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How to Achieve a Sustainable Budget Deficit

June 28th, 2011 . by economistmom

My latest column for the Christian Science Monitor emphasizes that it can’t just be about brute-force cutting the budget; those spending cuts or tax increases have to make sense for the economy, too:

The United States budget deficit has become a crucial issue lately, and not just because it’s about to put us over the debt limit. The concern is not so much that the deficit is unusually large right now, as we’re still recovering from an unusually bad recession. The problem is that over the next several decades, even if the economy moves back to full employment, the fiscal outlook looks unsustainable.

What does an unsustainable budget look like?

Imagine that Uncle Sam takes out a loan (the national debt) to buy an investment (the US economy). As long as the economy grows faster than the debt, everything’s great. Even when Uncle Sam falls short on his monthly payments and borrows even more to make up the difference (the federal deficit), lenders aren’t going to panic as long as the economy keeps growing faster than the debt.

Everyone knows Uncle Sam is getting richer, so he can afford the bigger debt.

Here’s the problem: Over the past few years, federal budget deficits have been equivalent to about 9 to 10 percent of the size of our economy (as measured by gross domestic product). That means each year America’s total debt has grown by a commensurate amount. Even when the recession ends and those deficits are projected to come down to 6 or 7 percent of GDP over the next decade under current policies, that implied growth rate of the debt will still far exceed the expected 2 to 2.5 percent annual growth in the economy over the same period.

That’s the definition of economically unsustainable: when an economic obligation rises faster than the means to pay for it.

President Obama’s fiscal commission set a goal of getting deficits down to about 3 percent of GDP within five years – 3 percent being the average annual growth rate of the US economy since World War II. But the magic number might not be 3 percent, if, for example, the economy doesn’t turn out to grow at 3 percent on average in the future.

It’s important for us to recognize that there are two sides to this “sustainability equation”: the spending side – i.e., the deficits – and the income side – which, in this case, is represented by a growing economy. Crucially, the choices we make about the first part – through the economic effects of those spending policies and not just the cost of them – affect the second part, economic growth.

That’s why we can’t just mechanically reduce the deficit as naive accountants might. Instead, we need to artfully reduce the deficit as smart economists should. After all, what would you say about a family that decides to trim expenses to a “sustainable” budget by cutting spending on its most productive household investments, such as education and preventive health care, but does nothing about its most frivolous and least-productive spending for, say, lavish parties or flat-screen TVs? Such poor choices made in the name of frugality just end up hurting the family’s future income (their “human capital”) and the level of future spending such income could support.

The same concept applies to the government’s budget. Whether it’s getting the most economic “bang per buck” out of deficit-financed policies designed to stimulate short-term demand, or reducing the longer-term deficit with policies that minimize disincentives to work or save, getting our deficits down to “sustainable” levels requires paying attention to both sides of the sustainability equation: future income as well as spending.

9 Responses to “How to Achieve a Sustainable Budget Deficit”

  1. comment number 1 by: Vivian Darkbloom

    I agree that we need to focus on smart spending and not just on the amount of spending. That’s a very good point. Economist Mom, I know you are proud of your profession, but where have all those smart economists been the last 50 years? As a smart progressive economist, are you willing to put aside some of that well-intentioned but disastrous entitlement spending, such as 99 week-long unemployment benefits in favor of smarter infrastructure spending that delivers long-tem economic benefits and jobs? It seems to me that smart progressive economists share a great amount of responsibility for distorting economic incentives, particularly through the tax code, with their over preoccupation with income redistribution and immediate progressive political gains rather than long-term gains for our national economy.

    But, perhaps there is some hope for economists after all. Donald Marron, a very smart economist, has, I think, in the National Review, written one of the most cogent and intelligent pieces on tax expenditures and tax policy I’ve ever read. It is longer than a blog piece, but that is one of its advantages. It should be required reading.

    http://www.taxpolicycenter.org/UploadedPDF/1001542-Spending-In-Disguise-Marron.pdf

  2. comment number 2 by: Ralph Musgrave

    EconMom, Congratulations on your statement that “we can’t just mechanically reduce the deficit as naive accountants might.” In other words while a microeconomic entity like a household or business can reduce a deficit by cutting expenditure or raising income, a macroeconomic entity like government cannot do this. Indeed, there is even evidence that cutting public spending actually RAISES public spending. (The world of macroeconomics is bizarre.) See:

    http://www.debtonation.org/wp-content/uploads/2010/06/Fiscal-Consolidation1.pdf

    Having said that, I don’t like the way you go along with the conventional wisdom, namely that there is some big difficulty in cutting the deficit – even paying off the debt. Solving this problem is easy. Just buy back the debt, and the money from two sources. First, get some from the printing press (i.e. continuing with QE). Second, get some from raised taxes. As long as the inflationary effect of the former equals the deflationary effect of the latter, there’d be no net effect (except that the debt comes down). For more details, see:

    http://www.thejeffersontree.com/the-debt-and-deficit/

  3. comment number 3 by: economistmom

    Vivian: Yes, Donald Marron’s piece should indeed be required reading. I love his point that we should stop calling tax expenditures “loopholes” or “tax earmarks” (which sounds like they benefit only special interests) and just come to terms with the fact that most of the largest tax expenditures confer benefits on a very broad part of our population and to which we all tend to feel “entitled.”

  4. comment number 4 by: Vivian Darkbloom

    Economist Mom,

    Regarding your point about loopholes: I agree.

    I know you are found of President Obama’s rhetorical skills, but just a few minutes ago I finished watching the last part of his press interview. Well, it was a disaster. Among other things, in a long and rambling response he completely denied not showing leadership on the debt issue and tried to put all the blame on Congress. He also indicated that the negotiators on the debt limit issue have identified spending cuts we can afford and now we need to look at closing some “tax loopholes”. I wish I had been there to ask him to identify a couple hundred billion dollars of those “loopholes” we need to eliminate.

  5. comment number 5 by: SteveinCH

    Actually the part that frustrates me is that the Democratic position appears to be that we need to limit the ability of the wealthy (but not others) to take advantage of tax breaks. In my view, this type of change is nothing other than a rate increase.

    I would fully support the elimination of provisions in the tax code (regardless of what you call them) as long as the provision is eliminated rather than creating even more complex rules for when different provisions can be applied.

  6. comment number 6 by: Gipper

    Economistmom,

    I’m always amazed by the conceit of Kenyesians regarding their powers to pull levers of government spending, taxation, and monetary policy to impact long-term growth rates. Always this is done under the guise of empirically sound, well-researched reasoning masking the underlying politics of an ever-expanding welfare state.

    Kenynesianism, like religious theology, is impervious to refutation. The stagflation of the 70’s put it in disrepute, but the desperation of grasping for an understanding of the Great Recession brought it back from the grave, where it should have lain.

    We’ve seen an administration give Keynesianism the good college try, and it’s failed. The reason is that it’s at the micro level where decisions are made by entrepreneurs and labor force participants to actually produce wealth for consumption today and tomorrow. This administration and the Keynesian tax and spend policies are crushing these participants. The PPACA, high minimum wages, 99-week unemployment benefits, and other inane ideas from the left, are taking the wind out of the sails of economic progress.

    Talk until you’re blue in the face about tax expenditures and whatever other revenue enhancing hobby horse you’re riding, but I’ll take the wisdom of entrepreneurs over economists and accountants any day.

  7. comment number 7 by: Ralph Musgrave

    Gipper, You clearly don’t understand much about Keynsianism if you think it consists of “tax and spend”. If government removes an extra $X from the private sector pockets via tax and spends it on say law enforcement, it just means that households spend $X less on cars, housing, food, etc and $X more is spent on the police, courts, etc. Net effect on employment is about zero.

    Keynsianism, to oversimplify, consists of government spending more, period. No extra tax is collected. Alternatively tax is reduced period and public spending is left constant. That means the private sector has more money to spend and thus create jobs.

    As to the idea that Keynes was particularly left wing, that is nonsense: he advocated that public spending should be no more than 25% of GDP. That’s way below the current European average and slightly below the current US figure.

    Having said that, obviously high minimum wages and long periods of entitlement to unemployment will tend to raise unemployment – I agree with that.

  8. comment number 8 by: Jim Glass

    For the record, one shouldn’t confuse today’s countless variations of “Keynesianism” with Keynes himself.

    E.g.: the Palgrave (1998 edition) notes something surprising:
    ~~~

    Despite the fact that the economics of deficit finance began with the Keynesian Revolution, it has been conclusively established by Kregel (1985) that Keynes himself did not ever directly recommend government deficits as a tool of stabilization policy.

    Keynes played a conservative political hand and viewed budget deficits with a ‘clearly enunciated lack of enthusiasm’.
    ~~~

    Keynes opposed deficit stimulus spending on multiple occasions, such as in Britain, 1937 (with unemployment at 11%).

    While he did often discuss the potential need for govt spending to support the macro economy, that generally was via the balanced budget multiplier.

    Whatever one thinks of JMK, he’s certainly suffered from “the law of dimishing disciples” and the effects of political football.

  9. comment number 9 by: Anandakos

    Mr. Musgrave,

    Your definition of “Keynesianism” shows only one half of the picture. Keynes always favored running a surplus in the flush parts of the business cycle and only advocated deficits when (as now) there was large slack in the economy.

    Now there’s no doubt that both parties have conveniently forgotten the admonition to run a surplus when everything’s coming up roses. But that’s not Keynes’ fault.