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Neil H. Buchanan

Everyone Seems to Agree That Budget Deficits are Harmful. Can They All Be Wrong?


Thursday, July 16, 2009

"The federal budget deficit this year is going to be over a trillion dollars." "No, over one-and-a-half trillion." "No, even more than that!" "The deficit is bad." "The deficit is worse than we thought." "The deficit is destroying the economy." "The deficit is ruining our grandchildren's lives."

Surely, we should all want to reduce the deficit, right? Actually, no. Unfortunately, there seems to be a direct correlation between the volume of public shouting about the budget deficit and the level of misunderstanding of what the deficit means – or, indeed, even what the deficit is.

The recent spate of disappointing news about the economy, in a context where we had all been hoping that the worst had passed, has apparently put President Obama on the political defensive over the level of deficits. However, this need not be so.

Once we understand the basics of deficit finance and the alternatives that we currently face, it becomes clear that the President need not apologize for the size of the deficit. If anything, we should be happy that he has thus far mostly ignored the "deficit hawks" (both in his own party and among the opposition), and we should support him if he decides that it is necessary to inject more stimulus into the economy later this year or next.

What Are Deficits, and Why Do They Seem So Scary?

The concept of a budget deficit is deceptively simple. If I spend more money in a year than I have received, then I have run a deficit. This situation then requires either that I take money out of any savings that I might own, or that I borrow money to cover the difference.

This basic definition, more technically known as a "cash-flow" deficit, simply says that a deficit exists whenever the year's revenues are less than expenditures. This year, the U.S. federal government's cash-flow deficit is likely to be about $1.7 or $1.8 trillion, which is about 12% or 13% of the country's annual income.

These numbers certainly seem big. For some people, they are unimaginably large. It is, therefore, all too easy for opportunistic politicians simply to point at those numbers and repeat the word "trillion" as loudly as possible, in order to suggest that this level of deficit is simply horrible, no matter what.

To enhance the scare factor, some will go further and divide the deficit (and the overall national debt) by the number of families in the country to express "your family's share" of the total, frightening people into imagining that somehow the deficit is going to result in their – or their grandchildren's -- being required to someday write the government a check for tens of thousands of dollars.

The reality is that deficits serve some very important purposes, and it is generally better to run deficits than to try to eliminate them. One useful analogy is to think about the concept of taking pills. Some pills are always bad for you, but some are good for you -- and even essential -- either for a short period of time (such as antibiotics) or as an essential part of a healthy life (such as vitamin supplements and medications that control and mitigate chronic diseases).

Refusing to take any pills at all will not necessarily kill a person tomorrow, but for some very sick people it might, and for others the damage will be felt further down the road. Similarly, increases in the federal deficit are sometimes necessary to end a severe illness (and the current recession surely counts as that), and deficits also should be used to improve the long-term health of the economy.

Deficits as Medicine

The current economic situation in the United States and most of the world is as precarious as it has been in decades. Despite the current, welcome feeling that we seem to have pulled back from the precipice of out-and-out global economic depression, the trends are negative in far too many areas -- most obviously, in the continued loss of jobs. I should emphasize "seem to have pulled back" in that last sentence, because it is not at all certain that the financial system has recovered sufficiently to support an economic rebound, nor even to withstand the renewed round of home foreclosures and job losses that could well be in the offing.

When the economy is as weak as it is now, strong medicine is necessary. Macroeconomists have known for decades that the economy can be brought out of periods of ill health by having the government spend money when everyone else is pulling back on their own spending. That is not, of course, "Plan A." Everyone would have been much happier if the economy had continued to expand, which would have made stimulative deficit spending unnecessary. We also would have liked it better if monetary policy (lower interest rates) could have reversed the economy's slide, but rates are already as low as they can go. The last resort was to try to expand the economy directly, which is what the stimulus package from this past Spring was all about.

The increase in the deficit in the face of the weakening economy is, in fact, one of the reasons that focusing on the "cash-flow deficit" can be so misleading. It is one thing to say that we are running a deficit of, say, 12% of national income during boom times, but it is quite another to say we are running a deficit of that magnitude during a recession. During a recession, we should expect that the deficit will be temporarily high, for two reasons:

First, when the economy is weak, we collect fewer tax dollars (because so many people have lost their jobs or have seen their incomes fall), and we also have to spend more money on benefits to prevent people from suffering catastrophic and irreversible harm as they try to find new jobs.

Second, the deficit is also higher during a downturn than it would normally be because of the government's attempts to stimulate the economy. More than a quarter of the projected deficits for this year and next, for example, are due to the stimulus bill -- a law that is explicitly a two-year commitment of federal borrowing as an attempt to reverse the slide. If the recession ends, the need for stimulus will end.

These explanations for the temporary rise in annual federal deficits also explain why we should not respond to these deficits by trying to reduce them. Cutting deficits during a downturn not only is the opposite of being stimulative (thus predictably worsening the crisis), but it is also affirmatively counterproductive. That is because (as states like California are demonstrating even as I write this) attempts to balance budgets by cutting spending and raising taxes become a vicious cycle, since budget cuts throw people out of work and discourage businesses from hiring.

To return to the analogy to taking one's medicine, a patient might respond to an illness by saying, "I hate that medicine. I'm just going to buck up and do what I normally do. I'm going to the gym. That will make me feel better." The patient might even feel virtuous about how "tough" he is being. As we know, however, refusing medication and putting added stress on one's body can prevent healing and worsen symptoms. (There is also an analogy here to the spreading of germs in the gym locker room, but I will leave the interdependence of global economies aside for now.)

In other words, even people who really, truly do not think that borrowing is a good long-term strategy should not object to running deficits in the current economic situation. Indeed, the sooner we get out of this recession, the sooner deficits will go down as we move forward.

Deficits as Vitamins

Some economists, however – and I am among them -- emphasize that it is wrong even to think that the deficit should be reduced to zero during good economic times. We point out that the federal government is always uniquely placed to be able to spend money in ways that improve the long-term performance of the economy, and we conclude that that unique positioning justifies running annual deficits as a matter of sound economic management.

Support for basic research and development, education at all levels, nutrition for children at the critical early stages of physical and mental development, and countless other forms of federal spending constitute "public investment" that enhances the living standards of both current and future Americans. We should try to increase spending on those crucial items, not reduce it.

Notably, this is true even if the money to fund these government programs is borrowed. (This is exactly the way businesses treat their investment spending, by the way, borrowing money to pay for those items that promise to have long-term payoffs.) Although there is a financial calculation required that is too involved to discuss here, there is no serious disagreement about the point that a government can improve the lives of its current and future citizens by borrowing money to finance many of the things on which the U.S. federal government actually does spend money. While it is possible to collect sufficient taxes to pay for all of those things up front, doing so is unnecessary, because the benefits that the borrowing will bestow on future citizens exceed the additional debt that they will inherit.

The point, therefore, is that the economy's health can be improved significantly by having the government administer "vitamins" regularly in the form of spending programs that will enhance future growth. Moreover, this future growth can take the form of growth in the quality of life, such as environmental improvements, that might not show up in the economy's measured income but that will certainly be appreciated by people in the immediate and distant futures.

As is true with any medical intervention, of course, there can be too much of a good thing. Given that the current economic stimulus package was reduced in size at the last minute (to accommodate concerns about the increase in the deficit) by cutting spending on decaying schools, however, it is difficult to see how one could argue that the federal government is currently spending too much on educating our young people. The crumbling bridges and roads, and the people becoming sicker because of inadequate health care, are further testament to the fact that we are giving the economy "vitamin shots" that are too small, not too large.

Spending and Deficits in a Democracy

In addition to the possibility of over-using or misusing deficits in their roles as medication or vitamins, it is always possible that we could increase the deficit in a way that neither helps mitigate recessions nor enhances long-term growth. If we run deficits simply to give money to people who neither need it for immediate spending, nor use it to hire people or build up businesses, then we are doing the equivalent of dosing the economy with toxic drugs.

This possibility requires us to be vigilant in making sure that any borrowed money is not shoveled to those with political connections, or used to fund projects that simply are not in the long-run interests of the country. That balancing act is the essence of governing, and there is no short cut that will guarantee that we always get it right. Calling for "balanced budgets" does not do the trick because, as I have explained above, the budget affirmatively should not be balanced during a downturn, and it need not be balanced during prosperous times.

In short, we elect our leaders in part so that they will apply their best judgment to the array of choices that the country faces. The key, therefore, is not to listen to politicians who would have us believe the fantasy that fiscal responsibility lies in setting platitudinous and self-defeating goals with no economic sense or reasoning behind them. The key, instead, is to insist that our politicians drop the tired talking points and understand that budget deficits can be good as well as bad.

Neil H. Buchanan, J.D. Ph. D. (economics), is a Visiting Scholar at Cornell Law School, an Associate Professor at The George Washington University Law School, and a former economics professor.

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