It’s Not the Deficit, Stupid

by Reihan Salam

Keith Hennessey points out that two of the main drivers of the federal government’s improved fiscal position are the tax increases under the post-cliff ATRA legislation and, as Economics 21 recently noted, surging dividends from Fannie and Freddie, which reflect the effective nationalization of mortgage finance. Hennessey’s core contention, which is clearly correct, is that the new deficit news is far less promising than it looks, particularly if you prefer a lower tax burden and a truly private market for mortgage finance. Sen. Bob Corker (R-TN) has proposed legislation that would prevent the federal government from using revenue from Fannie and Freddie to subsidize other government functions on the grounds that turning the government-sponsored entities (GSEs) into cash cows will make reform all but politically impossible. But of course this kind of self-denial is never likely to be popular in Congress.

Once again, the new deficit projections are a reminder that focusing on the deficit alone has always been a fool’s errand. The country faces a number of interrelated challenges. Reforming entitlement programs, and in particular health entitlement programs, are among the most important of these challenges, but not just because they are a driver of future deficits. After all, we could raise taxes, including relatively efficient consumption taxes, to address fiscal imbalances. Rather, the deeper problem is that while some of our institutions work relatively well for most people — we live in one of the world’s most prosperous countries, and gains in the material standard of living have been pretty decent for Americans living above the bottom two-fifths of the household income distribution, even during periods of sluggish growth —  a lot of them work really badly for people in the bottom two-fifths. It’s not that K-12 education is substantially worse now than it was in the 1970s. It’s just that as family patterns have changed and the demand for skilled workers has increased while the demand for less-skilled workers has decreased, we need K-12 schools to do more for more people, and the strategies we’ve pursued to meet this need (e.g., reducing class sizes) has proven to be both very expensive and of limited efficacy, a miserable combination.

Something broadly similar is true of medical care. In The Cost Disease, the economist William Baumol observes that in 2005, U.S. health care spending per capita was $6,400 while all other spending per capita was $35,400. He projects that if growth in output continues at its historical average while growth in medical expenditures does the same over the next century, health care spending per capita in 2105 will be $213,000 while all other spending per capita will be $130,000. That is, health care spending will go from 15 percent of GDP to approximately 60 percent in the space of a century. Baumol’s eye-catching extrapolation has potentially enormous implications for how we ought to think about government. As of 2011, the federal government financed 28 percent of total U.S. health expenditures while state and local governments accounted for an additional 17 percent, with the rest divided between business (21 percent), households (28 percent), and other private revenues (7 percent). Medical expenditures by business and households and other private sources are subsidized in various ways by government at all levels, but we’ll leave that aside and say that government accounted for 45 percent of medical expenditures in 2011. This number will most likely increase as the Affordable Care Act is implemented, but let’s also leave that to the side and imagine that government will account for 45 percent of medical expenditures in 2105 — government spending on medical care alone with represent 27 percent of GDP. This is the best-case scenario. In this world, total government expenditures (federal, state, and local) might represent as much as 60 percent of GDP. Even if we achieve fiscal balance with government expenditures at 60 percent of GDP, the space for private enterprise, civil society, and voluntary cooperation writ large will be smaller than it is today, and it is not unreasonable to believe that this might have deleterious consequences on dynamism and initiative. 

This landscape creates opportunities for more ambitious thinking. In the realm of medicine, for example, James Pinkerton has called for what he calls a “cure-first” approach, which aims to reduce medical expenditures by curing seemingly intractable ailments, thus reducing the demand for medical care. Early experiments in online education and blended learning remain in many cases inferior to the best brick-and-mortar alternatives, but like all disruptive innovations, they have the advantage of being cheaper and thus more accessible to the non-consuming population and they have the potential to get better faster than brick-and-mortar education. These causes are fairly familiar on the pro-market right, and for good reason: they are paradigmatic. And though both are related to the cause of spending restraint, they are also related to the cause of delivering better services and a better quality-of-life. Focusing on the deficit, meanwhile, gives advocates of tax increases and status quo government the upper hand. 

Ross Douthat has some excellent thoughts on related themes. We’re in this, or we should be in this, for more than just paring down the debt.

The Agenda

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