Two deficits that just don't matter

Wriston, Walter B.

Wolf, Charles, Jr.


Two deficits that just don't matter

Two deficits that just don't matter


Two of the supposed indicators of the U.S. economy's health -- the trade deficit and the federal budget deficit -- are constantly under the media spotlight, yet they are actually among the least important indicators we have. This is not to say that they are unimportant, or that reaching a trade balance or a budget balance by 2002 would be unwelcome, but only that these two figures are among the most unreliable indicators of the economy's health and prospects.

So why do they get so much attention? What are the other, more important indicators of economic performance, and why do they receive so little attention?

The answer to the first question is that because the trade and budget balances appear to be simple, easy to measure and talk about, they give politicians something to talk about that they and voters can easily understand: "Your family has to keep a balanced budget -- why not your government?" is a staple of campaign rhetoric. Similarly, there is an unspoken, and erroneous, assumption that a trade deficit is bad for a country's economy. Remember Pat Buchanan standing on a pier decrying Japanese imports? In reality, however, economies often, indeed typically, prosper while experiencing large trade deficits, and, conversely, their performance can lag badly while they are amassing large trade surpluses.

A quick look at recent economic history illustrates the point: The economies of the U.S., Hong Kong and South Korea have all experienced solid growth for most of the past decade, and more recently Poland, the Philippines, Turkey and Croatia have been doing likewise while following the former group's practice of running substantial trade deficits. On the other side of the ledger, Japan, Germany, France and Russia have demonstrated lagging economic performance while running up large trade surpluses.

The explanation for these seemingly counterintuitive situations is that a trade deficit (i.e., an import surplus) often reflects the strong demands of a booming economy for investment, consumption and intermediate goods. Conversely, a trade surplus often reflects the weak demands of a depressed, deflationary economy in which internal savings outstrip the availability of domestic opportunities for profitable investment.

Moreover, the way we measure a country's trade balance is an artifact of another age. Now, and increasingly so in the future, much of what is labeled as trade represents transactions among the international subsidiaries of one parent company. But even apart from measurement flaws, the trade balance shows very little that is important in divining the health of a nation's economy.

Similarly, the federal budget surplus or deficit, despite the inflated political rhetoric of recent years, says little about the economy's performance and outlook. It does not take an economist to figure out that tax revenues fall and entitlement payments rise when the economy is doing poorly, and that the situation is reversed when the economy prospers. If private companies measured their profit and loss the way the federal government keeps its books (i.e., by counting borrowing as revenue and running no capital account), they would quickly attract attention from the criminal division of the SEC. For these reasons and many others, the existence of a budget surplus or deficit doesn't indicate anything crucial about the health of an economy.

One vital fact ignored by the budget balance -- one that does have great significance for the economy's overall performance -- is the level of spending at which the balance (or deficit) occurs. For example, a budget deficit incurred at a spending level that represents a relatively modest (by modern standards) share of gross domestic product, say 30% (the U.S. level), may be a much more favorable economic indicator than a budget balance at a spending level that is a much larger share of the GDP, say 45% or 50%, as is the case in most European economies.

There is another important consideration overlooked in the debate about a balanced budget: the proportion of any given budget that is allocated for public investment in roads and other productive infrastructure, rather than for transfer payments.

If the trade and budget balances are not the most important and reliable indicators of economic performance and prospects, what are the preferable harbingers? These would include the rate of productivity growth (both labor productivity and "total factor productivity") insofar as we are able to measure it in an economy in which information is a key input; the economy's "openness" to competition (high numbers of start-up firms, for instance, low barriers to imports, and limited and clear regulatory restrictions); the level and growth of employment opportunities; the state and progress of the educational system; the stability and predictability of the money supply, the price level and the currency's exchange value; the level and rates of change in domestic savings and investments; and, as a summary, aggregate measure, the inflation-adjusted rate of economic growth.

Each of these indicators, and especially the last, indicates more about how well an economy is doing and its future prospects than the budget and trade balances. The problem is that the meaningful indicators don't make good sound bites -- they are harder to measure, more difficult to explain and more complicated to discuss. The question "Why can't the government balance its checkbook?" gets us where we live -- especially since none of us could legally keep our own books on the government model. But this is not the right question if we are really interested in how the economy is doing, and how it will do in the future.

Mr. Wolf is dean of the RAND Graduate School of Policy Studies and corporate fellow in international economics at RAND. Mr. Wriston is former chairman of Citicorp.