Is the Deficit a Friendly Giant After All? (2024)

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After all is said and done, Robert Eisner is right about one thing: the federal budget deficit is not the most important threat facing the U.S. economy. When policymakers focus narrowly on the budget deficit, they ignore what truly drives rising prosperity and long-term economic growth, that is, saving and investment. There is real danger in Washington’s myopic fear of the deficit. As we have seen too often in recent years, a focus on deficit-driven government accounting can place growth-oriented economic policy in a straitjacket.

At the same time, Eisner and I could not disagree more over the best ways to increase investment and spur long-term growth. While he thinks the government should take a larger role in our economy, I put my faith in the genius of the free market. Instead of expanding the budget deficit to boost public investment, as he suggests, I believe the United States should restore the incentives our economy needs to create new private investment. Our differences really boil down to the way we answer a single question: “Who do you want to spend the next $100 billion in the U.S. economy?” To me, the answer is obvious. When I look around the world, I see again and again that private-sector entrepreneurs, not government bureaucrats, consistently make the most productive investments.

The real damage the budget deficit inflicts on the U.S. economy is the way it prevents policymakers from expanding incentives for private saving and investment. Since the mid-1980s, initiatives to cut the capital gains tax and to revitalize individual retirement accounts have been shelved due to budget “scoring” methods, which take into account only their potential short-term effects on the deficit, not their important long-term benefits to the U.S. economy. This is no way to make sound economic policy.

The fact is, the budget deficit is only one part of a larger national problem: the U.S. saving deficit. Last year, America’s net national saving rate, the sum of saving by governments, businesses, and individuals, was just 0.6% of GDP, the lowest rate since I joined Merrill Lynch 45 years ago!

To get a sense of the magnitude of this overall crisis, consider this: even eliminating the budget deficit would not solve our saving problem. If we could magically balance the federal budget, our saving rate would still remain more than 25% below the saving rate the United States averaged during the 1960s and 1970s and well below what we need to grow, to create jobs, and to compete and win in global markets. Deficit reduction is important, but America should attack its fundamental saving crisis on all fronts.

The often overlooked reason for America’s saving deficit is the deterioration of U.S personal saving. This has occurred at exactly the wrong time, both for the overall U.S. economy and for the welfare of individual Americans. With the baby boom generation moving quickly through their peak earning years toward retirement, the need for individuals to begin saving is growing larger every day.

America’s future holds boundless opportunity. To help secure this future, we must ensure that promoting long-term growth remains the number one goal of U.S. economic policy. It is a shame that our deficit-driven government accounting has precluded us from adopting policies to create more private saving and investment. Over the long run, private-sector saving and investment, not the budget deficit, will determine our grandchildren’s prosperity.

Robert Eisner has been saying these things for years. It’s a pity the Washington crowd doesn’t seem to listen. Since 1982, innumerable tax hikes have been pushed through Congress in a misguided attempt to cut the deficit. Revenues rose but invariably fell short of the Treasury’s predictions, which were based on a static model of the economy. Spending rose faster than revenues, and over the last four years, the deficit, even when measured as a percent of GDP, has been higher than in any other peacetime period throughout our history.

One wishes, therefore, that Eisner had included a section called “Tax Cuts or Expenditure Increases?”. For while his central thesis that deficit reduction is counterproductive when there are unemployed resources is correct, it is also true that the manner in which higher deficits are generated matters greatly.

History shows that federal spending is far less efficient at providing economic stimulus than tax cuts are. The most recent “jobs” bill, the 1983 Emergency Jobs Act, for example, cost the government about $165,000 (in 1993 dollars) for every job created, according to the General Accounting Office. By contrast, the average private-sector employee costs his or her employer only $34,000. It follows that this well-intentioned legislation may have actually destroyed nearly five jobs for every one it created.

Pork barrel politics, fraud, and nepotism explain only a small part of the relative ineffectiveness of federal spending. More important is the extensive time required to design, plan, and contract for public works projects. By the time they are put into place, economic conditions have usually changed. Instead of mitigating recessions, they exacerbate economic booms.

An investment tax credit is perhaps the quickest, most cost-effective way to attack unemployment. A 10% credit granted this year could have generated 400,000 new jobs by 1994, at a cost of $3.5 billion in lost revenues, according to some economists. Similarly, we should stop taxing saving and investment income twice, and dividends should be at least partly deductible by the corporations that are paying them. Economic growth would dwarf the rise in the deficit following changes like these.

Eisner may be looking at the wrong variable, of course. Total spending, not the deficit, is the real burden that the government imposes on the economy. If the government spends $1.5 trillion in a $6 trillion economy, there is $4.5 trillion left over for state and local governments, private individuals, and businesses to spend and invest however they want to, whether the government finances itself with taxes or by borrowing.

How do deficits influence total spending? Economists are divided into two camps on this issue. James Buchanan’s public-choice theorists regard the deficit as a means of concealing the true cost of government spending from taxpayers, enabling politicians to increase spending beyond the amount economically justified. The seemingly inexorable rise in government spending as a percent of GDP lends credence to this view.

Milton Friedman, on the other hand, argues that, at some point, an increase in the budget deficit serves the useful function of restraining government spending. This certainly was the case in the 1980s, when the average annual rate of real federal spending fell to half what it was in the 1970s, before deficits were perceived as a major problem. If Friedman’s view is correct, then the positive correlation between deficits and economic growth reported by Eisner may really reflect a negative correlation between government spending and the economy.

Robert Eisner writes a good polemic. The debate on the U.S. budget problem preceding the presidential election propagated a number of startling misconceptions on debt and deficit, which Eisner does well to set right. But does it really take 11 pages to expound the basic Keynesian proposition that, in times of slack capacity, higher deficits can be a good thing? The article stretches the basic Keynesian idea too far for its own good—so far, in fact, that it risks being labeled vulgar Keynesian. I would like to highlight three instances where Eisner’s attempt to defy the conventional wisdom goes over the top.

1. Eisner points out the failure to distinguish adequately between capital and current expenditures and highlights the prolonged squeeze on capital spending, which he dislikes. (The United States is not alone in this. Many developed and developing countries, confronted with the fact of finite revenues, have found it politically easier to squeeze capital rather than current spending.)

But from this point follows a remarkable policy conclusion that is implied but not made explicit. Since Eisner’s point is that a higher deficit during the 1980s and earlier has actually been good for growth, it is difficult to square this with his complaint about the squeeze on capital spending, other than to conclude that deficits should have been allowed to rise even faster than they did. Yet can one seriously argue that the chief contributing factor behind higher deficits, that is, the rise in what the Office of Management and Budget calls mandatory spending (things like social security and health care), and interest payments, which are now approximately two-thirds of total outlays, have actually enhanced growth?

2. Eisner takes issue with OMB’s blue-chip-forecast-inspired projections on growth and interest rates for the mid-1990s and particularly does not accept the view that a 6% nominal GDP growth rate can coexist with short-term interest rates of 5%. He prefers a combination of a 7% nominal GDP growth rate (which implies 4% inflation even on highly optimistic assumptions about the long-term growth rate of the U.S. economy) and a 3% interest rate, which leaves me either nervous or incredulous!

3. There is one prize non sequitur in the article. Eisner states that the growing debt will give our children “a nice cushion of accumulated savings [my italics]. Is that necessarily so bad?” This must be the most original rebuttal ever written to the old idea that “robbing Peter to pay Paul” showed the futility of raising the national debt. To make any sense, however, it must be shown that this “nice cushion of accumulated savings” would be smaller without the higher government debt. Eisner does not do this.

Surely, the private sector is capable of saving in forms other than public debt. Since it has not been proven that government can use savings as productively as companies (especially when savings merely finance higher transfer payments), the consequence of higher savings in the form of public debt and lower savings in the form of private debt is at best neutral and probably worse than that for consumer welfare.

Other adverse consequences follow, none of which Eisner mentions or deals with satisfactorily. With accumulating debt, interest payments will rise as a share of outlays (up from 7% in 1971 to 15% now), and long-term interest rates will be higher than otherwise. Eventually, if the problem is not tackled in time and the debt trap finally arrives (as occurred in Italy), taxes will have to be raised steeply or expenditure slashed to prevent a calamity.

Eisner’s plea for larger deficits has failed to persuade the profession. Mainline economists believe that deficits, properly measured, crowd out investment, and they believe that overly large debt leads to financial fragility. Even if professional consensus were given no weight, Eisner’s plea that today is a good time to launch ourselves passionately into deeper deficits is at odds with common sense.

To the proverbial man with a hammer, everything looks like a nail; there are so many wonderful things government might do. Eisner demonstrates scientifically that bigger (adjusted) deficits produce higher growth, lower unemployment, and increased investment. And if there were any issue on how to get bigger deficits, he advocates higher public-sector spending with proven productivity performance and not the tax cuts that readily come to the minds of most Americans.

In the past 10 years, the U.S. rate of net investment has declined to only half the level of the past 30 years, and, at least in part as a result, real wages have declined by almost 10%. Low investment reflects in good measure an overly large deficit. Moreover, if our recovery from recession is barely moving forward, at less than half the pace in the past, one reason is that the public and policymakers alike have become gun-shy over deficits, even in a recession. Our debt to GDP ratio has risen since 1980 from 26.8% to 51.1% and is projected to rise to 77.6% by 2003. We are not bankrupt, whatever the Japanese might think, and, perhaps, there is even some room for complacency. But surely this is a poor time to indulge deficit passion.

Eisner’s evidence is unpersuasive. When Congress votes increased structural deficits during recessions, of course, spending, output, and employment rise. And as the economy emerges from recession, investment recovers. All that says is that countercyclical fiscal policy works. This is not really red-hot news. There is an entirely separate issue, whether or not we should widen deficits every time we get a chance and never, even at high employment, return toward balanced budgets. If our economy suffered shortage of demand endemically, we might have to worry about reducing deficits, but that is not the case. We overheat with great regularity, and that is the time when budgets should be cut. If that course is followed, we would avoid the routine tight-money end of growth cycles because fiscal tightening would cool the economy. Phasing in deficit reduction today, to go forth over the next six years, is precisely the strategy to ensure that our recovery can go forward for years without running into inflation problems and the resulting urge by the Fed to put an end to growth.

Some public-sector investment is worth having. Defense conversion frees up resources to do just that but, hopefully, in a very targeted fashion and far away from potholes. We also have a heaven-sent opportunity today to clean out wasteful government by applying deficit-reduction strategy. Finally, for the first time in 20 years, interest rates are returning to reasonable levels. Robert Eisner’s deficit passion would stop these highly favorable developments. We need bigger deficits like we need a hole in the head.

There are also important initiatives to be taken in managing the public debt more effectively and at lower cost. One direction is to shorten the maturity of the debt, which today stands at a 30-year high. In addition, we should certainly look at the possibility of issuing indexed debt. Better management of public resources is a more productive direction than ever-larger deficits.

Much of the postwar fiscal history of the federal government can be written in three sentences: receipts have remained between 16% and 20% of GDP; spending as a share of GDP has increased persistently; a growing budget deficit is the result.

What matters most about budget deficits is how fast they grow, what they pay for, and how they are financed. Government, like everyone else, can finance its deficit by borrowing, but unlike the rest of us, can tax and print money. Inflation results when money grows faster than output does. Many countries have experienced high inflation because of budget deficits and excessive money growth.

Borrowing to finance budget deficits can be useful if we use the borrowed resources productively. If the large deficits of the 1980s and 1990s had financed productive investment, we would be richer now or in some way better off. To the extent that the Reagan deficits financed a military buildup that the Soviets would not and could not match, the world is now more peaceful, and we are better off. Of course, we could have paid for the buildup with current taxes, but doing so would have concentrated the costs at a point in time instead of spreading them over present and future beneficiaries.

A common argument against recent deficits is that they financed a consumption binge. It is true that reported investment grew relatively slowly in the 1980s, but published data are misleading. A larger issue is whether or not increased consumption is bad or should be avoided. It is not a cause for alarm if the public willingly chooses to consume more today than tomorrow. Most of us do just that when we buy a house and take out a mortgage. As a society, however, we should be concerned about biases in the tax system, in laws, in regulations, and in government spending that tilt spending toward consumption and against investment or that encourage borrowing and indebtedness. If there are such biases, we should correct them in the interests of efficiency. The gain from increased efficiency is worth having, whether the budget is in deficit or surplus.

Eisner performs an important public service by reminding us of two points that are usually overlooked in discussions of the budget deficit. First, the deficit is measured so imprecisely that the reported numbers tell very little about the government’s fiscal position. Second, relative to the size of the economy, current and prospective budget deficits, as measured, are well within our past experience.

Eisner then makes several points that are either impractical or misleading. A capital budget for the federal government is impractical. As President Clinton’s budget shows, this government classifies food stamps, treatment of AIDS, and local pork barrel projects as investment. By calling expenditures such as these investment, a government can justify deficits of any size. A capital budget for government requires an independent authority to define capital and investment and ensure that accounting rules are followed.

Eisner is misleading when he writes that government debt gives our children “a nice cushion of accumulated savings.” The only way we can enrich future generations is by having more knowledge or more capital assets, things such as plants, equipment, schools, and airports. For society, government deficits, no less than private borrowing, reduce total saving.

Eisner’s appeal for increased government spending takes us to the heart of the issue. Most of the fuss and noise about the budget deficit is not about deficits. It is about spending and redistribution. Many of the critics of recent deficits want to spend more, not less, and to tax the “rich.” One needs only to look at the current Clinton budget and the coming health care proposals to see that tax rates and government spending will rise without reducing the deficit much below the levels projected without the additional taxes. But many of those who railed against “deficits” will fall silent.

Eisner’s premise that deficits can be good “if they generate otherwise lacking purchasing power for the products of American business” has some merit, particularly as it serves to point out that the subject of deficits deserves more rational and less emotional responses by our government. Many of the points he raises in support of this argument are difficult to refute and reflect the sound analysis of an experienced economist who has been examining this subject with a professional, open mind for many years.

I want to comment on a few points that deserve closer attention and suggest that his premise might be modified to something more palatable: deficits may not be harmful if they are directly associated with specific, high-priority, economic restructuring activities. Indeed, this statement can accommodate Eisner’s argument, as long as stimulating “purchasing power for the products of American business” is seen as a high-priority, near-term, restructuring goal.

I am in agreement with Eisner that the definition of the federal budget deficit needs to be standardized and made relevant to what it addresses. It certainly should, as a minimum, distinguish between current or operating outlays and capital expenditures; and the budget should include only the depreciation on past tangible investment, not current tangible capital investment. Along the same line of thinking, those expenditures that are of a strategic nature and aimed at addressing near-term economic structural adjustments should be handled separately in the accounting. Dealing with a single bottom line, in which all entries are weighted equally, can lead to contradictory conclusions about whether “the deficit” is good or bad. Even Eisner is not entirely consistent in his appraisal of past deficits, saying at one point that “…for most of the past half-century…deficits have been too small…” and at another point, “…deficits, over the past three decades at least, have been good for us.”

According to Eisner, if deficits add purchasing power and aggregate demand to the private sector, they are good. But what if those purchases are largely for imported goods or merely stimulate activity in sectors that don’t generate investment or growth in areas consistent with long-term economic development? Some may argue that this is what happened over the past decade and that we are now discovering that we stimulated spending in directions that were not in our economy’s best long-term interest. The fact of the matter is that our deficit should have addressed problems on the production side, not on the consumption side.

In terms of revenues, we need similarly to be careful to recognize the structural and strategic implications of tax proposals. If, indeed, we are primarily interested in stimulating consumer spending, then that has one set of implications, but that is not our economy’s greatest need at this time. The energy tax, for instance, does focus on an important structural problem, that is, how to change our national energy consumption patterns, encourage more investment in conservation, and develop alternative sources. Along with taxes, tax incentives must be aimed at supporting structural adjustments, such as encouraging R&D in high-tech industries.

Finally, we should note that our deficit in comparison to GDP is not terribly out of line with that of other OECD countries (10% to 15% in Italy, Germany, and Canada; 4% to 6% in Japan, Britain, and France). Nor is our debt in comparison to GDP out of line (Belgium 125%, Netherlands 80%, and Denmark 70%). What makes the world so nervous about the U.S. deficit and debt, however, is their magnitude and the fact that within a short period of time the United States went from being the world’s largest creditor to being its largest debtor. Furthermore, increasingly, foreign interests are handling the financing of the debt. Hence, the whole world is watching us closely.

Therefore, if the United States is to maintain its economic leadership role, it must give the world the confidence that whatever deficit it incurs is under control and directly related to financing effective solutions to important structural problems. Demonstrating this should restore confidence in the economy and, in turn, encourage growth and thereby reduce the deficit’s share of GDP, as Eisner predicts.

From time to time, the United States goes through bouts of hysteria about the federal government’s budget deficit. Eisner’s essay is refreshing because he does not succumb to the tendency to regard the deficit as public enemy number one. His analysis of problems in measuring the deficit is particularly compelling. The size of the deficit during a given year depends on one’s accounting conventions. Given the arbitrariness of any number that purports to be the deficit, it is silly to spend a lot of time worrying about whether or not the economy hits some particular target deficit.

Despite the fact that it is difficult to measure, the deficit is a very important issue, in my opinion. Nevertheless, it is only of second-order importance. The issue of first-order importance is the size and composition of government spending. Fundamentally, the burden of government on the economy is the amount of resources that the government diverts from the private sector. The deficit is merely one possible mechanism for financing that transfer of resources.

Other possible mechanisms are methods such as taxes, user fees, government confiscation of property, etc. Deficit spending is probably worse than some taxes but better than others. It is easy to think of measures that would lower the deficit and still make the economy worse off. For example, lowering the deficit by increasing our highly distortionary corporate income tax might lower the overall efficiency of the economy.

Our national debate should be paying less attention to deficit reduction and more attention to the first-order question: Are we getting our money’s worth out of the $1.5 trillion that the federal government spends each year? If the answer is yes, then we should be happy to raise taxes to finance that spending or, perhaps, to finance it by borrowing. If, on the other hand, we don’t think that the government is spending our money wisely, then we should be talking about reducing spending, or at least reallocating the spending already being done.

This is my main disagreement with Eisner; he seems to view the expansion of the public sector as costless and doesn’t care much about the composition of government expenditures. In contrast, I think these issues should be central to the debate. In short, I agree with Eisner that our obsession with the deficit distracts attention from the really important issue. We disagree on what that issue is.

I admire Robert Eisner. He did not sacrifice his Keynesian principles for the sake of scoring political points against Reagan about the deficit. I have been amazed to watch liberals abandon their Keynesian precepts and become partisans of the old Republican doctrine of crowding out, which formerly they had ridiculed. Eisner is amazed too and asks where the theory and evidence are to support this abrupt change of posture.

It is impossible to fathom how the few basic points that might be shaved off interest rates by deficit reduction could possibly offset the Keynesian, much less the supply-side, adverse economic effects of higher taxation. People who will pay such a high price for deficit reduction apparently assume that the interest rate is the only element in the cost of capital and that after-tax earnings play no role. Such an assumption is implausible.

Eisner is determined to protect macroeconomics from being misused in an anti-Reagan jihad that will turn around and bite us with bad policy. Where I part company with Eisner is in his assumptions about the productivity of the “public” sector. Throughout history, governments have done little except plunder. Only liberals believe that a government they run can produce fairer and more efficient results than the market. There is no basis in public-choice theory or human experience for this assumption. The confidence that liberals place in government reflects nothing but their emotional need for a convivial existence that they are convinced cannot be met in an “atomized” market. As Ronald Coase used to tell his students, it sometimes helps a theorist to look out his or her window at the wider world.