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Deficits Don’t Matter

Debt that provides a positive real return is a good thing.

By 3.29.04

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I can't believe that I am writing about budget deficits again. The Bush Administration's $520 billion deficit forecast for this year doesn't bother me, but the deficit phobia and media outcry is getting tiresome. I thought this had been resolved and agree with Vice President Cheney, who reportedly told Paul O'Neill, "Reagan proved that deficits don't matter." He was right.

Budget deficits in the United States have never caused interest rates to increase unless the Fed has tried to monetize them. They have never crowded out any private investment, they have never created a trade deficit, and they have never made anyone (except for Paul Krugman) think that the U.S. is becoming a Third World country. They have also never influenced the outcome of an election unless a President reacted to them by raising taxes.

Deficits, and debt, transfer consumption over time -- that is all. Those who are willing to consume less of their income today provide funds to those who want to spend more than their income. Interest rates are both the cost and benefit of this activity. From the government's point of view, the only question is whether to borrow or tax the revenues that it needs.

No matter how the government chooses to finance spending, every dollar must be taken from the private sector. The only difference is that borrowing is voluntary, while taxation is not. This is why "crowding out" is such a wimpy theory. It may sound good on the evening news and make sense in Macro 101, but the data has never supported the theory.

RONALD REAGAN EXPERIENCED budget deficits every year he was in office and retired with some of the highest approval ratings of any President. Moreover, the economy underwent the worst recession in 50 years during his tenure in office, and between November 1982 and July 1990 experienced what was at that time the second longest expansion in history.

The ten years between March 1991 and March 2001 became the longest expansion in history, even though they included 7 years of deficits and just 3 years of surplus. Despite surpluses that equaled 2.4 percent of GDP in 2000 and 1.8 percent in 2001, business fixed investment peaked in 2000 and crashed along with the stock market in 2001. If deficits crowd out private investment, then the surpluses should have pushed up business investment in 2001.

Instead, the economy fell into recession and deficits grew again. Despite this and the attacks of 9/11, GDP started to expand in late 2001 and has now grown for nine consecutive quarters. Personal investment in homes hit all-time record highs in both 2002 and 2003, and business investment has grown for three consecutive quarters.

The Wall Street Journal's Panel of 54 economists expects real GDP to expand 4.4 percent during 2004. While an excessively easy Fed policy has caused my models to forecast some sharp increases in long-term interest rates for this year, the consensus expects only a slight 50 basis point rise.

If deficits are bad and surpluses are good, as former Treasury Secretary Robert Rubin tells anyone who will listen, then why did manufacturing and investment falter in late 2000 and why did the economy fall into recession in early 2001? Why did the recovery begin just when budget deficits were returning?

If deficits supposedly push up bond yields, then why did rates fall during the 1980s, stabilize during the late-1990s when surpluses appeared, and then tumble to 40-year lows in the early 2000s when deficits returned again?

MAYBE GOING OVER THE ISSUES once again will help. As Milton Friedman has argued, two nations of equal size ($10 trillion GDP) could have the exact same $300 billion deficits, but face two different economic futures.

Assume that the rule of law exists in both countries and country A has total spending of $300 billion, but no taxes whatsoever, while country B has $3.0 trillion in spending and $2.7 trillion in tax revenues. Entrepreneurs and investors would have every incentive to move to from B to A. Now imagine that country B raised taxes by $300 billion. Despite having a balanced budget, country B's growth rate would slow even further. The deficit alone should never be the centerpiece of any economic analysis.

When taxes reach extraordinary levels, as they did in the latter Clinton years, bad things happen to the economy. A tight Fed and a sharply increasing tax burden caused the economy to dip into recession. Tax cuts became a necessity. Contrary to popular belief, stronger growth has boosted revenues despite the tax cuts. Total federal revenues for the first three months of FY2004 are up 3.1 percent from the same three months of a year ago, the strongest growth in tax revenues since 2000.

Debt that provides a positive real return is a good thing. Borrowing money to go to college or graduate school will pay benefits for years to come. Running a deficit to fight a war against terrorism is an investment in protecting the freedom that creates growth. Cutting taxes to boost economic growth may not always boost revenues right away, but over time the growth that tax cuts create is essential to balancing the budget.

Ronald Reagan exemplified how these two policy decisions can have huge payoffs. Reagan cut taxes to boost growth and increased defense spending to defeat communism. Following the collapse of the Berlin Wall, the world reaped the benefits of his investment and experienced a "peace dividend." Bill Clinton was able to cut defense spending from 5.4 percent of GDP in 1991 to 3.0 percent in 2000. This 2.4 percent drop in defense spending as a share of GDP is exactly equal to the 2.4 percent of GDP surplus that the U.S. experienced in 2000. Coincidence? Hardly.

The Reagan tax cuts were the primary reason that the high-tech boom of the 1980s and 1990s occurred in the U.S. and not in Japan or in Europe. The U.S. became an entrepreneurial haven compared to most other countries in the world. And once that boom started, even the tax hikes of 1991 and 1993 could do little to stop it.

The increase in the defense budget from 3.0 percent of GDP in the late 1990s to 4.0 percent in the 2004 Bush Administration Budget proposal will eventually return another "peace dividend" to the U.S. economy in the form of greater security against terrorist threats. The Bush tax cuts have reduced the amount of money involuntarily taken from taxpayers and will result in a more efficient allocation of resources. This will boost economic growth for years to come.

WHILE DEFICITS ARE CLEARLY back for the time being and the just-released Bush budget forecasts a peak deficit of just 4.5 percent of GDP in 2004, this deficit is small compared to the past. Between 1982 and 1986, the federal budget was in deficit by an average of 5.0 percent of GDP. The economy continued to grow, with low inflation and falling interest rates, throughout the 1980s, and there is no reason to believe that deficits in the 2000s will result in any different outcome.

Some may say that it is different this time because baby-boomers are starting to retire and Social Security and Medicare are about to hit the wall. This analysis is misguided. These programs are financially flawed and will eat our economy alive unless they are fundamentally restructured. If not, then government spending will soar and truly crowd out the private sector. No amount of government surplus will pay for these programs.

I doubt this is the last time I will have to explain these realities about budget deficits, but I hope I have set the record straight this time. Reagan taught us right -- deficits don't matter, spending does.

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About the Author

Brian Wesbury is chief economist for First Trust Portfolios, L.P.