Illustrations by Cleo Brock ’16
Throughout most of U.S. history, the nation’s biggest budget deficits have come in times of war. From the Revolutionary War through Vietnam, armed conflict has ballooned the nation’s budgets and borrowing. But when the fighting stopped, so did the inflated spending. Borrowing slowed as the air flowed out of the deficit balloon.
Then, about 40 years ago, the pattern changed. In the aftermath of Vietnam, instead of returning to the lower deficits and budget surpluses typical of peacetime, spending and borrowing remained high. With the exception of the years between 1997 and 2001, the inflation-adjusted deficit was more than $100 billion — and climbing.
As this “new normal” of peacetime deficit spending was beginning to take shape in the mid-1970s, a promising young associate professor of economics at Emory University named Richard Cebula was taking note and feeling the first twinges of alarm. He watched, with concern, as U.S. Congress quietly embraced the obscure concept of Ricardian equivalence, which, in simple terms, posits that the economy is largely unaffected by big deficits.
According to the theory of 19th century English political economist David Ricardo, consumers increase their savings when the government spends more than it collects in revenue, mainly in the form of taxes, because they anticipate that taxes will have to rise eventually, and they want to be ready. This increase in saving, in turn, keeps inflation in check and encourages companies and individuals to continue investing for the future.
Or so goes the theory. Cebula, on the other hand, was skeptical. In the mid-1980s, he channeled his skepticism into studying the possible “crowding out” effect of government borrowing. With the government consuming so much cash, he wanted to know if that borrowing was elbowing companies and individuals out of the capital markets, dampening corporate investment in new plants and machinery and individual investment in new homes.
Cebula sharpened his analysis in 1988, with his first academic paper examining the impact of federal budget deficits on long-term interest rates. Other economists had looked at the impact of deficits on short-term rates and found little or no correlation. But Cebula believed they were asking the wrong question. His concern wasn’t about short-term rates. Who buys a home or expands a factory based on the cost of a 3-month loan? He was focused on long-term rates and the willingness of companies and individuals to spend on big-ticket items that create jobs and strengthen the foundation of the national economy.
“Congress was buying into this notion of Ricardian equivalence, but where was the empirical evidence that people save more when the government borrows more?” Cebula says three decades later. “I wanted to see what was really happening in the economy as a result of these large budget deficits. The real impact, if there was one, was going to show up in the long-term rates.”
What he found confirmed his suspicions. The conventional wisdom appeared to be dead wrong, and Cebula charged into a battle that he is still fighting — with stakes that are growing ever greater.
An issue of ‘profound importance’
Today, Cebula is the Wells Fargo endowed chair in finance at Jacksonville University, where one of his primary professional goals is to raise awareness about an increasingly inconvenient truth. He has written hundreds of academic papers on a wide range of topics, but the topic with the most importance and urgency continues to be the size of the federal budget deficit.
“This issue has profound importance,” Cebula contends. “Its negative impact on job growth has the potential to compromise the American dream, and it’s happening already.” He notes the economic impact of large deficits has been explored extensively by economists since the 1980s, and many have found enough indication of a negative effect to raise concerns. However, interest waxes and wanes, despite the fact that deficits soar. In response to the Great Recession that officially began in December 2007, the federal government increased spending in an attempt to stimulate the economy. By 2009, the federal budget deficit had ballooned to $1.4 trillion.
“I thought it was time to take another look at what this was doing to the economy,” Cebula says. The results of his analysis can be found in a new paper that takes the first in-depth look at the deficit impact since the stimulus spending in 2008 and 2009. Cebula’s paper is especially important because it examines a longer period than has been studied in the past, pulling in more than 40 years of data, from when the Vietnam War was winding down and acceptance of deficit spending was gearing up.
The paper is titled, “The Impact of Federal Budget Deficits on the Ex Ante Real Interest Rate Yield on Ten-Year Treasuries During the Post-Bretton Woods Era.” That’s a mouthful and, while methodologies Cebula describes are perhaps too much for a non-economist to digest, the findings are clear and sobering.
Cebula’s analysis finds “the federal budget deficit (as a percent of GDP) exercised a positive and statistically significant impact on the ex ante real interest rate yield on ten-year Treasury notes, leading to the conclusion that, over the long run, federal budget deficits reduce economic growth in the economy as a whole by reducing investment in new plants and equipment.”
That might not keep the average working American up at night but, to an economist, it is cause for insomnia, especially in light of the size of the impact Cebula calculated. His analysis uses modern econometric techniques to strip away the distortions that make it difficult over time to evaluate interest rate data and the factors that influence them.
Inflation is an obvious distorting factor, and economists have developed techniques to subtract its impact, so they can make consistent comparisons while examining over longer periods — apples to apples, in layman’s words.
Inflation has many nuances, however, and it is only one of the factors that obscure the meanings buried in the data. Cebula’s techniques — long equations of acronyms and mathematical symbols, such as “EARTENt = α0 + α1 TDYt + α2 MYt-1 + α3 EARAaa t + α4 EARTHREEt + α5 NCIYt + α6 CHPRCGDPt + α7 AR (1) + ut — are able to smooth out the imperfections in the lens through which the data are viewed, enabling him to see a purer picture of interest rates over time.
The real cost of federal borrowing
Cebula’s distillation of “real” interest rates from the raw data produced a result that some economists and policy makers might have suspected but lacked real evidence to support. Cebula found that a 1 percent increase in the budget deficit as a percentage of the nation’s gross domestic product (GDP) elevates the real 10-year interest rate yield by 17.3 basis points, or 0.17 percentage points.
What does that mean to the average American? Cebula explains: “It appears that factors elevating the federal budget deficit act to raise the real cost of borrowing to the U.S. Treasury and, hence, to the U.S. taxpayer.”
From the perspective of an average taxpayer, the concern over interest rates driven higher by government spending might seem overblown. Mortgage rates, after all, remain near historic lows. But Cebula says it’s important to look at the current low interest rates charged by banks in the context of what consumers can earn on their deposits, which is essentially money they lend to the banks, or to the government, in the case of 10-year Treasury notes. Most money market accounts are paying less than 1 percent, and the yield on a 1-year Treasury bill was just 0.37 percent at the beginning of November.
“When you’re earning next to nothing on your deposits, paying 4 percent on a mortgage looks pretty expensive by comparison,” Cebula notes.
Moreover, the 40-year time period of his study shows that this relationship between high deficits and higher interest rates “appears to be an enduring one that policymakers cannot afford to overlook in the long-run if the private sector of the economy is to grow and prosper.” Cebula concluded in his report, “Furthermore, the cumulative effects of deficits on the size of the national debt as a percentage of GDP, a ratio that has come to exceed 90% during the past six years, imply a reduction in the long-run growth rate of the U.S. economy of about 1% per year.”
As with interest rates, the average taxpayer might not view a 1 percentage point drag on the economy as alarming, but, again, Cebula adds the necessary context.
“In economic terms, 1 percent is frightening,” he said. “From the late 1940s though the present, the average real growth rate has been close to 4 percent. As a result of high deficits, government borrowing has crowded out investments and reduced the growth rate to 3 percent or just under.”
That’s a one-fourth reduction in the rate of growth, which, according to Cebula, results in economic expansion that “is not enough to keep up with the growth of the labor force, and it reduces the standard of living that we would have in the absence of those high deficits.”
When the levee breaks
As bad as Cebula’s interest rate analysis sounds, it’s not the worst of it. Equally, if not more, concerning, he says, are the huge amount of bank assets — about $3 trillion — being held by the Federal Reserve, through a monetary strategy known as “quantitative easing,” to support the financial sector and promote growth in a shaky economy. Financial institutions are content to keep their money on account at the Fed, which is paying much higher interest than the banks could earn by purchasing, say, Treasury bills.
But what will happen when inflation resurfaces and interest rates begin to rise, which Cebula says will occur eventually? When banks can earn a greater return on their money outside of the Federal Reserve, the dam will break and those $3 trillion in deposits will flood into the capital markets.
“It’s a $3 trillion economic monster,” Cebula says. “As soon as interest rates start to rise substantially, banks will start taking money out of the Fed and investing in the markets. That will send bond prices falling and everyone who owns bonds, from individuals to private firms to pension plans, will see their wealth decrease significantly.”
That will result in less spending and a shrinking economy.
According to Cebula, although the threat of this doomsday scenario is very real, it doesn’t have to be inevitable. To avoid the devastating impact of the combination of high deficits and massive quantitative easing, he contends, policy makers need to take note and get busy.
“We have to bite some hard bullets,” he says. “Federal spending has to decrease.” In particular, he says, policy makers need to rein in the size of “transfer payments,” which include Social Security, Medicare, government employee pensions and other government assistance programs that make up well more than half of all government expenditures.
Among the ideas that Cebula says should receive serious consideration are reducing Social Security benefits to high-income taxpayers and increasing the age at which retirees can begin receiving Social Security benefits. He also suggests that Congress overhaul the federal tax code. A flat tax on all taxpayers — with an income threshold to protect the poor — would be less expensive to implement and would greatly decrease the opportunities for tax fraud created by the complexity of the current tax code.
Cebula realizes these types of measures can be politically sensitive, but says failure to face the discomfort now is likely to create far more pain later.
“We need a makeover — in our spending and our tax system — that will make us more prosperous and be more sustainable in the long run,” he says. “To do less will threaten the very foundation of our economy, and if our economy goes, our democracy goes with it.”
Cebula makes his strongest case yet in the battle to raise awareness of the looming threat of unchecked deficit spending. Economists with whom he has shared his findings have responded with positive comments and are hopeful it will have an impact on policy decisions in the months and years ahead. Whether that happens, only time will tell.
Richard J. Cebula joined Jacksonville University in 2010 and is the author of 14 scholarly books and nearly 550 articles in refereed scholarly journals in finance, economics, general business, management, and statistics. His research has appeared in such venues as the Quarterly Journal of Economics, Journal of the American Statistical Association, Economic Inquiry, Journal of Regional Science, Journal of Financial Services Research, Quarterly Review of Economics and Finance, Kyklos, Journal of Legal Studies, Southern Economic Journal, Public Choice, Land Economics, Industrial Relations, Industrial and Labor Relations Review, Journal of Labor Research, Journal of Management Studies, Applied Financial Economics, Journal of Housing Research, Regional Studies, Urban Studies, Metroeconomica, Weltwirtschaftliches Archiv, Journal of Economics and Finance, and the International Journal of Management.
Dr. Cebula has a distinguished teaching record. He was recognized for his teaching excellence by the Economics profession’s highest award when in 2007 he was the sole recipient of the Kenneth G. Elzinga Distinguished Teaching Award (awarded annually by the Southern Economic Association in a global competition). He also received three “Teacher of the Year” and “Most Articulate Professor” awards at Emory and in 2009 was recognized as the “NROTC Professor of the Year” for his teaching and devotion to student success.