely spent, and spent quickly.
  4. That’s why tax cuts for the poor and middle class have a big impact, too (though not as big as extending unemployment benefits).
  5. That’s why tax cuts for the rich have a much smaller impact:  the rich allocate a much smaller fraction of their income to buying goods and services.

In brief:

We need deficit spending to boost the economy, but our deficit is so high we can afford only the most effective measures, and tax cuts for the rich just don’t meet that criterion.

That’s an argument you might have with your relatives over Thanksgiving.  If you say tax cuts for the rich will add $700 billion to the deficit, then an informed opponent will call you on it, you’ll be easily proven wrong, and you’ll lose all credibility with anyone around the table who’s still undecided.

Update: Rachel got it right last night.  I don’t know if she’s now just using debt and deficit interchangeably, or if she’s now gotten it right.

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14 comments to Debt vs. Deficit

  • 1
    Scot Colford says:

    Officially the most useful fact of the month for me. Thanks, Rob!

  • 2
    tavdy79 says:

    I’m a layman when it comes to economics, but it seems to me that there’s some pretty sound – and bloody obvious – logic behind your statement that giving $70bn/year in tax cuts to top earners is not the most effective use of deficit spending. If you want the entire $70bn/year to end up with retailers and other similar businesses, the most effective use of the money is to give it to those most likely to spend rather than save. Typically the proportion of a person’s income that goes into savings is linked to the level of wages earned, with (in the UK) those under about £12K/year ($20K/year) unlikely to save anything while above that point savings increase as wages increase. So to get the $70bn/year to retailers, the best people to have the money are those on the lowest wages.

  • 3
    Shawn P. says:

    Baking pies!  Teaching Economics!  Leading LGBT advocacy in the blogosphere!  Is there nothing you can’t do?

  • 4
    robtish says:

    Just for the record, the pie was a Claimjumper dutch apple pie, the best pie in the world.  All I had to do was put it in the oven.

    But I do make the world’s best chocolate chip cookies. (Just the standard Tollhouse recipe with a couple tiny secret changes).  Will doesn’t appreciate them because he likes them crispy.  I, however, think they’re best when chewy and almost falling apart, and I’ve figured out how to keep them that way even after a day or two.

  • 5
    Piper says:

    Chocolate chip cookies are best when chewy, gooey, and melty.  You have the right side in this oh so important debate!  My mom is of the horrid crispy cookie persuasion, so when I don’t want to share, I make sure that none of them are crispy!  What is your secret to keep them that way longer?  I just freeze them and then briefly warm them up in the microwave, but sometimes they get to hard that way.

  • 6
    DN says:

    I’m with Will on the cookies.  Sorry, dude =D

  • 7
    tavdy79 says:

    I guess I’m lucky – I’m not bothered whether cookies are squidgy or crispy, I like them either way! I guess that makes me bi-cookie-able?

  • 8
    Richard Rush says:

    Well, personally, I think that chewy/gooey/melty chocolate chip cookies have a dangerously high texture deficit, so I owe a debt of gratitude to the Tollhouse folks for promoting the crispy recipe.
    But seriously, Rob, thanks for the economics lesson. So now maybe you can answer another question: The Federal Reserve recently announced that they are going to buy about $600 billion in government bonds. I have heard that when the Fed buys bonds, they do it with money that is created “out of thin air,” i.e., they just make it up, or print it. And that is why it is inflationary – it dilutes the value of all the dollars already out there. Is all of that correct or not? And if the government can buy bonds with magic money, is there anything to prevent them from buying other things with it?

  • 9
    Mike says:

    what kinda cookie a person eats in the privacy of their own home is their business, but i do not need to have my face rubbed into those cruchy cookie people and there immoral cookie lifestyle choice

  • 10
    Kevin S. says:

    Richard, if I’m not mistaken, the Fed has a certain budget allocated to it, with which it can lend to banks, purchase US treasuries, purchase foreign treasuries, etc.  It really can run its own independent monetary policy (in fact, that’s the idea).  While the Fed can issue more currency should it choose to, it doesn’t have to every time it wants to make a move.
    Rob, I may be overstating the dangers, but while I believe in the potency of an activist monetary and/or fiscal policy, don’t the lags in information, deficiencies in information, and lags in effect on the economy make such policies like trying to hit a specific goose in a flock of geese, without hitting the other geese, with a Gatling Gun?  For example, the first round of Bush tax cuts helped mitigate the tech bubble bursting not because they were in response to the economy turning, but because Bush was going to cut taxes come hell and high water, and the timing was just particularly fortuitous.  Or do I need to take the tin foil off my head?

  • 11
    John says:

    On the other hand, Rob, I don’t believe that raising taxes on anyone during an economic downturn is necessarily a smart idea.  This isn’t about giving a new tax cut, it’s about maintaining the status quo for everyone with regards to taxes.  That seems wise to me.  Entitlements followed by defense spending are where everyone’s attention needs to be focused.  We cannot tax or spend our way out of this.

  • 12
    Richard Rush says:

    I think I found the answer to my main question. There are many sources, but here is one: A recent article in the Washington Post by Greg Ip, the U.S. economics editor at The Economist and the author of “The Little Book of Economics: How the Economy Works in the Real World.” Basically, the answer is that the Fed can and does create magic money. I’m not trying to make a positive or negative judgement about what the Fed does, as I have no qualifications to do so. I just find it interesting. From Myth #1 in the article (“By printing money, the Fed will create runaway inflation“):

    The Fed’s current policy of “quantitative easing” essentially means it is printing money ($600 billion) to buy assets such as government bonds. The Fed isn’t literally printing the $20 bills that end up in your wallet – it’s doing the electronic equivalent. When it buys a $100 bond from a bank, it deposits $100 into the bank’s account at the Fed. This electronic money is called reserves, and the Fed conjures it up out of thin air.

    One thing I have always understood is that if the Fed has to err on the side of inflation or deflation, it will prefer inflation every time, because deflation is apparently much worse for the economy than some moderate inflation. While many of us, including me, would probably like to personally experience some deflation, the experience of Japan seems to show the negative consequences. The 1990s are often referred to as “the lost decade” in Japan, and some are now including the following decade. So, is deflation a cause of economic stagnation, or is it a result? Damned if I know.

  • 13

    […] Fed and the Money Supply After I posted “Debt vs. Deficit”  a few people asked how the Fed controls the money supply. I’ve pulled up an old […]

  • 14

    Hey Rob, would you be available to help me balance my checkbook?

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