July
21, 2003, 7:00 a.m.
Deficit
Politics
The Democrats don’t like tax cuts. That’s what it’s
all about.
ast week’s announcement
that the federal budget deficit will reach $455 billion this fiscal year
(which ends on September 30), brought predictable denunciations from the
Democratic side of the aisle. It’s not so much that Democrats care about
deficits — after all, they are the party that invented deficit spending
— they just want to score points against the Republicans.
I don’t blame them.
In their shoes, I would do the same thing. I wrote many a press statement
denouncing Democratic deficits during the Carter administration, when
I was a young Republican staffer on Capitol Hill. Although I never thought
deficits mattered very much, I knew that there were many people out there
who did. So, lacking anything else to say, we Republicans attacked Carter’s
deficits.
The problem was that
although most people think deficits are terrible, they are even more opposed
to any measure that will actually eliminate them. Huge majorities were against
tax increases or any particular cuts in spending to bring deficits down.
Thus, while Republicans felt good about themselves for being fiscally responsible,
they gained no electoral advantage whatsoever.
It wasn’t until 1980,
when inflation and interest rates both reached double-digit levels, that
the deficit issue had any electoral potency whatsoever. That is because
there was a plausible case to be made that deficits were inflationary, as
well as raising interest rates by crowding out private borrowers from the
market.
The problem is that
it just wasn’t true. Inflation is exclusively a monetary phenomenon. It
results when the Federal Reserve creates too much money. That is the one
and only cause of inflation — meaning a sustained rise in the general
price level. Individual prices go up and down continuously. But the overall
level of prices cannot rise unless initiated or accommodated by the Fed.
Inflation was also
the principal cause of higher interest rates at that time. Borrowers knew
full well that the debt repayments they received in the future would be
reduced, in real terms, by inflation, so they demanded an inflation premium
in interest rates as compensation. Long-term rates in particular rose percentage
point for percentage point with inflationary expectations. Thus, if a mortgage
rate would have been 4 percent with zero inflation, it would be 12 percent
if 8 percent inflation were expected.
Therefore, both inflation
and high interest rates resulted from the same basic cause: Federal Reserve
policy. Whatever impact deficits may have had was very small by comparison.
Some argued that deficits
were inflationary because the Fed was monetizing the debt — in effect,
paying it off with printed money. If so, this was a counterproductive strategy,
because interest rates rose faster than the deficit. The inflation resulting
from faster money-supply growth raised interest rates, rather than lowering
them, by raising inflationary expectations. Higher interest rates raised
the Treasury’s borrowing costs, which made the deficit worse. Thus, except
in the very short run, printing money to pay off national debts just doesn’t
work.
Of course, some countries
do resort to the printing press to pay their debts and in such cases deficits
are inflationary. But the Federal Reserve is an independent institution
that operates as it pleases. Administrations can influence it, but they
can’t control it. Consequently, there is no direct linkage between deficits
and inflation in the U.S.
The notion that deficits
raise interest rates is more plausible, but the evidence doesn’t support
it. Since 2000, the budget has gone from substantial surplus to substantial
deficit, yet interest rates have fallen steadily over that period. The reason
is that whatever impact deficits may have on interest rates is small relative
to the impact of other factors, such as the business cycle, Fed policy,
and exchange rates.
Politically, the main
importance of the deficit is that it undermines the case for tax cuts. Indeed,
every Democrat running for president next year would reverse already-enacted
tax cuts, at least in part. They want the higher revenues to pay for increased
spending, rather than deficit reduction. But higher deficits make their
case easier.
One problem is that
current deficits have very little to do with tax cuts. If all the tax cuts
over the last three years were magically rescinded, we would still have
a deficit of almost $300 billion, due to the economic recession and higher
spending for national security. Moreover, economic growth would be slower
and unemployment would be higher — substantially so according to a
Treasury Department study.
In the end, the deficit
is more of a metaphor than something real. Republicans use it as a shorthand
way of saying spending should be lower, while Democrats use it to imply
that taxes should be higher. One’s preferences in this regard will largely
determine one’s perception about the importance of deficits at any given
time.
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ast week’s 
