Fodder for my course

A Note on the Deficit—and a Question for Political Scientists or Sociologists

This is being submitted to the Facing Up Blog Carnival on the $9 trillion debt.

One of the economic issues for which journalistic and public discussion generates the lowest ratio of light to heat—it wouldn’t be easy to pick the winners—is the issue of the federal government’s deficit spending. Even worse, as I’ll try to explain below, deficit spending is almost entirely a phony issue.

I’m reminded of this by a recent report that the Democrats in Congress would like to spend more money than President Bush wants. This follows several years’ worth of the Democrats energetically arguing that deficits and debt are bad. A representative statement from them is, “Instead of policies that help America's working families, he [President Bush] continued to tout the economic policies that have led to record deficits and passed on trillions in debt to our children.”

But both major parties have reversed themselves at least once on this issue. During the 60s and 70s, the Democrats happily accepted deficits. Sometimes they cited Nobel laureate Paul Samuelson, who wrote in his best-selling text that—I paraphrase from memory—in a healthy, growing economy, funding worthwhile investments through deficit spending posed no problem at all and could continue without problem indefinitely. Republicans, on the other hand, tended to be horrified—just horrified—by deficits. They were labeled the party of Scrooge and of “green eyeshades”. Once Ronald Reagan was elected, however, the Republican Party did not seem to worry about deficits much, while the Democratic Party began to.

Behind these apparent inconsistencies, there is a simple logic. Broadly speaking, Democrats want to increase spending but don’t want to increase taxes (taxes on the “rich”, on “windfall profits”, and a sin tax or two notwithstanding), and they don’t mind deficits that are created or increased in this manner. Republicans want to cut taxes but don’t want to cut spending (and they are willing to increase spending on “roads to nowhere” and defense) and don’t mind deficits created or increased in that manner. And each party objects to the type of deficit the other party is content with. (And each party pursues a version of “pleasure today, pain tomorrow”, arguably one of the serious defects of our—or any—political system.)

The real issue between our modern parties is, therefore, one of the main issues in our politics since the Founding: the size and scope of government, particularly the federal government. It’s an issue that has been debated especially ferociously since—take your pick—the Progressive Era, the Great Depression, or the Great Society.

Economists think that this is a debate well worth having. While we disagree sharply on the taxing and spending policies that are best, we agree that the proportion of the economy commanded by government has large effects on economic variables, and on our quality of life generally.

But on the issue that seems to command much more attention from journalists and the public, how much of a given amount of government spending is financed through borrowing—how big the yearly deficit is—at least some economists believe it is, at most, of minor importance. We believe this for three reasons.

  1. There are serious problems with the way the deficit is usually measured. It’s economically reasonable to adjust for the rate of inflation, for the change in the government’s assets, and for the stage of the business cycle. Most importantly, any changes in the government’s unfunded liabilities—such as Social Security, government pensions, and contingent liabilities—should be included, but in popular discussions, almost never are. See this.
  2. Even if it were properly measured, the deficit—and indebtedness more generally—should always be compared—but usually isn’t—to the economy’s ability to pay. Here’s Greg Mankiw (Principles of Macroeconomics, Third Edition, p. 514):

“Critics of budget deficits sometimes assert that the government debt cannot continue to rise forever, but in fact it can. Just as a bank officer evaluating a loan application would compare a person’s debts to his income, we should judge the burden of government debt relative to the size of the nation’s income. Population growth and technological progress cause the total income of the U.S. economy to grow over time. As a result, the nation’s ability to pay the interest on the government debt grows over time as well. As long as the government debt grows more slowly than the nation’s income, there is nothing to prevent the government debt from growing forever.”

Note that this is the same point that Paul Samuelson made in the 1960s.

  1. An economic hypothesis, Ricardian Equivalence (named for the economist David Ricardo), posits that how government spending is financed has no real economic effects. An overview of the theory is here . A well-known and heavily-cited review of the theory and evidence for the hypothesis is by my colleague, John Seater, “ Ricardian Equivalence ,” Journal of Economic Literature, 31(1), March 1993. Seater concludes:

“Theoretically, we can be almost certain that Ricardian equivalence is not literally true; it simply requires too many stringent conditions to be believable. Nevertheless, equivalence appears to be a good approximation. Although some of the early empirical literature sent conflicting signals, recent work generally supports Ricardian equivalence. . . . Empirical success and analytical simplicity make Ricardian equivalence an attractive model of government debt’s effects on economic activity.” (p. 184)

A more recent survey by Robert Ricciuti, “ Assessing Ricardian Equivalence,” Journal of Economic Surveys, 17(1), February 2003, concludes virtually the same way:

“Even if it is difficult to believe that there is a one-to-one relationship between tax-cuts and the increase in the size of bequests, optimizing individuals appear to follow Ricardian equivalence, at least in an approximate way. Indeed, debt neutrality is nothing but a consequence of some widely used concepts and methods in modern macroeconomics. We think that more refined econometric work—in particular along the line of stochastic models—may cast more light on the field. Still the onus of the proof lies on those who support debt neutrality.” (p. 74)

Brian Goff and Robert Tollison note that (“Explaining Deficits: 1889—1998,” Economic Inquiry, 40(3), July 2002), Ricardian Equivalence makes popular discussion puzzling. “We do not attempt an explanation of why deficits, which seemingly exhibit no or small real effects (Ricardian equivalence), could lead politicians and voters to treat deficits as if the Ricardian hypothesis were rejected.”

Even a number sometimes touted as more meaningful, the debt-to-GDP ratio, yields the American public and policymakers little useful information. Information at Wikipedia for a large group of countries shows that the U.S.’s current value is not too far from France’s—some Democrats believe that the U.S. should try to do what France does (but not on nuclear power and apparently not on debt)—and those of Germany, Canada, and Portugal. It’s not even too far from the ratio of that supposed paragon of fiscal probity, Switzerland. And it’s rather substantially below Italy’s and Japan’s.

I believe politicians, journalists, and the public should pay attention to specific spending and taxing proposals and to the total amount of government spending, rather than commentating and thinking almost uselessly about the deficit and the debt.

Why they don’t is a question for political scientists or, maybe, sociologists.

UPDATE (11/14 at 3:00 p.m.): An embarrassingly large number of mistakes have been corrected, thanks to careful reader Michael Greenspan.