The Deficit Danger

Federal budget policy threatens to undercut economic growth and erode American society.

At the time of the last presidential election campaign, four years ago, the government was running a sizable budget surplus. That surplus, then-Governor Bush argued, belonged to the taxpayers, and they should get it back. When critics objected that a tax cut on the scale he proposed would throw the government back into the red, the candidate derided their claims as "fuzzy math"; there was plenty of room in the budget, he argued, to cut taxes without risking a deficit.

Two wars and three tax cuts later—including what the new president proudly called the largest tax cut in U.S. history—the government has just run the largest deficit in U.S. history in dollar terms ($375 billion) as well as the largest as a share of our national income (3.5 percent) since 1993 (see figures, below). The 2004 deficit will almost surely be larger still. More important, under current tax and spending policies, the budget will remain far out of balance for the foreseeable future. Even with a full economic recovery, the Bush administration now predicts deficits averaging 2 percent of the national income for 2005 through 2008. And if the administration's estimates of the cost of our ongoing engagement in Iraq continue to be too low, as has certainly been the case so far, the deficit will be just that much larger.

During the president's first two years in office, when U.S. business was operating well below capacity and the number of Americans on the job was shrinking month after month, having the government run a deficit was actually helpful. When the government bought airplanes and ordnance for the military, and engaged contractors to pave the roads and repair the bridges, that spending helped put people back to work. Lower taxes enabled private citizens to spend more on everything from houses and cars to meals and movies. But during this past year the economy has returned to more rapid growth and lately even employment has begun to pick up.

By election day, the recent recession and the unusually sluggish recovery that initially followed it will be just a memory. But the budget won't be back in balance—not by this election, nor (under current policies) by the next one. And after 2010, when the oldest members of the baby-boom generation will become eligible for Medicare as well as full Social Security retirement benefits, the gap between the government's spending and its revenues will begin to widen in earnest.


What is at stake in all this is America's economic growth. Any economy requires investment to grow. A modern economy requires sophisticated investment—in up-to-date equipment, in a well-trained labor force, in research to develop new technologies—and plenty of it. That's what enables business to become more productive, which in turn allows both workers' wages and shareholders' profits to outpace whatever inflation takes place, which in turn means that the entire society's standard of living improves over time.

When the government spends more than it takes in from taxes (that's what running a deficit means), the Treasury has to borrow in the financial markets to cover the overage. People who put their savings into banks or mutual funds don't think of themselves as financing the government's deficit. But when these institutions use the deposited funds to buy Treasury securities, that's exactly what they are doing. The government's borrowing therefore absorbs private saving that otherwise would have remained available to finance investment in productive new plant and equipment.

The root of the problem is that America has always been a low-saving country. If we had a saving rate like Italy's (11 percent) or Korea's (above 13 percent), having the Treasury absorb an amount of our saving equal to a few percentage points of our national income would be of little concern. But during the last 10 years, the total amount of saving done by families and firms in our economy, beyond the amount we need merely to replace the factories and houses that are wearing out (in other words, the saving that is available to enable our economy to do more than just keep running in place), has averaged not even 6 percent of our national income. If the government's deficit averages 2 percent of national income later this decade, as the Bush administration has predicted, it will therefore take up more than one-third of America's net saving. More likely, the deficit will be larger and so will the share of our national saving it absorbs.

When a similar situation occurred during the Reagan administration (in those years the deficit averaged 4.2 percent of national income), defenders of the president's policy offered a variety of stories about how the saving rate would rise in step with the government's borrowing, or how business could become more productive and wages improve without new investment, or how some other break with prior experience would solve the problem. Those ideas were intellectually interesting. But they also proved wrong. During the big-deficit years of President Reagan and the first President Bush, the share of U.S. national income devoted to net new investment in plant and equipment fell to the lowest average level in the postwar period, and real wages—and therefore the real income of the typical U.S. family—stagnated.

To make matters worse, in order to finance even the meager investment we were able to make during the Reagan-Bush years, with the government absorbing so much of our saving, America borrowed so much from abroad that we became the world's most highly indebted country. During the last few years, the United States has also been running a large trade deficit, and consequently has been borrowing heavily from foreign lenders, in this case for reasons having little to do with the budget deficit. Business here may have been weak, but it was stronger than in Europe, or Japan, or Latin America. We also buy more than $100 billion in goods each year from China, but sell the Chinese little in return. Last year, as our economy started to do better, our international imbalance widened to a record level.

If our government continues to run a sizable budget deficit, that will only make this imbalance yet worse, causing America as a nation to go yet more deeply into debt to foreign lenders. Meanwhile, as President Bush's ill-fated steel tariffs illustrate all too well, at home the inevitable result of a large and chronic trade deficit is political pressure leading to protectionist measures that in the end hurt most Americans by making what they buy more expensive.

Most important, however, continuous large budget deficits, maintained year after year even at full employment, take away the economy's means of achieving economic growth. President Bush and other members of his administration have hailed the changes in the structure of taxes that have gone along with his series of tax cuts—most recently, the reduced tax rate on corporate dividends—arguing that they will help promote investment and growth. That might be right, if everything else stayed the same. But everything else isn't staying the same: the harm done to America's investment and growth by large chronic deficits will likely outweigh any spur that might otherwise come from changing the structure of taxes.

In the end, the most fundamental threat that the president's big-deficit policy poses is not to the U.S. economy but to the character of American society. Countries where living standards for the majority of citizens improve over sustained periods of time are more likely to seek and preserve an open, mobile, tolerant society and to strengthen their democratic institutions. Countries where living standards stagnate, or even erode, instead mostly tend toward rigidity and intolerance, and their democracy weakens.

The United States is no exception. Living standards have improved over most of our country's history, and over time our society has become more open and tolerant and our democracy has broadened and strengthened. But even in America these basic values are at risk when our living standards stagnate. Median U.S. family income showed virtually no increase, beyond inflation, from the early 1970s to the early 1990s. Much of what happened during that time—the rise of the "militia" movement, the wave of ugly xenophobia, the open retreat from generosity toward our own most disadvantaged citizens—was the predictable pathology of a society whose citizens knew they weren't getting ahead.


What could the president do now? There are three approaches to getting rid of a government deficit: hope it goes away on its own; cut government spending; and raise taxes. Hoping for the economy to grow fast enough to solve the problem without a change in policy was the approach favored by President Reagan. It didn't work. As numerous economists predicted—including many at Harvard, among them both Democrats and Republicans—even the quite rapid growth of the mid and late 1980s came nowhere close to generating sufficient revenues to close the budget gap Mr. Reagan's policies had created. Doing that required a combination of tax increases (first under the elder President Bush and then under President Clinton) and spending cuts (mostly in the military budget at the beginning of the Clinton administration, and then in domestic programs after the new Republican majority took control of Congress in 1995).

In principle, cutting back on government spending should be a natural for the younger President Bush as well. Indeed, many conservatives have hailed his tax cuts precisely on the grounds that they will deprive the government of revenue, eventually "starving the beast" into retreating from its role in areas of American life where, so the argument goes, it has no valid presence.

Source of graphs: Office of Management and Budget; author's estimate for 2004

In fact, President Bush's commitment to reduce "government spending" (without saying what kind) is mostly a sham. He and his party have enthusiastically supported more spending for military hardware, military manpower, enlarged farm subsidies, a bail-out for the airlines, and a new prescription-drug benefit for all elderly Americans including the needy and the not-needy. To be sure, each of these programs may be worthy on its merits. But the same goes for spending programs that Democrats normally favor, like putting more teachers in the classroom and more police on the beat. President Reagan turned out to be against "government spending" only in the sense that he was against the spending programs he didn't like and for those he liked—importantly including not only the military budget but also the large entitlement programs, like Social Security and Medicare, that serve all elderly Americans. (These universal entitlements cost more than three times as much as means-tested entitlements, like Medicaid and other welfare programs, that serve only the poor.) President Bush's approach seems to be similar.

Finally, what about raising taxes? George W. Bush's determination to cut taxes is one of the hallmarks of his administration. Moreover, it is clear that this determination transcends any specific rationale. The president first said he wanted to cut taxes in order to give back the government's surplus. When it became clear that the surplus was already gone, the justification became to help speed the economic recovery. Now that the recovery is solidly in progress, the new argument, Reagan-style, is about supply-side incentives for business to invest and for individuals to save.

Nor, apparently, is the president uncomfortable with the inconsistency between the way many American conservatives talk about taxes and what they say about spending. "Tax Liberation Day"—normally some time during the spring—marks the end of the portion of the year corresponding to the fraction of the typical person's income that goes for taxes. Federal income taxes, however, now amount to only 10 percent of total personal income (and far less for the average family). Much of what the average working-age taxpayer hands over to the government is actually in Social Security and Medicare contributions. But the elderly Americans who benefit from these two programs do not believe they are receiving a government handout; they think they are only getting back what they paid in during their working years. Those who trumpet Tax Liberation Day rarely disagree, even though excluding from the calculation the amount contributed to Social Security and Medicare (which together account for more than one-third of all federal spending) would place the date a month earlier.

President Bush took over a government that had a budget surplus and that plausibly anticipated staying in surplus until the baby boomers retired. Now there is a deficit—a large one—and under our current policies it will persist. To run a continuous deficit that absorbs a large share of our scarce national saving, even at times of full employment, is irresponsible policy, harmful to the nation's future. Whoever is president a year from now—whether George W. Bush or one of his Democratic opponents—should restore the government's fiscal posture, and with it America's prospects for long-run economic growth, to the way President Bush found them when he first took office.


Benjamin M. Friedman '66, Jf '71, Ph.D. '71, is Maier professor of political economy. His newest book, on the moral consequences of economic growth, is forthcoming from Alfred A. Knopf.    

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