So Who's Afraid of a Deficit? Economic sense in an age of superstition

National Review, May 14, 2001 by Alan Reynolds

The Bush economic plan will help the economy, but the way the administration is selling it risks doing serious harm. Probably the most important element of the Bush plan is the proposed reduction in marginal tax rates. These cuts account for just 31 percent of the $1.6 trillion revenue cost of the entire Bush program, but GOP publicists keep stressing the huge $1.6 trillion figure instead of the relatively inexpensive-but economically crucial-marginal-rate cuts.

Why has the administration downplayed one of its most valuable initiatives, one that would strengthen the economy for years to come? What accounts for this miscalculation? The answer is to be found in psychology: an irrational fear of budget deficits and an equally irrational obsession with chronic surpluses-that is, an obsession with overtaxing Smith for no reason except to buy back Treasury bonds owned by Jones. The Republican party has hamstrung itself with meaningless economic slogans that sanctify perpetual budget surpluses. Some have even maintained this reverent attitude toward surpluses while simultaneously entertaining the contradictory hunch that any crackpot rebate scheme that wastes a lot of money is equivalent to serious tax reform as a "fiscal stimulus."

The current political correctness of perpetual budget surpluses originated in the Clinton Democrats' unusual embrace of the archaic ideology of Eisenhower Republicans. President Clinton never stopped telling us that the 3.9 percent annual growth of the economy from 1993 to 2000 was vastly superior to the 4 percent annual growth from 1983 to 1990, solely because the '80s were a period of deficits. But what is it, exactly, that is so wonderful about budget surpluses?

Over the past 15 years, prominent macroeconomists promised that switching from budget deficits to surpluses would result in several miracles. Taking more money from taxpayers and giving it to the IRS was supposed to raise the national savings rate and thereby push real interest rates lower. That, in turn, would supposedly rid us of the evil "twin deficits"-because the trade deficit was sure to vanish as soon as budget deficits receded. These predictions were based on an Eisenhower-era variant of Keynesian reasoning, and they were thoroughly bipartisan. In 1987, future Clinton Treasury secretary Larry Summers wrote that "changes in the government's fiscal posture are the most potent and reliable way to increase national savings . . . It may be necessary for the federal government to run chronic budget surpluses in coming years." In 1995, former Reagan adviser Martin Feldstein argued that "with a lower level of current and expected future government borrowing, real interest rates would decline and the dollar would come down with them. . . . A lower budget deficit would thus reduce our trade deficit."

Not one of these bold promises and predictions came true. National savings did not rise, real interest rates did not fall, and the trade deficit became much larger rather than smaller. Consider the facts:

--The national savings rate averaged 17.4 percent of GDP from 1993 to 2000, down slightly from 17.6 percent in 1983-90, as the budget swung from deficit to surplus. Even with growing surpluses in 1998-2000, combined public and private saving was still no greater than it had been in 1984-85, when budget deficits were 5 percent of GDP.

--The real prime interest rate, after subtracting inflation, averaged 6.7 percent from 1997 to 2000, up from 6.2 percent from 1985 to 1989. Real interest rates are always lowest in recessions and highest when the economy is strong-because the real return on borrowed funds is most promising when the economy is healthy, and the Fed raises rates when the economy is booming and lowers rates during slumps.

--From 1993 to 2000, as economic expansion moved the budget from deficit into surplus, the current account deficit grew steadily larger, topping 4 percent of GDP by 2000.

The promises and predictions of Keynesian economists who advocated chronic budget surpluses in the years 1987-95 have now been thoroughly tested-and disproved. Remarkably, however, the theology that perpetuation of budget surpluses must have "the highest priority" outlived the discredited economic fallacies that spawned it. Fed chairman Alan Greenspan, for example, continues to testify solemnly that budget surpluses boost national savings and hold down real interest rates. (Tell it to Japan, where the budget deficit is 6 percent of GDP but interest rates have long been near zero simply because the economy is going nowhere.)

The hoax that surpluses reduce real interest rates made it possible to turn Keynesianism on its head, and assert that balancing the U.S. budget was the cause (rather than the consequence) of the 1996-2000 technology boomlet. Yet the same Democrats who claimed surpluses were the cause of prosperity in the Clinton years now claim the economy needs the "fiscal stimulus" of a $60-85 billion one-time "rebate" (i.e., silly little checks distributed randomly and written at the expense of the upper-income taxpayers funding the surplus). Surpluses stimulate economic growth, yet smaller surpluses stimulate even more?