Thursday, March 4, 2010

Wrong time for deficit reduction

By Vijay K. Mathur

Published in Standard-Examiner, Feb 21, 2010

Budget deficit increases have been ignored by politicians and policy wonks on both the right and left from the 1970s, with the exception of a brief period of surplus from 1998 to 2001. Budget surplus during 1998-2001 turned into budget deficit starting in 2002.

In terms of our capacity to pay determined by GDP (Gross Domestic Product) there was 354 percent increase in the proportion of budget deficit from 2001 to 2008. Now, when the country has just missed another great depression and is still not fully recovered, we hear a battle cry by some politicians and deficit hawks against budget deficits and public debt. We did not hear the same concern in peacetime, when the economy was humming in the latter part of the 1980s, and before the recent severe recession.

It seems that our political leaders are ignoring the bigger picture of deficits and public debt. They are either unwilling and /or unable to put the current deficit in historical context. According to Congressional Budget Office (CBO), actual deficit as a percentage of GDP was 4.9 percent in 2008 and after reaching the projected peak of 8.9 percent in 2009, it is expected to decline to 1.2 percent in 2015.

During the Great Depression, budget deficit at the start of Roosevelt's administration in 1933 was 4.6 percent of GDP and after peaking to 5.48 percent in 1934, it declined substantially until the start of the WWII build up in 1939. It should also be noted that in 1930's the Federal government was not saddled with enormous liability of mandatory spending as it is today.

According to CBO, mandatory spending (only on Social Security, Medicare and Medicaid) is expected to increase to 86 percent of total spending in 2015 from 79 percent in 2008. It leaves little room to cut spending, given the unwillingness of many conservative politicians and tea party-goers, to change current laws to modify these spending programs and taxes.

According to the study in November 2009, by economist Gary Richardson in the online journal The Economist Voice, "red" states "that typically support Republican presidential candidates -- and that send the bulk of Republican representatives and Senators to Washington, D.C. -- are the states that receive the most in expenditures relative to the taxes their citizens pay." These are the same states where we hear the loudest complaints against taxes and higher spending. Spending and tax policies are not right vs. left issues, because we all have a stake in a fiscally sound government and a health economy.

We are all interested in reducing deficits because they may pose problems when the economy is growing and both private consumption and investment spending are growing robustly. For example, in a growth economy close to full employment, persistent deficits may aggravate inflation and may dampen economic growth by crowding out private investment. The decrease in capital stock due to the reduction in private investment also increases income inequality as it decreases productivity of labor and thus wages. Since national saving must balance investment and net exports, budget deficits may reduce national saving and hence investment and/or net exports. The decline in net exports implies sale of assets to foreign countries and thus leakage of investment returns. Deficits also transfer income from domestic wage earners to Treasury bond holders, domestic as well as foreign.

CBO projects decline in gross public debt as a percentage of GDP from 85% in 2010 to 78% by 2015. Despite this hopeful sign, once the economic recovery is assured with jobs our political leadership must be willing to raise some taxes and significantly reduce growth in mandatory and discretionary spending, to put the economy on the long term path of fiscal balance. Persistence in accumulated deficits, even during robust and stable economic growth, put us on a risky path and may make the fiscal policy impotent during the next economic crisis.

There are two ways to reduce public debt. First is to reduce budget deficits. Second, the economy has to grow faster than the interest rate we have to pay on the debt. CBO projections give us some hope on the growth front.
Projections show that during 2011-14 inflation adjusted GDP growth rate will be slightly higher than the interest rate on 10-year Treasury notes. But growth rate projections will not materialize if we cut spending programs to promote new investments at this time.

The recovery is fragile, and private markets are plagued with uncertainty of recovery. The call for deficit reduction and cuts in spending at this time, specially meant to promote investment, invites either very slow recovery or outright decline in growth rate and thus deprives our children and grandchildren of wealth and good life in the future.

Mathur is former chairmen of the economics department and professor emeritus of economics at Cleveland State University, Cleveland, Ohio. He resides in Ogden.

No comments: