Deficit Dangers

Volume IX, Number 1 March 10, 2003

Amid so many grave concerns about the state of the economy and the world--from the sinking stock market to the looming war with Iraq, from 9/11 to Enron--it's hard to get Americans to focus on the federal budget. That's too bad, for while we were all looking the other way the budget outlook has undergone the swiftest and largest reversal in our history. Two years ago, the CBO was projecting a surplus of $353 billion for FY 2003. According to CBO's latest numbers, the actual 2003 budget is now running a deficit of $246 billion--for a negative swing of $600 billion in a single year. And this doesn't include any of the current White House budget proposals, which CBO says will push the 2003 deficit to $287 billion. The dangers of resurgent deficits are highlighted in a new Committee for Economic Development report. The report concludes that, on our current course, massive federal borrowing threatens to crowd out productive investment and lower future living standards. The Concord Coalition welcomes CED's timely warning. Apologists for today's budget policy give many reasons for not worrying about the return of deficit spending. Some say that today's deficits are temporary--and that the budget will soon be in surplus again even if we do nothing. Others argue that, with interest rates near historical lows, there's no way the deficits can crowd out investment. Still others acknowledge that the deficits are a cause for concern, but insist that today's weak economy and uncertain geopolitical climate prevent us from doing anything about them. None of these arguments withstands scrutiny. It's time we dispensed with excuses and relearned the fundamentals of responsible economic stewardship.

A More Realistic Scenario

To begin with, the real fiscal outlook is much worse than the official projections indicate. According to the CBO, the deficit will start easing next year. The budget balance will turn positive in 2008 and eventually cumulate to a ten-year surplus of $891 billion This projection, however, assumes that the 2001 tax cut will expire on schedule, something almost no one in Washington believes will occur. It also assumes that discretionary spending, the part of the budget that pays for national defense, will shrink continuously as a share of the economy. This is supposed to happen even as the nation strengthens homeland security, mobilizes for war, and conducts a global campaign against terrorism. If we assume that current tax rules remain in effect and that discretionary spending keeps pace with the economy, CBO's ten-year surplus of $891 billion becomes a ten-year deficit of $2.0 trillion. In this more realistic scenario, deficits continue throughout the ten-year budget horizon and beyond--even without the enactment of the President's proposals for additional tax cuts or a prescription drug benefit

History's Bottom Line

The problem with deficits is that they soak up national savings and crowd out productive investment. They do so by raising interest rates.  CED estimates that, over the course of the business cycle, each one percent increase in the federal deficit as a share of GDP pushes up interest rates by one-half percent. It is true that, despite resurgent deficits, interest rates are near historical lows. The phenomenon, however, is cyclical and cannot last. With the economy still struggling, investment demand remains weak. As the economy revives and investment rekindles, interest rates will surely rise--and the vast majority of economists agree that they will rise faster and farther with large deficits than without. Since America's savings pool is shallow, the impact of large deficits is especially harmful. The U.S. net national savings rate is already low both relative to other developed nations and to our own history.  From 10.9 percent of GDP in the 1960s, it slid to 4.8 percent in the 1990s--and to a postwar low of 3.3 percent in 2001. Current fiscal policies are due to push net national savings still lower, ultimately driving it beneath zero. This brings us to history's bottom line, as insisted on by one economic luminary after another, from Adam Smith to Karl Marx to Alfred Marshall to John Maynard Keynes: No country can enjoy sustained living standard growth without investing, and no country can sustain high investment for long without saving.

These thinkers all understood that capital formation may not be a sufficient condition for rising living standards, but it is certainly a necessary condition. Moreover, it is the one condition that a society can directly influence. We cannot legislate technological breakthroughs--nor even a higher private savings rate. But we can legislate a budget surplus, and surpluses add to national savings just as surely as deficits subtract from it. It may not matter much to private savers whether they end up purchasing a tractor or a T-bill. But it matters a great deal to the economy. The deficit apologists sometimes argue that America's declining national savings rate doesn't matter because foreign savers are taking up the slack. And in fact since the late 1990s surging capital imports have helped to prop up U.S. investment. What the deficit apologists forget is that America will have to pay back the loan--or else cough up a permanent debt service charge. Either way, future living standards will suffer.

There's another concern. Already, 35 percent of the U.S. public debt is owned by foreigners, a percentage that has doubled over the past ten years. If the trend continues, the United States may find itself increasingly hostage to global financial markets--and perhaps even to the whims of foreign governments.

A Credible Plan

Some who share these concerns believe, nevertheless, that the economy is now so weak that it needs near-term fiscal stimulus to get it back to full employment and full capacity. Perhaps. But stimulus isn't at issue. Just 5 percent of the tax cuts in the President's “economic growth” package would end up in consumers' pockets this fiscal year. Far from being counter-cyclical, the package tilts the budget toward permanent deficits. Concord believes that what the near-term economy really needs is a credible long-term budget plan. Just beyond the ten-year budget horizon, America's age wave begins to roll in. Over the entire decade of 2003 to 2013, the CBO projects that Social Security, Medicare, and Medicaid will grow by less than 1 percent of GDP. But from 2013 on, they will be growing by 1 percent of GDP every three and one-half years. If senior entitlements are left on autopilot, all projections--by the CBO, the GAO, and OMB--indicate that deficits will eventually rise to economy-shattering levels. The American public is beginning to understand that the status quo is unsustainable. It's hard to imagine anything that would do more to boost near-term economic confidence than a credible plan to address America's long-term budget challenge.

Never the Right Time

A couple of years ago, when the budget was running large near-term surpluses, many claimed that the long-term problem would solve itself. Now that the budget is running large near-term deficits, many claim that the choices required to solve the problem would be too painful. The outlook is always too good or too bad. Somehow, it's never the right time to do the right thing. Congressional leaders will soon be drafting next year's budget resolutions. Concord urges them to move beyond denial and diversion and put the budget on a sustainable trajectory. The longer we wait, the more difficult the choices will become and the bigger the price our children and grandchildren will have to pay.