A favorite pastime of the Democratic presidential candidates is to denounce the big federal budget deficits. They are fond of pointing out that President Clinton left the current administration with a budget surplus and that it vanished during the Bush administration. According to most, the Bush tax-rate cuts are to blame. It follows that to restore “fiscal responsibility” we must repeal part or all of them. A secondary line of attack is that we have runaway defense spending that needs to be reined in. But this line of reasoning does not square with the Keynesian views the candidates advocate.
In the context of a simple Keynesian model, tax cuts increase disposable incomes and that in turn leads to an increase in aggregate demand. Increases in government spending also result in increases in aggregate demand. Hence, if deficit financing leads to an increase in aggregate demand, something else must be dragging down the economy. What?
The favorite answer given by former Treasury Secretary Robert Rubin is that the deficit leads to higher interest rates which slow down economic activity. This view is not exclusive to the Democrats. Former Commerce Secretary Peter Peterson shares the Rubin view. Recently, former-Sen. Warren Rudman joined Rubin and Peterson at a press conference where they denounced the budget deficits. They called for “fiscal discipline”– a euphemism for higher tax rates.
Many in the financial press take the Rubin-Petersen-Rudman argument for granted. Once you buy into their assumption, their logic is very compelling. There is only one small problem — the data do not support their views.
In the 1980s, for instance, if you track federal budget surpluses as a percent of gross domestic product along with the yield of the 3-month Treasury bill, both trend downward. This shows a positive relationship between surpluses as a percent of GDP and the T-bill yield. This is an important point: the correlation is opposite of what the deficit mongers forecast. So, here are two competing conclusions: Either budget deficits have no impact on interest rates, or there is a long and variable lag and deficits impact interest rates down the road.
The first hypothesis is the best: Budget deficits have no impact on interest rates. And if there is no real link between the two, as the data suggest, the deficit mongers have no argument.
So, if we need not worry about the possible effects of the deficit on interest rates, what should we be concerned about? Well, it seems to be that we should want to stimulate the economy without producing a long-run deterioration of the budget deficit. And what is needed is some government action that produces an increase in economic activity sufficiently large enough to expand government coffers so that the government action pays for itself over the long run. In other words, to steal a bit from the Beatles: All we need is growth . . . growth is all we need.
In the context of a Keynesian model, an increase in government spending or a tax cut will increase the economy’s aggregate demand. If the action is large enough, it is possible for the final increase in GDP growth to lead to higher revenue collections that will fully finance the higher spending.
Supply-siders, however, focus on the incentives generated by tax-rate changes. Lower tax rates increase the incentives to work, and thus result in higher output — bringing the economy closer to its potential output. Lower tax rates also increase the incentives to save and invest, thereby expanding the economy’s potential output. Thus tax-rate cuts help us accomplish two objectives: they push the economy closer to its potential output as well as expand it.
A low inflation rate, strong economic growth, and a safer world make up the appropriate policy mix needed to produce an improving deficit condition. The optimal policy mix seems to include a domestic price rule (where price levels guide Federal Reserve action), lower tax rates, restraint on overall spending, and a strong defense. This combination served Presidents Reagan and Kennedy quite well and should help President Bush if he stays on this course. Lower tax rates and a low inflation rate provide an economic environment that fosters risk taking and work effort, the benefits of which should be long lasting. As real GDP rises, long-term budget-deficit projections will look better and better.
It is important to note that the current recovery coincided with the passage of the Bush dividend-tax-rate cuts. This is reassuring to those of us who hold a classical pro-growth view of the world. However, this view is not universally shared. There are those who espouse the view that the recovery is the result of higher government spending (on defense, etc.), and that as the spending spikes subside, so will the stimulus. Viewed this way the current recovery will be short-lived and unless we increase spending some more, there will be an economic slowdown by spring.
In contrast, the supply-side view is that lower tax rates, as long as they become permanent, will increase incentives to save, work, and invest and that in turn will result in higher real GDP growth and a stronger economy for some time to come. Time will tell which of the two views is correct. By the middle of the primary season we should know for sure. Those who are betting against the current policy mix and want to reverse it are taking a big gamble. If history is any guide, they will be sorely disappointed when next summer rolls around.
— Victor Canto, Ph.D., is the founder of La Jolla Economics, a research and consulting firm based in La Jolla, Calif.