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The Budget Deficit is (Mostly) Endogenous

People love to assign economic blame or credit to the President.  Government debt and deficits are particularly popular talking political points when one is trying to confirm their political bias.  For instance, since President Obama took over in 2008 we constantly hear Republicans talk about how he has expanded government debt.  Since 2011 he’s been widely credited by Democrats with bringing the deficit down.  This is almost always a misleading story.

One myth that I’ve discussed in detail in the past is the Clinton surplus and how Democrats like to cite this as an economic positive (which it wasn’t, but that’s a story for another day).  The problem, however, is that the President really doesn’t control the direction of the budget deficit or surplus thanks primarily to its endogeneity.

I was talking about this yesterday on Twitter when Brad Delong and Noah Smith became enraged at me for saying that Clinton didn’t really cause the budget decline of the 1990’s.  Noah posted the following chart and then claimed that the 1993 Omnibus Budget Reconciliation Act set the stage for the deficit decline and the surplus.  He claimed that the spending cuts started in 1993 after Clinton’s budget passed.


This all looks like a plausible story if you squint your eyes and wave a Democratic flag. Except for the fact that the spending “cuts” clearly peaked in 1983.  If one were politically biased you could find some cool sounding Reagan storyline here about how he cut spending drastically.  Or, you could do what many Republicans do and cite the 1990 Budget Enforcement Act as the policy that really kickstarted our way to surplus.  See how that works?  Depending on your political preference you can basically torture the data and the storyline enough to make it say whatever you want it to.

The alternative approach is to remove the political bias from much of this and look at what has mainly driven the budget in the last 30 years: the state of the economy.  And if we look at the budget fluctuations relative to economic growth we see a clear pattern:


You can clearly see that the budget fluctuates with the economy because spending and revenue trends are highly influenced by the state of the economy and automatic stabilizers.  So, when the economy is strong the deficit tends to contract and when the economy is weak the deficit tends to expand (as automatic spending and tax receipts increase/decrease and the denominator collapses).  As a result of this and the procyclical nature of the deficit/surplus we find that the state of the economy plays the most important role in driving the deficit/surplus.  Clinton didn’t cause the deficit to decline any more so than he caused the 90’s economic boom.  Likewise, Obama didn’t cause the 2008-2011 deficit expansion any more so than he caused the economic collapse.

This doesn’t mean Presidents don’t have any impact on the budget.   That would be wholly naive.  But as Bill Clinton said, “it’s the economy, stupid”.  I think many economists and pundits have a tendency to assume causation where there is mostly correlation.  It makes for good political talking points, but it makes for very biased and bad economics.

Update – Here’s a nice chart from the CBO showing the procyclical nature of the budget deficit/surplus.  As you can see the deficit or surplus clearly correlates with the strength of the economy.  So, unless you think that government policy steers the entire economy then it should be obvious that the deficit or surplus is a residual effect of the economy rather than the driving force.