President Obama’s new budget, with its mind-boggling $1.75 trillion deficit is bound to stir up a lot of discussion about deficit spending. Many liberals are already trying to ensure that George W. Bush is saddled with the blame for our budget imbalances. And of course, many conservatives are gleefully mocking Obama’s pledge to be fiscally responsible. But I am going to take this opportunity to try to demystify some of the deficit arguments and in the process I will argue that (a) Deficits do matter, but (b) not all deficits are created equal, and (c) to understand the problem with deficits one has to think specifically about their impact on federal spending. Short version of my conclusions — for the most part over the past 50 years we have pursued a sound approach to fiscal policy despite running deficits most years. However, the Obama budget following on eight years of irresponsible Bush policies may push us past a tipping point where our debt burden is fundamentally unmanageable.

But that said, much of what passes for discussion of deficits is based on a misunderstanding of how deficits interact with the federal budget. My nemesis over that OutsideTheBeltway, Steve Verdon has argued, essentially, that our political system is broken and irresponsible, and that these flaws make deficit spending more or less inevitable. And that as a result, even though some costly programs like Social Security may be theoretically viable, the lack of discipline of the federal government makes it likely that in the worst out-years instead of Social Security adding a relatively small amount of debt to put receipts and outlays into balance, it will exacerbate an already out of balance federal budget. In short, he argues that in order to assess our fiscal situation we have to assume that the steady state of the federal budget is in deficit and that any program that might add to those assumed deficits is per se dangerous to our long-term economic health.

And indeed, a shallow assessment of the federal budget supports Steve’s argument. After all, from 1950 to 2007, the budget was in deficit 50 times and only ran 9 surpluses. Graph of surpluses/deficits are percentage of GDP follows:

Truman ran a surplus in 1951, Eisenhower in 1956, 1957, and 1960, and Johnson gets credit for 1969, I guess. Then nearly a thirty year gap before Clinton does the trick in 1998, 1999, 2000, and 2001. Clinton, obviously, gets an assist from a Republican Congress, though, ultimately it is the president’s budget that defines the debate for good or ill. And I won’t fight hard if you want to give Nixon partial credit for 1969 and the same for Bush in 2001.

So, at first glance, Verdon has a point. 85% of U.S. federal budgets since 1950 have been in deficit, and we are looking at addition deficits from 2008 to 2015 at a minimum. But is a “deficit” the best measure of an improvement or decline in the fiscal position of the nation? Does it really matter and how? Well, the problems with deficits isn’t the one-time imbalance in the budget, it is that deficits add to national debt, which increases interest payments and diverts resources from other governmental functions. So, what if you have a deficit which actually reduces debt? Of course, as a matter of definition, a deficit cannot reduce the gross debt, but it is certainly possible to run a deficit small enough that due to economic growth the ratio of debt to gross domestic product (GDP) actually improves. Simple example, if you make $100k per year and have outstanding debts of $20k, your debt to earnings ratio if 1 to 5. If you get $50k and take on an additional $5 in debt, you now have a debt to earnings ratio of 25 to 150 or 1 to 6. Even with more debt, you’re debt is lower as a percentage of income.

Well, that is nice in theory, but does it ever occur? Well, yes. On 20 occasions since 1950, we have run deficits so small that debt as a percentage of GDP actually declined, and that in addition to the 9 surpluses that lowered debt in a the absolute as well as the relative. So, in this sense our fiscal position with regard to debt actually improved 29 years and worsened in 29. Now, the government starts to seem less irresponsible, no? Here is the chart of debt to GDP since 1950:

So, even though deficits are common, “bad” deficits that worsen are fiscal posture are less common (and btw, are closely associated with the Reagan, Bush 41, and Bush 43 administrations).

But there are other complications. For one thing, a lot of debt is actually owed by the government to the government. This Social Security “trust fund” is a good example. This debt burden requires the government to pay interest to… the government. Now, this creates all sorts of accounting nightmares, and generally complicates any serious assessment of our fiscal position. But, nonetheless, debt owed by the government to the government is an accounting gimmick, not a fundamental burden on the government’s ability to meet its obligations.

So, instead of looking at changes in debt as a percentage of GDP, maybe we ought to look at public debt as a percentage of GDP. We we look at this, we find that since 1950 the ratio of public debt to GDP declined in 35 years and only increased in 23. Graph of public debt to GDP follows:

The big difference between the two prior graphs has to do with the massive growth of the Social Security trust fund. Anyway, now the federal government is looking more and more responsible. But there is another key variable, and this is where the rubber hits the road in terms of deficits. The problem with debt is not how much you owe, it is how much you need to spend to service the debt. In other words, the problem with debt is that the more of it you have, the more you have to spend in interest payments which divert resources from other expenditures. It is interest payments that squeeze or constrain the federal budget, not debt levels in the abstract.

Well, the good news is that since 1950, net interest payments as a percentage of GDP decreased or stayed the same in 39 years and only increased in 19. In short, our fiscal burden measured in terms of actual money diverted to pay for servicing the debt only increased 33% of the time. In short, our fiscal posture usually gets better not worse. Graph follows:

So, in short, the basically planning assumption does not need to be that things are bad and will continue to get worse, but rather due to the underlying strength of the U.S. economy, our fiscal constraints will decline over time. This is not a trendline analysis. It is a planning philosophy. It is not “unrealistic” to assume that if we can pay for something today, we’ll be able to pay for it at the same levels tomorrow.

In my next post in this series, I will explore the implications of these findings on the Social Security debate.

That said, there is an important caveat to consider. The dramatic increase in deficits over the past year will increase the burden of debt significantly. It is quite possible that the stimulus package passed by the Democrats will have very negative consequences for our fiscal posture for a generation. I understand the desire to respond vigorously to our current recession, but it is quite possible that the “cure” is worse than the “disease” here. If we get a quick and sustained rebound, many of these concerns will evaporate, but it is possible that Obama’s stimulus piled on top of Bush’s war and tax cut-deficits will push us past a tipping point where the burden of debt becomes unmanageable. We may yet get a very, very nasty hangover out of current policies. But the problem is with the present, it is not a structural problem with the federal government as an institution. Our problem is bad policy choices, not an inevitable consequence of structural factors. That is a very significant distinction to keep in mind and core difference between me and Steve Verdon.