Politics & Policy

In Defense of Deficits

They're not so bad, and at times they're necessary.

Doug Bandow, a senior fellow at the Cato Institute, recently criticized President Bush’s fiscal policy in an article called, “A Conservative Case for Voting Democratic.” Wrote Bandow, “So how do we put Uncle Sam on a sounder fiscal basis? Vote Democratic.”

We’re in a tight presidential election race — in a year when the liberal press portrays Americans as the bad guys in the Iraq war, and at a time when the Democratic contender for the White House resembles Neville Chamberlain. The last thing the Republican party needs is the reckless suggestion that conservatives vote Democratic.

In his article, Bandow echoed several free-market economists who today belong to the “almost all non-defense spending is bad” school. “Given the generally woeful record (on deficits) of Republican presidents,” Bandow wrote, “the best combination may be a Democratic chief executive and a Republican legislature. Thus, the only way we can realistically keep Congress and the President in separate political hands is to vote for John Kerry in November.”

The problem with advocating a vote for Kerry on the implied basis that a split-party government will mitigate any wayward deficit spending is that such advocacy reflects a misunderstanding of the role of fiscal policy — i.e., budget deficits — in maintaining a viable economy during times of crisis. (This is likely one of those times.)

The current federal budget deficit is about 5 percent of gross domestic product. The reason for this deficit is twofold. First, deficit spending supported economic activity as the U.S. transitioned from a “bubble” economy back to a normal economy. The “bubble” was inflated beyond capacity as companies of all sizes updated computers to handle the Y2K event. Once the threat of this electronic dislocation passed, demand for computers and related equipment dropped dramatically. This decline rippled through the economy.

The government’s first response to falling economic activity was to lower interest rates. The Federal Reserve reduced its policy rate to near record lows, expecting a quick pick-up in business borrowing. Yet the expectation of a recovery in business spending was not forthcoming — businesses didn’t want the money so it didn’t really matter what the interest rates were. Subsequently, after the expected nine-month waiting period, a sustainable rally in the stock market and the economy failed to materialize.

However, the real boost to economic recovery was the fiscal-policy stimulus of tax-rate cuts and increased spending, part of President Bush’s second fiscal-stimulus package in 2003.

Few economists recognize that the budget surplus inherited by President Bush was an albatross around his political neck. In fact, the faster he got rid of it, the better off he and the economy would be. Unfortunately, politicians were gleeful that budget surpluses could be used to eliminate the national debt. However, the problem with budget surpluses is that they collapse private-sector savings. Budget surpluses are a sign of excess taxation, and when the government sector saves, the private sector saves less.

This relationship is taught in basic economics. For example, when the government buys back debt, the macro effect can be described as follows: The government buys back bonds from the public by effectively raising taxes to pay for the bonds. At the end of the day, the individual has no savings in the form of the bonds, but has a higher tax bill. The public response is probably to spend less.

Budget surpluses are contractionary. They shrink the economy. Yet many conservative economists demand a return to budget surpluses even though deficits provide the stimulus to avoid deep recessions.

Not until the implementation of the president’s second stimulus package in the second quarter of 2003 did the stock market surge and the economy get back on a sustainable growth path. If the expected growth of 4 to 5 percent in real GDP is maintained, the budget deficit may not get any bigger. However, it may not get any smaller.

The second reason for a record budget deficit is higher defense spending. During the 1990s, President Clinton contracted defense spending and avoided confronting terrorism. Now that the U.S. is fighting a global terrorist threat, the government must increase spending on defense and on waging a new type of war. During World War II, the U.S. budget deficit as a percent of GDP jumped to 45 percent. Compare that with our 5 percent level today. Few economists would have advocated reducing the deficit in those days — when the very fabric of American life was threatened. We should be spending more, not less on defense.

Given that there are viable economic and political reasons for a large budget deficit, arguing that there is a need to reduce the deficit makes little sense in today’s economy. Rising economic growth and booming corporate profits should mitigate the growth in the deficit — not a tax increase for the rich as proposed by Sen. Kerry and the Democrats in general.

While anyone can correctly make the argument that there is much government spending that is wasteful, it is unlikely that a Democratic president and a Republican Congress would dramatically reduce pork-barrel spending, as Cato’s Bandow has proposed. Instead, this twosome might be less inclined to make the right choices that are necessary to keep the economy on a sustainable growth path.

Republicans should think twice about voting Democratic to reduce government spending. And both parties should simply think a little harder about budget deficits: Had we hung onto the surpluses of the late 1990s, we’d be in a world of economic hurt today. If that prognosis seems counterintuitive, take a look at what happened to the economy right after the big budget surpluses of the 1920s.

– Thomas E. Nugent is executive vice president and chief investment officer of PlanMember Advisors, Inc. and chief investment officer for Victoria Capital Management, Inc.

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