Understanding US Deficit Reduction Impacts

Originally published by: Wells FargoApril 10, 2012

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As the U.S. economy continues to gain momentum, attention has shifted among policymakers toward reducing deficits in the public sector. Indeed, both President Obama’s and Representative Paul Ryan’s recent budget blueprints call for significant deficit reduction this decade. In the first of two special reports on deficit reduction, we assess the evolution of public sector deficits from the perspective of a flow-of-funds accounting framework. By definition, deficit reduction in the public sector must be offset by less saving from some combination of U.S. households, U.S. businesses and the rest of the world.

During “normal” times, changes in private-sector behavior and in prices, interest rates and exchange rates facilitate the required changes that must take place in saving flows among sectors. However, there may currently be some impediments that could retard adjustment. Households may desire to keep their saving rates elevated to repair battered balance sheets, and businesses may choose to remain in cash-hoarding mode. The adjustment toward a smaller current account deficit, which implies fewer capital inflows from abroad, could be hampered by attempts of foreign governments to prevent their currencies from appreciating against the dollar. The U.S. economy could then become trapped in a vicious cycle of fiscal consolidation that leads to private-sector retrenchment and weak export growth, which is followed by further fiscal consolidation and then by further retrenchment and even weaker export growth.

Will fiscal tightening in the United States lead to such a vicious cycle? In a subsequent report, we will examine the fiscal consolidation that is currently underway in the United Kingdom to ascertain what lessons that experience may hold for the United States.

Click on the pdf link below to view the full report.

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