Do deficits matter?

The Obama Administration has been in something of a quandary lately as to whether to primarily emphasize its plans to spend more taxpayer money as “stimulus” or to paint itself as fighting against deficits. The former has the advantage of looking like the White House is doing – or trying against GOP opposition to do – something about the economy and its still-listless rates of growth and job recovery; the latter has the advantage of allaying voter fears that the Democrats have been doing too much and digging us into a fiscal hole, as well as offering at least the possibility of bipartisanship or faux bipartisanship that helps (whether Republicans accept or reject Obama’s offers) blur the lines between the parties on deficits and spending. Remember that the one thing Obama has sought from Day One of his stimulus strategy, and has largely failed at, is to avoid presenting a clear contrast between the two parties on spending and the size of government, that being an argument he cannot win.

With a deficit commission working on proposals that will be delivered after the fall election, some liberal pundits/activists like Ezra Klein of the Washington Post and Matthew Yglesias of ThinkProgress are trying to keep both options open by arguing that conservatives are somehow hypocritical for complaining about massive deficits under Obama and the Democratic Congress while promoting tax cuts to help with the lack of economic growth. But read their work and notice, as with Obama, what’s missing: they talk only about deficits, not about spending – you will search Klein’s column in vain for any indication that anyone should care how obese government gets, as long as it’s feasting on current tax revenues instead of on deficit financing. And naturally, when and if Obama tries to do something about the deficit, he too will view it mainly as a revenue problem, not a problem with spending and the size of government. Indeed, history shows that even Beltway Republicans have tended to fall into the trap of assuming that the problem is mainly one of raising revenue, or at least that any deal to fix the deficit can only attract Democratic support if it includes Democrats’ beloved tax hikes.

This is going about the question all wrong. Would you rather have a federal government that spends 15 cents of every dollar earned in this country, while taxing 12 and making up the difference by issuing debt – or a federal government that takes in and spends 30 cents of every dollar? I’d much prefer the former. The Democrats don’t want to have that conversation at all.

Either way the spending is financed, the amount spent by government is a portion of the economy that cannot produce meaningful growth. Yes, wise government can play a role in a better growth environment, and yes, at times the government produces a little growth on its own, e.g., government scientists invent things that can help the economy grow. But by and large, a dollar invested in the public sector is a dollar that will never bear more than a dollar in fruit, and next year the government comes looking for another dollar, while a dollar left in the private sector can grow and be used later in either private or public hands. (In Biblical terms, the dollar in the public sector is like the servant who buried his master’s money in the back yard) All of the growth we take for granted as producing increasing wealth over time comes from the portion of the economy that is not consumed by government. So, using our oversimplified example, which obviously excludes the state and local public sector, you have one economy in which 70 cents of every dollar goes back to the private sector to grow, and one in which 85 cents does. Which economy do you think will have more money after a couple of generations of this? Even at a paltry private-sector growth rate of 2% per year, the first economy has produced $1.59 at the end of three years for every dollar, and the second has produced $2.27. As I said, this is a vast oversimplification, but there’s simply no way for the first economy to grow faster unless you believe – contrary to the most fundamental tenets of economics and history – that the public sector can produce economic growth at a rate comparable to the private sector.

Moreover, within reason, running a modest deficit can make sense, for reasons somewhat analogous to why a corporation issues bonds as well as stock to raise capital, or why even well-off families (especially under the present tax code) may take out a mortgage: sometimes, debt is cost-effective. As long as it is a safe bet to repay its debts, the US federal government can borrow funds more cheaply than any other entity on earth, and while debt requires us to pay interest, which means mandated spending, if the money not taxed is growing in the private sector at a faster rate than the interest rate paid by the government, then deficit spending makes sense for the same reason why you might buy stocks instead of paying down your mortgage – the rate of return is better. Also, the federal government should never run a surplus, since if the government is collecting, say, 20% in taxes and spending 18%, it’s the 20% figure that represents the bite taken out of the private sector. So, the target for revenue should always aim for a little below spending.

But the fact that deficits can make economic sense under the right conditions does not mean that all deficits do – the bigger the debt, the more interest is paid on it (thus, more spending), and the higher rates must be paid (because too-large debt makes bond markets worry about credit risk); and the higher proportion of government spending that’s financed by deficits, the worse are your odds that the money left in private hands will grow faster than the interest rate. At some point, deficit financing becomes a very bad bet. And of course, there are situations where the government may need to run a surplus if it needs to use the difference to pay down enough debt to get back to its usual position of running a manageable deficit, a strategy used in the past after the federal government took on excessive debts in a short stretch to fight wars.

So, why are conservatives up in arms now over deficits? Two reasons. One – which the Democrats seem determined to ignore – is that public concern about deficits is often linked to concern about spending and the size of government. Huge deficits can be a major symptom of overspending. But they’re the symptom, not the disease. The chart below shows federal revenue, spending, deficits, debt and interest as a percentage of GDP, as well as deficits and interest as a percentage of spending (the Def% and Int % columns) and partisan control of the White House, House and Senate from 1947 through 2011.

Until the 2006 elections, we hadn’t been over spending 21% of GDP since the 1994 GOP takeover of Congress, and hadn’t been over spending 23.5% of GDP in the postwar period. But the first year of the new Democratic Congress took us to 20.7%, then 24.7%, with spending projected to crack 25% for 2010 and 2011 for the first time, as the deficit – never above 6% before, below 4% since 1993 and often below 2% during the era of GOP control of Congress – soars to 9.9% in 2009 and projected 10.6% in 2010. This is simply more spending than the economy can bear, and the deficit is a symptom of that problem.

And two, we’re in a situation now where the proportion of deficit spending is itself out of hand. Check the Def% column in the chart – in fiscal years 2009 and (projected) 2010, we’re paying for over 40% of government spending by issuing debt, while it had topped out at 18.1% during the years the GOP controlled Congress and 25.5% as the postwar high. It’s not at all unreasonable to be unconcerned when you’re borrowing 10% or 15% of your budget – when you’re borrowing 40%, you’re living beyond your means. And anybody who thinks you can fix that by collecting a quarter of GDP in federal taxes is insane.

Spending has to come down. That’s the only way to fix the deficit problem and the growth problem.

Here’s the chart:

Sources here, here and here, from the master budget-history site which has now been moved to the White House website. House/Senate historical partisan breakdowns here and here, including this note on fiscal years:

The Federal fiscal year begins on October 1 and ends on the subsequent September 30. It is designated by the year in which it ends; for example, fiscal year 2007 began on October 1, 2006, and ended on September 30, 2007. Prior to fiscal year 1977 the Federal fiscal years began on July 1 and ended on June 30. In calendar year 1976 the July-September period was a separate accounting period (known as the transition quarter or TQ) to bridge the period required to shift to the new fiscal year.

As with the prior iteration of this chart, I use 1947 as a starting point, as it’s the first year after full demobilization from World War II; the war budgets were colossal – in Fiscal Year 1943, the deficit was over 30% of GDP. And before the New Deal, federal spending was generally less than 10% of GDP. The OMB site has projections beyond 2011, but since we don’t even have a 2011 budget yet, much less the Congress that will vote on the 2012 budget, the projections further out than that are useless even if you assume that the federal budget forecasters have perfect clairvoyance about the state of the economy two or more years out (hint: I don’t).