The key issue is crowding out. Funding the Federal debt and paying interest on it absorbs private saving that otherwise could be channeled to investments that will benefit Americans in the future- homes; new plants and modern equipment; education and research; schools, sewers, roads provided by state and local governments; and income-earning properties in foreign nations.3

How much will budget deficits crowd out private investments? Figure 7.2 shows budget projections as calculated by the congressional budget office (CBO). We are so accustomed to deficits that most economists chart the size of the overspending. Thus the deficit that is a negative number is usually shown as a positive.

I think the CBO assumptions are somewhat optimistic, particularly with regard to future spending. Nevertheless, the CBO picture of the future is about as accurate as is available. It estimates that the U.S. federal government deficit will be large and will not shrink for many years to come.

$600 $500 $400 $300 $200 $100 $0

2005

2006

2007

2008

2009

2010

FIGURE 7.2 $500 Billion Deficits for as Far as the Eye Can See

Source: Congressional Budget Office

Whenever you read deficit projections, you should ask, how do these projections account for social security? During the 2000 presidential campaign, Vice President Al Gore talked about putting the social security savings into a lockbox. 4 This was such a theme of his campaign that he was mocked for his lockbox on Saturday Night Live. While the lockbox comedy skit was funny, the topic is deadly serious. When President Bush predicts that the deficit will be cut in half by 2008, he is using social security surpluses to cover other expenses.

Because social security currently has a surplus, combining it with other accounts makes the deficit look smaller. Since the social security funds will be spent in future years, I prefer to work with the on-budget figures. In other words, Figure 7.2 shows the deficit as if the social security funds were in a lockbox.

Given that the federal government is likely to be running large deficits indefinitely, these large deficits will put upward pressure on interest rates. To understand how much, we need to put these figures into the proper perspective.

The U.S. Annual Budget Deficit and Cumulative Debt in Historical Perspective

While the U.S. budget deficit seems likely to be large for the foreseeable future, the situation doesnt look particularly grim in comparison with other times in U.S. history.

There is a story of a snail who was walking through New Yorks Central Park. A tortoise attacked the poor snail and stole his money. When the police asked the victim what had happened, he said, I dont know, officer, it all happened so fast.

Like the speed of slow-moving creatures, most things are relative. Accordingly, the U.S. financial position should be compared with the size of the overall economy (GDP). Using this comparison, the current fiscal position is not as bad as at previous extremes in U.S. history. Figure 7.3

shows total U.S. federal government debt as a percentage of the overall size of the economy for a few selected years.

The three years shown in Figure 7.3 are the extreme points of their eras. During World War II, the United States ran up enormous debts. By 1946, just after the end of World War II, the U.S. federal debt had risen to 122% of the overall economy. Using the current projections, the most extreme figure over the next decade will occur in 2011 when the U.S. federal debt is projected to reach 74% of the size of the overall economy. Not only is this figure far below World War II levels, it is not substantially different from where we stood in 1996.

When we move from the cumulative federal debt to the annual budget deficit, the current projections look even better. While $600 billion is an enormous sum, when scaled against the size of the economy, our current deficits are tiny compared with those during World War II. Figure 7.4 shows the annual deficit as a percentage of the overall size of the economy for a few selected years.

In 1943, the governments one-year deficit exceeded 30% of the

140% 120%

s 100% со 80%

60% 40% 20% 0%

1946

1996

2011

FIGURE 7.3 The U.S.s Cumulative Debt Is Below Historical Highs

Sources: Office of Management and Budget, Congressional Budget Office