Thinking about Deficits Jude Wanniski February 4, 2004

When Vice President Cheney supposedly told Treasury Secretary Paul O’Neill that Ronald Reagan showed that “deficits don’t matter,” it reminds us that interest rates fell sharply even as federal deficits soared in the years following the Reagan tax cuts and spending increases of his first term. All that it showed, though, was that some deficits might be good, while not proving anything about all deficits. If government bonds have to be issued to finance a deficit brought about by lowering tax rates that are higher than they need to be to produce a revenue stream, the bond market will correctly judge that the bonds are a good investment. It turned out the increase in defense spending also was a good investment as it helped break Moscow’s resolve to win the Cold War. In other words, there is nothing in supply-side theory that rejects the idea of a budget deficit whether it comes about by lowering tax rates where they are too high or by raising expenditures where they are too low. 

The Bush Administration’s budget for 2004 with its $521 billion in red ink is being reviled by conservatives for spending too much, and by liberals for not spending enough. In actuality, the number is likely to be much higher because the administration knows that Congress will not agree to cut spending where it is proposed in the budget, and that the costs of the conflicts in Iraq and Afghanistan will easily exceed $50 billion not in the budget because the costs are supposedly not yet known. Even a deficit of this size could be handled in the $11 trillion economy because much of the $2.4 trillion in outlays will have positive returns. It is not all going down the drain. Neither the administration nor the leaders of Congress in either party are facing the fact that the mega-billion deficits as far as the eye can see are different than the Reagan deficits. 

When the CBO recently forecast the 2004 deficit at $477 billion, it noted that this would only be 4.2% of GDP, smaller than the 6% of GDP in the peak year of 1983. The 1983 deficit did not include any Social Security surplus, as that was the year the Greenspan/Moynihan commission decided to “save Social Security” by jacking up payroll taxes to accommodate what they then predicted would be massive shortfalls due to low growth and high inflation. Instead, the Reagan tax cuts began to work their magic and surpassed all GDP predictions at the same time inflation was being tamed. This meant that a good chunk of the surpluses of the Clinton years were due to labor and management overpaying on payroll taxes. If the surpluses in 2004’s Social Security account were removed to make a valid comparison with 1983, there is no question that the 2004 deficit will easily exceed the 6% and when the year is over may break all kinds of modern records. 

If we look beyond the short term, the numbers get progressively uglier. The Comptroller General of the General Accounting Office, David Walker, last week told John McLaughlin on his “One-on-One” show that he had added up all the federal government’s promises. Here is what he found:

MR. WALKER:  Well, right now we have about $6.8 trillion in total debt, but that doesn`t count certain things as accrued and unfunded military and civilian pensions, promises to veterans with regard to disability and health care. It doesn`t count guarantees that we have made with regard to government corporations or government-sponsored entities. And most importantly, it doesn`t count the discounted present value difference between what has been promised for Social Security and Medicare and what revenues are available. If you add up all those numbers, it`s not 6.8 trillion (dollars); it`s about $30 trillion, or $100,000 for every man, woman and child in the United States. That`s a serious gap.

I’d like to see the actuarial assumptions that went into this projection, but on the assumption that they are reasonable the number is clearly bigger than any deficit in U.S. history. The World War II debt in 1945 amounted to 15 months of GDP and constituted most of what the GAO includes in a projection that amounts to almost three years of GDP. That kind of deficit has to be taken seriously, on both the tax and spending side, but also on the monetary side. Much of the deficit has been the result of the monetary turbulence of the last 35 years, at least since the dollar was floated. A great many economic efficiencies have been lost as a higher percentage of the world force has had to be devoted to what I have been calling “the chaos industry,” those trained to help the economy cope with turbulence. 

It is unlikely that faster GDP growth alone can cut into the long-term deficit. The dollar must sooner or later be re-anchored as a means of gradually converting “chaos” workers into “productive” workers (i.e., from lawyers, accountants and tax advisors into doctors, nurses and engineers). On the spending side of fiscal policy, the federal government has to stop making more entitlement promises and limiting transfer payments to the needy instead of the general population. On the tax side, the government has to go through a fundamental reform of the tax code, from bottom up, liberating households and businesses – both large and small – from having to devote enormous amounts of time and effort to paying taxes. These are the only kinds of policies that can reshape the economy and its ability to meet the demographic challenges on the near-term horizon. 

The great resistance from the political establishment to the needed reforms is due to its familiarity and comfort with the present system. In addition, when it comes to monetary reform there are great benefits to both the U.S. and world economies from dollar stability. There is no reason why the $30 trillion burden couldn’t be lightened by having more low-value-added work outsourced to healthy, low-deficit countries such as China and India. But nailing down the dollar to gold also removes the ability to “inflate away the debt” by a Fed policy that glosses over the structural deficiencies in the system with easy money, gold perhaps going to $4,000/oz from $400. This really is not an option, though, especially in the geopolitical sense. It would mean a greater effort by the government to hold on to world power through military force and economic intimidation, which simply adds to the red ink. 

At the Davos conference last week there was serious thought given to the prospect of China’s yuan becoming the world reserve currency in the not too distant future.  The context was entirely economic, but the geopolitical context is just beneath the surface. If the U.S. is going to hold on to world leadership in the generation ahead, it will have to take the necessary policy steps -- as distasteful as it may be for those who now enjoy the benefits of the system as it exists. 

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