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Friedman Fundamentals
The deficit hawks won't gain much politically.


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One of the critical differences between conservatives and liberals is that the former think the overall level of taxes and spending is important, economically, whereas the latter think only the difference between the two matters. When taxes exceed spending, resulting in a surplus, this is good in the liberal view. When spending exceeds taxes, resulting in a deficit, this is bad. Conservatives, however, are concerned whenever spending or taxes increase, regardless of whether one happens to be higher than the other.

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Two years ago, revenues were close to $2 trillion, while spending came to just under $1.9 trillion, leaving a surplus of $127 billion. Liberals were happy. But last year, revenues fell to just over $1.8 trillion, while spending rose to about $2 trillion, resulting in a deficit of $158 billion. This made liberals unhappy.

Conservatives saw the matter differently. They saw taxes in 2001 as taking 19.9% of the gross domestic product — well above the historical average of about 18%. Spending came to 18.6%, well down from 10 years earlier when it was 22.3%. But almost the entire decline was accounted for by lower defense spending, which fell from 5.4% of GDP to 3.1%, and lower interest on the national debt, which resulted mainly from lower interest rates by the Federal Reserve. These two items alone accounted for 3.5% of the 3.7% decline in spending as a share of GDP.

Thus, domestic spending (all the rest) was virtually unchanged. The decline in defense was worrisome, while the decline in interest was meaningless. Economists view the latter as nothing but a pure transfer with no significant economic effects. In fact, they often deduct interest payments from government spending in order to calculate the primary deficit — the one that really matters for financial markets.

Consequently, conservatives were not particularly elated when the budget was in surplus in 2001 and not particularly upset when it fell into deficit in 2002. Insofar as the former was the result of high taxes and inadequate defense spending, it was a bad thing in the conservative view. And if the latter resulted from lower taxes and higher defense spending, that was okay.

Of course, conservatives didn’t always feel this way. During the 1950s and 1960s, they often obsessed about deficits and even supported higher taxes and cuts in defense spending for this reason. But deficits never went away because liberals always spent up to the point where deficits became politically intolerable. This gave conservatives the reputation of being tax collectors for the welfare state.

In 1978, this began to change as conservative intellectuals, especially the great economist Milton Friedman, argued that the conservative concern for deficits had simply led to higher and higher taxes and bigger and bigger government, with no offsetting benefits whatsoever. In a seminal article in the Summer, 1978, issue of Policy Review, Friedman argued forcefully for cutting government any way possible, even if it led to budget deficits. Said Friedman, “I would far rather have total federal spending at $200 billion with a deficit of $100 billion than a balanced budget at $500 billion.”

Friedman’s authority helped convince many conservatives to support the burgeoning tax revolt, even though it might result in deficit spending. They also discovered that if deficits became large enough, liberals would finally be forced to cut spending.

What conservatives learned is that there really is no downside to deficits as long as they result from lower taxes rather than higher spending. No Republican candidate was ever defeated for supporting tax cuts, even if they led to large deficits. And as long as the Federal Reserve maintained a noninflationary monetary policy, and the U.S. imposed no restrictions on international capital flows, interest rates could come down even as deficits went up.

By contrast, liberals paid a heavy price for deficits because they could no longer credibly support big-government spending programs for every real or imagined problem in society. Moreover, much of the spending that bought liberal votes was cut under the pressure of deficits. Domestic discretionary spending fell from 4.7% of GDP in 1980 to just 3% in 1999. Over the whole period, such spending was $1.5 trillion lower than it would otherwise have been.

As a consequence, liberals lost support among swing voters because they had nothing to offer them. This made such voters more receptive to the conservative tax-cutting message.

Now the Republican party has completely adopted the Friedman mantra, which he repeated in the Wall Street Journal on January 15: cut taxes any time, anywhere, and don’t worry about deficits. This has forced Democrats to become “deficit hawks” for lack of any other issue. The evidence suggests that it won’t do them much good politically.



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