The Corner

Debt and Deficits: When Symptoms Become Symptomatic

I testified yesterday before the House Ways and Means Committee on deficits and debt and their impacts on job creation. The other witnesses were Stanford professor Edward Lazear (who’s also a former chairman of the Council of Economic Advisers), AEI resident scholar Andrew Biggs, and Center for American Progress senior economist Heather Boushey.

The least I can say about the hearing is that it was highly entertaining. Congressman Stark called us clowns and second-rate economists, and suggested that the committee must have had to scrape the bottom of the barrel to find us — and that included his own witness. Lazear was amused and rightfully pointed out that his credentials had been vetted by the Senate not so long ago. Also, much of the Democrats’ attention was on the Bush tax cuts and our unfunded wars (these wars being Iraq and Afghanistan, not Libya).

My testimony focused on the ideas that debt and deficits matter because they are the symptoms of a disease called government (Ranking Member Levin remarked that comments like this one, along with the $61 billion cuts passed by the House, were signs of the extremism reigning in Washington right now).

I also argued that unfortunately, the persistent failure of lawmakers to cut spending has resulted in a situation where these symptoms have started provoking other symptoms. We should think of them like tumors. Tumors are a symptom of cancer. But independently tumors wreak all sorts of havoc on the body. They not only fuel their growth by stealing nutrients from other bodily purposes, but they also impinge on the function of vital organs like the brain, the lungs, and the liver.

So it is, after a certain point, with debt and deficits. They hinder economic growth and destroy jobs. Besides being expensive and self-perpetuating, they increase the probability of a severe fiscal crisis and can signal to investors that the United States may be getting closer to the time when it won’t be able to pay those investors back.

The problem, as always, is that while economists can tell you that things are likely to go bad, no one can seriously pinpoint the moment when things are going to collapse. In fact, it could be that things will stay rampantly bad without a real collapse. Or it could get really bad all of a sudden. So much of what will happen and when is a combination of each country’s characteristics. For instance, so far, the U.S. has benefited from its position as the world’s reserve currency, but that may change. It also benefits from the fact other countries are in pretty bad shape (investors rate countries on a curve), but that may change too, especially if we continue on this path. But what would happen if China’s economy got into a recession? It wouldn’t be in a position to provide so much of our capital needs. That could have bad consequences for us. In particular, it would have a negative impact on interest rates and the value of the dollar.

Biggs, Lazear, and I agreed that reforms should be put in place now. Biggs’s testimony was particularly interesting. He presented the conclusions of a recent paper he wrote with his colleagues Kevin Hassett and Matthew Jensen. In the article, the economists reviewed the extensive existing literature on fiscal consolidations. They also conducted their own data analysis to study that question. They used a large data set covering over 20 OECD countries and spanning nearly four decades to isolate over 100 instances in which countries took steps to address their budget gaps. Some of these fiscal consolidations were principally spending-based while others relied more on taxes. Here is what they find:

Our findings are striking: countries that addressed their budget shortfalls through reduced spending were far more likely to reduce their debt than countries whose budget-balancing strategies depended upon higher taxes.

The typical unsuccessful fiscal consolidation consisted of 53 percent tax increases and 47 percent spending cuts. By contrast, the typical successful fiscal consolidation consisted of 85 percent spending cuts. These results are consistent with a large body of peer-reviewed research.

Here is a Wall Street Journal article on their findings. They are consistent with the findings of Harvard’s Alberto Alesina and Silvia Ardagna (here is another paper by Alesina on the issue), and also consistent with the work of former Obama CEA chairman Christina Romer and her economist husband David Romer, which shows that increasing taxes by 1 percent of GDP for deficit-reduction purposes leads to a 3 percent reduction in GDP.

Overall, it was an interesting and entertaining moment. However, as my colleague Matt Mitchell noted after the event, many politicians are interested in politics rather than policy. His post here has very interesting data.

Veronique de Rugy is a senior research fellow at the Mercatus Center at George Mason University.

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