The Deficits Are Coming - Hide the Women and Children

Rudy! Actually, I didn't watch it, but I heard it was goood. Meanwhile the National Press was no doubt repeating ad infinitum that the Republicans are showing their moderate face to the nation as a cynical ruse. Meanwhile, 200,000 members of the Michael Moore contingent of the Democratic party were outside the gates doing their best audition to become carnies; and again, NBC probably found the one who wouldn't qualify as a carnie and pointing to the moderation of the crowd. That same crowd, of course, was in Boston, but you didn't see them, because the Democrats were showing their moderate face to the nation without one second guess from the media. See, you don't have to watch it ... The script is so predictable.

Here is an article, apropos of nothing, regarding the overblown political hype surrounding budget deficits. Snore. First published in a Minneapolis newspaper 3 years ago, here it it:

The vaunted budget surplus is disappearing before our eyes, and we are too bored with thinking about government fiscal matters to care. The Congressional Budget Office (CBO) has recently reported that their previous federal budget surplus projection of $5.6 trillion (for fiscal years 2002 through 2011) has fallen to $1.6 trillion. That is $4 trillion lost in the span of one year (and you thought you were getting hit by the downturn in the stock market). The CBO projects slight deficits over the next two years, followed by a return to more modest surpluses. Are you asleep yet? Not if you are a politician.

Why should you care if you are not a politician? What are the potential consequences of a return to deficit financing? If you gauge your understanding of the nature of the consequences by the shrillness of the political debate that surrounds the topic, it is clear that there is much at stake. I can imagine a few issues that elicit similar urgent concern: pestilence, war, and famine being just three. If I knew nothing else about the boring details of the subject, I would think my children's lives were in danger. Fortunately, because of what I know, I don't lose a wink of sleep over the issue, and neither should you. And here is what I know: the deficit is more important as a political debate than it is as a problem to our economy.

A federal budget deficit is a lightning rod for Republicans and Democrats alike because of the veneer of fiscal irresponsibility attached to it, and the consequent pressure to balance the budget. For Republicans in general, the desired response is to cut funding to programs (i.e. those in Democratic districts) that the taxpayers are being pillaged to fund. For Democrats, the desired response is to raise taxes on those who are not paying their fair share (i.e. those in Republican districts) in order to maintain funding of all the wonderful public goods brought to you by our beneficent government.

The debate over these matters is less shrill in times of surplus because each side can get a little of what it desires. Controlling for the effect of the economic downturn on the size of the surplus, the reduced estimates over the next two years is due in roughly equal part to reduced tax revenues and increased discretionary spending. Now that the black turns to red, expect the gloves to come off. The return of the deficit, no matter how modest, brings the debate over how big the federal government should be, and who should pay for its largesse, back into the limelight.

But is there more at stake with budget deficits than creating a battlefield for the opposing desires of our two political parties? Is there a sinister link between budget deficits and a crashing economy? One theory holds that deficits may indeed have a negative effect on the economy through their influence on interest rates. Deficits, under some circumstances, may raise the cost of borrowing money. Remember - pestilence, war, famine, and raising the cost of borrowing money.

The theory goes as follows: when the government increases its demand for borrowed funds, and there is no similar increase in the supply of loanable funds, interest rates rise. As interest rates rise, some private firms that are trying to raise financial capital for investments that will enhance productivity may find that such investments are not worthwhile at the increased borrowing rate. Private investment can therefore be "crowded out" by government deficits. Because private sector investment is one primary driver of productivity growth, and hence improving economic conditions, squeezing it out through deficit financing may reduce long-term growth rates in GDP.

Flash back to the townhall style debate between Clinton and Bush in 1992 - at the height of political concern over budget deficits - when a man who learned all of his economics from the back of a cereal box posed the question to each candidate as to how the deficits affected each personally. Looking at each candidate as a consumer, the question was absurd; neither was concerned about borrowing money because each lived in government owned homes, and each were transported in government owned vehicles. If they were planning on increasing their investment holdings immediately, higher interest rates would be a good thing for them. This is basically what Bush had said to the obvious dissatisfaction of the questioner. Bill Clinton, in contrast, bit his lip and spoke with the requisite empathy that is due to pestilence, war, famine, and rising interest rates, and the rest is history.

But do budget deficits actually lead to increased interest rates? Consider what happens if the government decides to eliminate the deficits by increasing tax rates. The increase in rates will leave you with less post-tax income than otherwise, both because you are taxed at a higher rate and because you may have substituted leisure for work (since the opportunity cost of more leisure is reduced by the increase in tax rates). If you have less money, chances are you are reducing both your savings and your spending. But if everyone reduces the amount that they save, the supply of loanable funds contracts, and interest rates will rise. So, if you are concerned about closing the deficit for the purpose of not increasing interest rates and crowding out investment, raising taxes is not likely to solve the problem - it only changes its cause from an increase in demand caused by government borrowing to a decrease in supply caused by less income in the hands of taxpayers.

There is therefore good reason to believe that the mix of financing (debt versus taxes) for a given level of government expenditures has no real effect on the economy. The same cannot be said, however, in regard to the amount and nature of government spending - both have very real effects on the performance of the economy. If one were narrowly focused upon keeping interest rates low so as to maximize private sector investment, reducing the size of the government budget would always have this affect.

In reducing the size of government, what is lost may be more valuable than what is gained. (By the same logic, it is possible to increase the size of government in a way that confers more benefits than costs.) The cost-benefit assessment depends upon where one proposes to cut spending. If, for example, the plan is to reduce law enforcement resources, the consequent reduction in perceived safety may lead people to purchase private security systems for their home at an expense that exceeds the benefits of reduced interest rates. Or, they may find themselves involuntarily paying high amounts for protection services offered by people who do not take no for an answer. On the other hand, if the budget reduction plan is to cut funding for building the Bill Clinton Presidential Library, I suspect only one person in this economy would regard that as a bad deal.

Because people think that deficits matter, Democrats and Republicans are forced to fight it out over the tax and spending policies of the government. But the truth is that the importance of this fight is largely independent of how the government finances its activity. In times of balanced or even surplus budgets, the size and nature of government spending still implies very real and pervasive effects upon the larger economy, some good and some bad. We would do ourselves a favor if we focused on the value of each dollar spent and the cost of each dollar raised by government rather than upon budget deficits.