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How Budget Deficits Reduce Investment

by Timothy Taylor, Conversable Economist

A identity is a equation that is true because of the way the terms are defined. Thus, when an economist says that “gross national product is equal to the sum of consumption plus investment plus government spending on goods and services plus exports minus imports,” that statement is actually just one definition of how to measure GDP.


When thinking about how budget deficits affect the economy, a different identity is typically used. This identity points out that for an economy at any given time, the total quantity of funds being saved must be equal to the total quantity of funds being invested. Or to spell it out a little more fully, the U.S. economy has two sources of savings: domestic saving, and the saving that flows in from other countries. The U.S. economy also has two sources of demand for those funds: private sector investment and government borrowing. Thus, it must hold true that when government budget deficits increase, some combination of three things will happen: 1) domestic saving will rise, to supply some of the funds needed for the rise in government borrowing; 2) the inflow of savings from foreign investors will rise, to supply some of the funds needed for the rise in government borrowing; or 3) private investment will decline, because the rise in government borrowing will “crowd out” some of the funds that would otherwise have gone to the private sector.

Again, this statement is not one where different schools of economics disagree; it holds true by definition, based on the meaning of these terms. Among professional economists, those who think budget deficits should be larger, or smaller, or about the same will all agree that if deficits rise, some combination of these three consequences must and will happen–by definition.

But how much of each will happen? Jonathan Huntley of the Congressional Budget Office lays out some evidence in “The Long-Run Effects of Federal Budget Deficits on National Saving and Private Domestic Investment,” published as a working paper by the Congressional Budget Office in February. As one might expect, the question of how more government borrowing affects these three other factors is not written in stone: it will vary both according to the specific situation of the economy and according to the econometric methods being used.

That said, Huntley describes the central estimate about the long-run effects of more government borrowing based on the review of the evidence like this: For each additional dollar of government budget deficit, private saving rises by 43 cents, and the inflow of foreign capital rises by 24 cents. Thus, [e]ach additional dollar of deficit leads to a 33 cent decline in domestic investment.

The lower range of estimates is that for each additional dollar of government borrowing, private saving rises by 61 cents and the inflow of foreign capital rises by 24 cents, so private sector investment falls by 15 cents. The higher range of estimates is that for each additional dollar of government borrowing, private saving rises by 29 cents, inflows of foreign capital rise by 21 cents, and private sector investment falls by 50 cents.

It’s perhaps useful to put these investment totals in context. Here’s a figure on U.S. investment levels created with the ever-useful FRED website maintained by the Federal Reserve Bank of St. Louis. The blue line on the top shows gross private domestic investment (quarterly data, seasonally adjusted annual rate). The red line shows net private domestic investment. The difference between the two lines is that a certain amount of U.S. capital wears out every year, and machinery, vehicles, computers, phone systems, and so on need to be replaced. A lot of gross investment goes to replacing existing capital, and the red “net” line thus shows the addition to the capital stock each year. Notice that for a couple of quarters toward the tail end of the Great Recession, net investment turned negative–that is, gross investment wasn’t high enough even to replace the existing capital.

FRED Graph

How much effect will the currently projected deficits have on domestic investment? Say that government borrowing now that we are past the worst of the Great Depress is about 4% of GDP each year into the future (which is roughly the CBO “baseline” estimate, which is probably optimistic for the long run). Then investment would be 1.3% of GDP lower as a result of government borrowing (that is, 33% of the 4% of GDP budget deficits). The US GDP in 2014 will be about $17 trillion. So a drop of investment equal to 1.3% of GDP is a fall in actual dollars of about $221 billion in investment.

Compared with gross private investment of about $2.8 trillion, this total doesn’t look especially large. But remember, most of gross investment is replacing existing capital as it wears out. Compare a decline of $221 billion in investment to the net private investment of about $600 billion, and it looks more sizable. Thus, the budget deficit is a substantial drag on how much the U.S. economy is adding–in terms of net private investment–to its capital stock each year.

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2 comments
Sigmund Silber
Sigmund Silber

I don't have a lot of confidence in the CBO and do not recall if I read their full analysis but I have to assume that they did regression analysis which shows correlation not causation. 


I agree with one of your identities namely that currently deficits are funded by domestic lending or foreign lending. Wow...what an insight. 


As far as deficits "causing" an increase in savings...perhaps. But an increase in savings generally means a decline in spending which reduces tax revenues and is often countered by deficit spending. So what came first? The chicken or the egg?


The assumption that a buyer of Treasuries would otherwise invest in real things (not just acquire assets from others) seems fairly unlikely to me. Lenders are usually not very adventurous. So I am not buying your crowding out thesis...I think it is ideological. 


When someone lends to the government their net worth does not decline, Treasuries make good collateral etc so again I think your premise is an assumption nothing more.


I don't see the connection between deficits and private investment. If the Federal Government borrows money to send to me, I may spend that money on consumption, invest it, or save it for a future decision. Investment would seem to be determined more by the need for investment and the potential return on investment as compared to the cost of capital. There may be a lag between investment expenditures and increases in tax revenues so that has to be taken into account. 

All in all I reject the analysis by the CBO as being useful for predictive purposes and I reject your analysis of their report. 

 

Inquisitive
Inquisitive

While the identities are correct, the language of the article implies causations which might not be true. 

From a different perspective, the heroic government takes the funds no longer wanted to be put into private US and foreign investment during an economic crisis thereby providing a safe harbour for risk averse capital and it spends the money to stabilise the largely (about 75%) private economy for the benefit of the private sector includng corporations and citizens.


Maybe instead of

 " For each additional dollar of government budget deficit, private saving rises by 43 cents, and the inflow of foreign capital rises by 24 cents. Thus, [e]ach additional dollar of deficit leads to a 33 cent decline in domestic investment."

it shoudl be 

"Over history on average, largely as a result of recurring economic crises when Americans and foreigners alike want to save but refuse to invest in the private sector or their foreign government because of concerns of losses of capital due to fear of private sector or foreign government default, each additional $1 of private sector savings in the US is accompanied by a switch from private investment to investment in government securities of 76.7 cents and a share of foreign capital wanting to invest in US government securities of  55.8 cents. This total of $2.33 that is invested in government securities by the private sector and foreigners is then used by the US government  to stabilise the economy in the face of the crisis."

The idea that government spends for some ulterior purpose to freeze out the private sector and reduce private investment is misleading.


In the main government provides a balancing factor between the private and external sectors to dampen the effects on changes in the private sector on the economy as a whole.