December 31, 1983
Michael Kinsley pioneered and perfected the genre of comic wonkery—the jaunty elucidation of dense policy with a touch of wiseass. This essay is the locus classicus of the genre. As editor—actually he did the job twice—he presided over a golden age. With the magazine’s criticism of liberal orthodoxy and brash humor, it didn’t just feel fresh; it was transgressive. The magazine made famous enemies and attempted ludicrous stunts. (At the height of the crack epidemic, Kinsley sent a reporter off to smoke the drug and describe the high.) Some critics of the magazine found its style vacuous, an exercise in self-indulgent troublemaking. And perhaps sometimes it was that. But it also had genuine policy passions and a very clear agenda.
One of the most dizzying things they try to make you believe in first-year economics is that the national debt is no cause for alarm because “we owe it to ourselves.” As late as the 1976 edition of Paul Samuelson’s famous textbook, talk about burdening future generations and analogies between the government’s budget and a family’s budget were dismissed as “the clichés of old-fangled shirt-sleeve economics,” at home “in any club locker room or bar.” The message was, leave that talk to the old fogies.
Who would have thought that this fogyish talk about the national debt would become the mainstay of Democratic political rhetoric? The temptation for Democrats to attack President Reagan’s budget deficits is irresistible, of course, and mostly warranted. But for reasons both of honesty and practical strategy, it’s useful for Democrats to keep in mind exactly why Reagan’s deficits are bad.
The basic Econ I point remains as true (albeit as hard to believe) as ever. A nation’s debt to its own citizens is different from a family’s debt to the bank. The debt itself doesn’t make the nation any poorer, and deficit spending can even make the nation richer if used at the right time to stimulate a weak economy. Hysterical warnings about civic bankruptcy are just as silly now as they were when uttered by Republican fogies. But other things have changed since the glory days of Keynesianism.
One change is that we no longer just “owe it to ourselves.” America will absorb about $30 billion of investment capital from abroad this year, and probably more than double that next year, a historic reversal from the days (two years ago) when America was a net capital exporter. All of this foreign capital doesn’t go toward financing the national debt, but it replaces other money that does. This alleviates some of the problems that would otherwise be caused by huge deficits. But it means that this nation, just like a family, will have to pay off those loans with real resources some day.
There have been three other changes, two in the nature of the deficit and one in the nature of our thinking about it. First, the deficit has reached a size—$200 billion a year—that Samuelson never dreamed possible. Second, Keynes’s idea was that deficits would give the economy a push in bad times; but this deficit will continue into good times. Right now, about half the deficit is caused by a still-weak economy, which reduces tax revenues and increases social welfare costs. This part is expected to shrink as the economy gets stronger over the next few years, but the other part—the “structural” deficit—is expected to get larger, so that the deficit will still be $200 billion in 1988, even if things are booming.
Third, Keynes was concerned with the “paradox of thrift,” the danger that people would save too much money and the economy would be anemic. In America today, for a variety of reasons, our problem is the opposite. We need to discourage consumption and encourage savings so there will be more money to invest in the future.
It’s clear to any sensible and honest person that these huge, undiminishing deficits will hurt our economy. What’s not clear is exactly how. They could re-ignite inflation by overstimulating demand as the economy reaches full capacity. If the Federal Reserve Board moves to prevent this by squeezing the money supply, we’ll tumble back into recession. And in any event, the deficit swallows up huge piles of capital that would otherwise go to private investment, thus reducing our future prosperity.
I would not hazard to guess whether Representative Jack Kemp was being stupid or dishonest when he wrote in the December 11 New York Times that “there is still no convincing evidence that deficits raise either inflation or interest rates.” Treasury Secretary Donald Regan, a smart fellow, has been bluffing with similar pronouncements, accompanied by flurries of studies. Ordinarily these gentlemen are great evangelists of the free market, but on this matter they wish to repudiate the law of supply and demand. Interest rates are the price of money. When someone enters the market to buy up a large part of the available supply at any price—which is essentially what the government is doing in the market for capital—the price goes up.
So why have inflation and interest rates come down during the Reagan megadeficit years? Inflation came down because the Federal Reserve Board created a recession. Anyone can do that. As for interest rates, they have not come down. Real interest rates—the nominal rate minus the part that’s just making up for erosion of the dollar—are higher than ever. Fifteen percent interest minus 12 percent inflation was a better deal than today’s 9 percent minus 3 percent inflation. They would be even higher, except that the non-government demand for capital has been weak because of the recession. As private demand for capital increases, high interest rates will “crowd out” borrowers who (unlike the government) can’t afford to pay any price or bear any burden for capital.
The biggest pile of government-issue malarkey on the subject of deficits has come from the President himself. On November 3, for example, Reagan told two lies he has repeated often: “We face those deficits because the Congress still spends too much.” And, “I’m prepared to veto tax increases if they send them to my desk, no matter how they arrive.”
Oh, really? And what if they arrive all gift-wrapped, with a little note that says, “Here, with love, is the tax increase you requested last year”? In the spring of 1983 the Reagan Administration proposed a “stand-by” tax increase for 1986, including a new energy tax and a 5 percent across-the-board income tax surcharge. “Stand-by” means that the tax will only be imposed if it proves to be necessary, based on statistical conditions only slightly more certain to occur than the sun rising tomorrow. All of the Administration’s official predictions about future economic conditions assume this tax increase. Secretary Regan confirmed last week that a “contingent” tax increase will be proposed again this spring.
The transgression of Martin Feldstein, chairman of the President’s Council of Economic Advisers, was not to propose a tax increase, but to point out that Reagan has already proposed one. That’s why those who say Feldstein should resign if he disagrees with Administration policy miss the point. Feldstein agrees. It’s Reagan who disagrees, or pretends to, in a brilliant feat of political legerdemain.
Reagan’s second lie is that continuing huge deficits are the fault of a recalcitrant Congress, which refuses to cut spending. John Berry of The Washington Post reported last week that the budget Congress approved for fiscal 1984 is only $1.17 billion bigger than the one Reagan submitted. There was some very minor juggling of domestic and military spending, but the $200 billion deficit was just about exactly what Reagan requested.
More important, Reagan has never proposed enough spending cuts to balance the budget, even in the distant future. A chart prepared by Feldstein makes this clear. It predicts the general shape of the budget every year through 1988. Assuming a buoyant economy by that time, and current spending plans, Feldstein foresees a $210 billion deficit. Another column on the chart, labeled “Administration Policy,” is the 1988 budget if the Reagan Administration gets every change it wants between now and then. This column shows a deficit of a mere $82.2 billion. About half the improvement, though—$61 billion—is that now-you-see-it, now-you-don’t tax increase. Even if Congress goes along with every additional spending cut Reagan plans to request between now and 1988, and even if the economy is booming, without new taxes there will still be a deficit of almost $150 billion, according to the Administration’s own figures.
Lately Feldstein has been trying to re-ingratiate himself with his employer by pointing out in speeches that “nearly two-thirds of the current structural deficit was inherited from the Carter Administration.” What this means is that if it weren’t for the recession we’re still coming out of, Reagan’s current deficit would only be half again larger than Carter’s deficit in fiscal 1980. This is a devastatingly modest claim. By the same tortured calculation, Carter actually reduced the structural deficit by a quarter, from 2.7 percent of gross national product “inherited” from Gerald Ford in 1976 to 2.2 percent in 1980. Reagan has raised it to 3.4 percent.
What’s worse, this comes despite Reagan’s historic reversal of trends in spending for social welfare. Feldstein’s second great offense against Reagan mythology has been to make clear that domestic spending is not to blame for the increasing chunk of the economy being swallowed by the federal deficit. Under the changes in law already enacted, the share of G.N.P. taken by social programs other than Medicare and Social Security will have dropped from 9.3 percent in 1980 to 6.3 percent in 1988. This is about the level of the early 1960s. In other words, apart from Medicare, we’re back to where we were before the Great Society. Even including Social Security and Medicare, domestic spending under current law will have dropped from 15 percent of G.N.P. in 1980 to 13 percent in 1988. Defense, by contrast, will have increased from 5.3 percent of G.N.P. to 7.7 percent, and revenues will have dropped from 20 percent to 19.5 percent. A bit of subtraction, and here we sit.
Feldstein’s numbers constitute the temptation for the Democrats, and also the trap. Having beaten Reagan over the head with this chart, how do they propose to rewrite it? There are only two ways: cut spending or raise revenues.
The gap that needs to be closed is $210 billion in 1988, or 4.2 percent of G.N.P. Cut defense spending? Holding defense to its current share of G.N.P. (6.9 percent)—a proposal few leading Democrats would be dovish enough to support—gets you less than one-fifth of the way there. Even cutting defense back to its share in the bad old Carter days would close less than half the gap. There is no way to make a serious dent in the deficit by spending cuts without more deep chops in domestic programs. Medicare is the most logical target. Its share of G.N.P. is expected to rise from 1.2 percent in 1980 to 2 percent in 1988. But for a politician, the thought of publicly attacking Medicare takes most of the fun out of Reagan-bashing over the deficit.
The two leading Democratic Presidential candidates have already fallen into the biggest trap on the revenue side of the ledger. Both Walter Mondale and John Glenn have come out for delay or repeal of tax-bracket indexing, the only part of Reagan’s tax cut that hasn’t taken effect yet. It’s due to start next year. Without indexing, inflation pushes people into higher tax brackets even if their real incomes don’t increase. It’s tempting, because the government gets extra revenues without an official tax increase. But repeal of indexing is a ludicrous stand for Democrats to take. Indexing is the tax break for their constituency.
Feldstein’s figures show that despite Reagan’s alleged tax cuts, the share of G.N.P. coming to the federal government in taxes has stayed at about 20 percent. That’s because of “bracket creep” and because Reagan’s cuts, which favored top brackets and income from capital, were offset by large increases in Social Security taxes, which fall only on wages up to middle-class levels. Most potential Democratic voters haven’t gotten any tax cut. This powerful political message will be hard for Democrats to put across, though, if Republicans can accuse them of wanting to reinstitute bracket creep: a middle-class tax that barely affects the rich (because they are already in the top bracket), and doesn’t affect corporations at all.
If political courage were in greater supply, there would be plenty of ways to help bring the budget into balance without being unfair, or risking our national security, or damaging the economy. (There were a few suggestions in the TRB column of October 10.) But all these ledger calculations reflect the same fallacy Samuelson attributes to the old fogies around the clubhouse—thinking of the government like a family in debt. If the real problem is finding more capital for productive investment, then the proper focus is on all government policies that affect the supply of and demand for capital. In this, the budget itself plays a surprisingly small role.
For example, the personal interest deduction will cost the government $36 billion in 1984. But by encouraging people to borrow money for consumption, it will drain far more than that from the capital markets. According to Lester Thurow in the December 22, 1983, New York Review of Books, private consumer borrowing eats up two-thirds of private savings in this country. Three steps forward, two steps back. Reducing or eliminating this subsidy could have a huge payoff.
By contrast, cutting Medicare by reforms such as raising the deductible may be largely self-defeating. This will reduce the federal deficit, but if people pay the difference out of their savings, the supply of capital will be reduced by an equal amount. (And if people can’t pay the difference out of their savings, that’s a good reason for pause.) Only by using its power as a large buyer and regulator to reduce health care costs can the government hope to direct significant sums away from this form of consumption and toward productive investment.
Then there is government spending that actually increases private consumption spending, such as the ludicrous farm price support system that costs us billions both as taxpayers and as consumers. Phasing it out would reduce government costs and leave also more money in family budgets, some of which would get saved.
At little or no apparent cost to itself, the federal government guarantees or actually provides loans to individuals and companies for various purposes such as new housing, encouraging exports, aiding small business, and coddling farmers even more. The Congressional Budget Office estimates that by 1988 such government-sponsored borrowing will be absorbing new capital at a rate of $134 billion a year. That’s almost two-thirds of the expected budget deficit. These policies don’t get nearly the scrutiny that direct federal spending gets, yet they are precisely the same drain on capital markets.
Finally, on a more positive note, Democrats shouldn’t be afraid to note that a lot of government spending is productive investment. The proper analogy is not to a family but to a business. A business is not “living beyond its means” if it borrows money for investment that generates a higher return than the cost of credit. According to the General Accounting Office, almost a fifth of the 1982 federal budget—about $135 billion—was spent on capital investments, narrowly defined. This includes construction and repair of the nation’s infrastructure, scientific research and development, and education and training. Our future prosperity depends on these investments just as much as on private outlays, and it is foolish to skimp on them just because they are paid for by the government.