The Drunkard's Walk and the Moment of Truth

The National Commission on Fiscal Responsibility and Reform has finally issued their report on the U.S. Deficit, "The Moment of Truth". They are not the only ones trying to seize the moment. The Economic Policy Institute has issued its report "Investing in America's Economy: A Budget Blueprint for Economic Recovery and Fiscal Responsibility." And, the Bipartisan Policy Center has released its report "Restoring America's Future." There are enough recommendations in and questions raised by these reports to keep many policy analysts busy blogging for many years in the future. Before jumping into the issues, I'd like to put a stake in the ground.

What do we expect to see when we look at a historical time plot of the U.S. Deficit? If the deficit hawks are right, we should see the deficit increasing uncontrollably over time when, in fact, the deficit should always be zero. The Keynesian viewpoint is that we should see periods of deficits during recessions followed by periods of surplus during recoveries. In other words the deficit should be a drunkard's walk, randomly moving from surplus to deficit based on shocks to the economy. The only issue is the range of movement: conservatives think there should be very little, if not zero movement and liberals say it depends on economic conditions.

The first figure above, using data from the CBO, fits a random walk model to the U.S. deficit. Although the fit is not bad, it looks like the model is always "catching up" and missing the turning points. What is striking about the graphic is that the deficit "excursions" are increasing in amplitude: economic shocks getting worse, spending responses ("bailouts") and attempts to "stabilize an unstable economy" getting more desperate.

Both the conservative and Keynesian views miss seeing that the U.S. deficit is part of a system. During an economic downturn, there is a flight to quality. Investors want to unload their higher-risk investments for the safety of U.S. debt which is covered by the "full faith and credit" of the U.S. government. During normal times, purchasing U.S. debt allows country's with trade imbalances (e.g. China) to do something safe with their dollars.

When we add debt held by the public into the random walk model, the predicted fit is much better (second graphic above). For the U.S. deficit to exist, there has to be a counter-cyclical market for U.S. debt. The market is somewhat self-correcting. If investors don't want to purchase U.S. debt, the only other way to create a deficit (as is the case in many "debt crisis" countries) is to print money.

What does this all have to do with the common explanations for the U.S. deficit being repeated in the policy echo chamber? Is it those mandatory entitlement expenditures such as Social Security, Medicare and Medicaid that must be eliminated to eliminate the deficit? Is this a reasonable conclusion from the graphics and discussion above? Is it the entitlement programs or the shocks to an "unstable economy" that are driving the deficit? It all depends on the time path of the entitlement programs compared to the time path of the deficit, a topic I'l talk about in future posts.