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The Agenda

NRO’s domestic-policy blog, by Reihan Salam.

We Don’t Need to Balance the Budget—Ever.



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Kevin Williamson has a post up today accusing Republicans of not having a realistic vision for budget sustainability, and for the most part I think he’s right. However, he makes one very common error among budget hawks.

Kevin says: “But here’s the thing: If you want spend 21 percent, you really need to tax 21 percent. If you want to tax only 18.5 percent, you can only spend 18.5 percent.” This isn’t true. The federal government can, and should, run a structural budget deficit in perpetuity.  The key is just that the deficit should not be too large; roughly, 2 percent of GDP would be an acceptable figure.

This is an idea that people tend to recoil from instinctively. Deficit spending is supposed to be irresponsible, and you can’t do it forever! But take a look at these two charts, based on data from the Office of Management and Budget. The first shows federal budget surpluses or deficits from 1960 through 2010. As you’ll see, the federal budget was in deficit for 48 of those 51 years, on average by 3 percent of GDP.

The last two years’ budget deficits are unprecedentedly large (excluding those seen during World War II) but deficits were not invented by George Bush or Barack Obama; indeed, deficit spending was the norm in the 1960s and ramped up during the Reagan era.

That bar chart may look pretty alarming. But here is a graph of Debt Held by the Public (real outstanding bonds, not pieces of paper held by the Social Security Trust Fund) as a share of GDP, over the same period:

The period from 1960 to 1982 saw improving debt to GDP ratios, even as the government ran a budget deficit during every year except one. During the 1980s, larger budget deficits reversed the trend—modest deficits are OK, but deficits around 4 percent of GDP are too big. Then in the 1990s, a strong economy and a series of fiscal adjustments moved the ratio down again, though notice that debt/GDP started declining in 1995 even though budget balance was not achieved until 1999. Budget deficits returned under George Bush, but it wasn’t until 2008, with a severe recession and truly enormous budget deficits, that the debt-to-GDP ratio began soaring.

For most of the last 50 years, we had a sustainable fiscal policy and budget deficits. That’s because key to sustainability isn’t balance—it is making sure that the public debt does not grow faster (over the long term) than the economy.

Let’s say that your structural budget gap is 2 percent of GDP, meaning that will be your average budget deficit, though it will be higher in recessions and lower in expansions. And let’s say that your long term rate of nominal GDP growth is 4 percent. Maintaining those two trends will ultimately cause your debt to GDP ratio to stabilize at 50 percent—in any given year, the economy will be twice as large as the public debt and will grow by twice as many dollars.

The ideal debt to GDP ratio is debatable, but 50 percent is certainly acceptable and sustainable. If you want to aim for a lower figure, you simply have to tweak your structural deficit down relative to nominal growth.

For this reason, it is unnecessary for fiscal reform plans to target a balanced budget, and it would be foolish for Congress to enact a Balanced Budget Amendment. Fiscal adjustments are unpleasant, and going all the way to balance would put Americans through more pain than is necessary. Maintaining budget balance through economic cycles would force the government to take pro-cyclical actions during recessions (i.e., tax increases and spending cuts), harming the economy. And ultimately, a balanced budget requirement would lead to the withdrawal of government bonds from the financial markets, which is a problem because they play a valuable role for investors seeking security.

Our current fiscal path is unsustainable. It must be adjusted and, in the medium-term, it will be adjusted. But it’s important to take the long view: for over 220 years, the federal government has been able to borrow to pay for current operations, and in general it has used that power well. We should strive for budget sustainability, as we historically have. But we should not start making a fetish of actual budget balance.

Edit to add: To be clear, I don’t mean to specifically endorse a structural deficit target of 2 percent of GDP, or a debt/GDP ratio of 50 percent. I don’t have a firm view but my inclination would be to aim a little bit lower. We don’t have firm numbers on how public debt affects economic growth, but recent research suggests that a percentage point change in the debt to GDP ratio starts to matter much more once you cross some threshold of sustainability. The threshold is definitely higher than 50 percent, but a lower target would give us more breathing room to borrow in recessions.



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