DEFICIT WATCH: All We Need is Growth---Deficit Delirium

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.

Despite improving economic and budgetary news, there is rising pressure to do something about the budget deficit. I expect this pressure to grow rapidly over the next year. By early 2005, I believe such pressure will be irresistible. It's not too soon to start thing about where this could lead.

The main reason why I see pressure building for a budget deal is that interest rates are going to rise sharply over the coming year. Following are some reasons:

Economic growth is accelerating. Many economists are now expecting 4 to 5 percent growth over the next year. This by itself will raise interest rates because it means that the rate of return to capital will be rising. If a firm can make more on a new investment, it will not mind paying more to borrow to capitalize on this opportunity. Thus increased business borrowing will raise rates.

Inflation is likely to reemerge. For the last several years, deflation or falling prices have been the economy's biggest problem. In response, the Federal Reserve has increased the money supply and added a lot of liquidity to the banking system. I believe that this has finally reversed the deflation problem. But inflation raises long-term interest rates by adding an inflation premium to rates.

The dollar is likely to fall. The Bush administration seems convinced that forcing other countries, especially China and Japan, to raise their currencies is the key to reducing manufactured imports and raising exports. This is part of its electoral strategy for appealing to blue collar workers. But raising foreign currencies is just another way of saying that the dollar will fall. While this may improve the trade balance, it will also reduce the willingness of foreigners to invest here. Reduced foreign capital inflows will raise interest rates.

Finally, the Fed will eventually see that inflation and a falling dollar require a tightening of monetary policy. This will raise short-term rates.

These are the most important reasons why interest rates will rise. But politicians and the media are likely to focus on only one thing: the federal budget deficit. Even though serious economic research shows little impact by deficits on interest rates, all of the rise in rates will be blamed on the deficit and only the deficit. This will be hyped in the liberal media ceaselessly in order to hurt Republicans and aid the prospects of whatever Democrat gains the presidential nomination.

I expect to see Democrats start to talk more and more like Ross Perot in 1992 about the danger of deficits and the need to take action. They will shift their criticism of President Bush's Iraq policy almost exclusively toward its budgetary implications. This was also the way they responded to the Vietnam War initially — questioning only its cost, not its basic wisdom. Later, after making it harder and harder to prosecute the war effectively, they turned toward attacking the war itself. They will try the same thing with Iraq.

Of course, Democrats will also sharpen their rhetoric on taxes, blaming the tax cuts as primarily responsible for the deficit and therefore rising interest rates. All of the Democratic presidential candidates are on record as favoring some scale-back of the 2001 and 2003 tax cuts. Only Howard Dean favors a total repeal. Lately, he has even endorsed other tax increases on top. He hopes to paint himself as a fiscal conservative in order to offset his image as the most left-wing major candidate running for president.

Already, Dean has fooled a few Republicans like Steve Moore of the Club for Growth into thinking he really is a fiscal conservative. In fact, none of the Democratic candidates care anything about the deficit except as an excuse to raise taxes. They want higher taxes to soak the rich and raise spending, not to reduce deficits. But they may be successful in forcing President Bush to respond to the challenge and put forward some sort of deficit-reduction plan next year.

By early 2005, I expect the pressure to reduce deficits to be inexorable. While Republican control of the House and Senate may cause any budget deal to focus more on budget cuts and less on tax increases than they usually do, the latter are inevitable. It is simply unrealistic to think that a large deficit-reduction plan can rely solely on budget cuts. Revenues will be on the table.

Remember that Ronald Reagan signed major tax increases in 1982, 1983, 1984, 1985, 1986, and 1987. By 1988, he had taken back almost half of the 1981 tax cut. But at the end of the day, he cut taxes more than he raised them. That is why conservatives forgave him and why they will probably forgive George W. Bush as well.

Times are different now than in Reagans term. We now have a global economy, and tax cuts do not create american jobs, they just create demand for asian products, and thus create asian jobs.

A jobless recovery will not get rid of the deficit today, because people that lost their jobs to asian and communist chinese, do not pay taxes.

In a global economy the free traders must push for increased taxes to be paid by those who still have jobs - it is the only way to balance the budget in the free trade economy that they want.

Until then, conservatives will NOT forgive bush for having trillion dollar deficits, that is not conservative.

"Until then, conservatives will NOT forgive bush for having trillion dollar deficits, that is not conservative." You wake me when we have a trillion dollar deficit. We're a long way away from there. This year, we had a $345 billion deficit. I'm sure we'll hit one eventually but it won't be under G.W. And in Regan's time, the worry was jobs going to the Japanese, so I guess I don't understand what your point is. People that lost their jobs to the large Japanese companies didn't pay taxes either. Yet the tax cuts worked then.
Are you bragging about a $345 deficit? IF so, you are no conservative.
The federal budget deficit is projected to be $480 billion this year, and even the bush administration officials say they have no hope of getting it below $250 billion deficit per year in the foreseeable future, even if the jobless somehow got jobs. In addition, we have a $40 billion a month trade deficit, combined, that equals a trillion dollars a year.
There is a difference between then and now, back then , those who lost their jobs to the Japanese were able to get retrained, and find other jobs, and they still ended up paying taxes. Now, there are no other jobs to train for, if your factory closes and moves to communist china, you cant learn computer programming and get another job.
FYI, a real conservative, any conservative, would not be bragging about having a trillion dollar deficit, nor even a $350 billion dollar deficit.

Those who dont care about hundred billion dollar deficits are certainly not conservatives, please dont pretend to be one.

Those who dont care about hundred billion dollar deficits are certainly not conservatives, please dont pretend to be one. "

You are spin disoriented. {;-D

Just remember - Republican deficits good - Democrat deficits bad. Republican budget busting good - Democrat budget busting bad. Democrat war bombing is Monica time - Republican war bombing same places is fighting terrorism.

Clinton's 1993 budget included a section on intergenerational taxation which concluded that maintaining the power and cost of federal bureaucracies at their 1993 level would require the average child born in the U.S. in 1993 to pay 82% of their lifetime earnings in federal taxes. Intergenerational taxation was dropped from the 1994 Clinton budget, and subsequent budgets, when it was determined that the bills passed by Congress in 1993 and signed into law had caused the projected lifetime federal tax rate on a child born in the U.S. in 1994 to rise to 84%. Dramatic reduction in the power and cost of federal bureaucracies, not higher taxes, will reduce the exploitation of America's children by Washington politicians and powerful special interest groups.

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