Fiscal deficits, economic growth and government debt in the USA

A simple model illustrates interactions between the ‘primary’ fiscal deficit (total deficit minus interest payments), economic growth and debt. The deficit/income ratio responds countercyclically to growth while growth may respond positively (a ‘Keynes’ case) or negatively (à la ‘Merkel’) to the deficit. The recent Great Recession in the USA was atypical in that there was a weak countercyclical fiscal response. The increase in government net borrowing was significantly less than the decrease in private borrowing—an historically unprecedented asymmetry. Econometric estimates verify the historical pattern and further suggest that there is a strong positive effect on growth of a higher primary deficit, even when possible increases in the interest rate are taken into account.