Deficit Hawk, Progressive Style, Part I

As the national debt balloons, the deficit hawks have swooped in again, crying for “fiscal responsibility.” According to C. Fred Bergsten of the Peterson Institute for International Economics, that means restricting or cutting spending on “entitlements”: Medicare, Medicaid and Social Security, and imposing a national consumption tax. And now President Obama has heard their cries–and proposes to freeze discretionary spending–except for the military!

The hawks’ concern is justified. But their policy conclusions don’t follow.

When a government runs a “deficit”–spends more than it collects in taxes, it borrows by selling securities, mostly short and long-term bonds known as treasuries. When a government runs a “surplus”: it pays off treasuries. People often muddle deficits–one year’s borrowing, with national debt–accumulated borrowing, which equals the quantity of treasuries outstanding.

National Debt as Percent of GDP

Chart I shows national debt held by the public as a percent of US Gross Domestic Product (GDP), the total annual value of goods and services. From a high during World War II, it falls to an all time low in the mid 1970’s, rises under Reagan-Bush I, falls under Clinton, and begins to rise again under Bush II Debt as projected by the Congressional Budget Office (CBO) really takes off under Obama, as bailouts and stimulus take their toll.

High levels of national debt weaken the economy. That’s because buyers of the debt, domestic and foreign, substitute passive holding of US treasuries for productive investment. They avoid riskier but productive private investment in small to medium business–precisely the investments that create the most jobs and products and services per dollar invested. In economic language, the passive investments “crowd out” the productive ones.

The more unequal the economy the worse the effect. In fact, growing debt itself can worsen inequality. Consider who holds most of the debt: banks, mutual funds, large corporations, wealthy individuals and–in recent years–foreign governments, notably China. So a buildup of debt both cuts productive investment and tips distribution of wealth towards large passive entities.

The recent history of US debt supports the inequality connection. Chart II, from the US Census, shows the ratio of the 90th to 10th percentile of income, from 1967 to 2008–a rough measure of inequality. (By other measures, inequality fell steadily after WW II before the Census time series begins.) As the Census series shows, inequality loosely parallels debt as a percentage of GDP, at its lowest in the mid 1970’s, rising steeply during the Reagan-Bush I era, leveling off during the Clinton era, and rising again during the Bush II era. (Of course many other factors, including the business cycle, also affect year-to-year debt and inequality numbers.)

I don’t consider the debt-inequality parallel a coincidence. The same policies that drove up the debt after the 70s–tax cuts and other favors for wealthy interests, Star Wars and Iraq spending–also raised the level of inequality in the US. It’s also no coincidence that when President Clinton paid down the debt, we enjoyed a brief economic boom that increased jobs and wages, especially at the lower end of the scale.

Consequently the “stimulus”–funded by growing the debt–may do more harm than good. Money spent on “shovel-ready” construction, much of it in rural areas, may briefly create a few jobs–or divert a few jobs from elsewhere–but it’s not productive investment. Only where stimulus spending helps maintain vital high-value services, notably in health and education, can the benefits outweigh the economic drain of deficits–at least as a short-term measure. The “pop Keynesian” argument for the stimulus simply disregards both the quality of spending, and the damage from running up the debt.

So the deficit hawks are right about national debt. But the answer isn’t to cut social spending and raise regressive taxes. In brief, the answer is to go back where we were after World War II–to high social spending, high progressive taxes, and (sometimes) low military spending.

In Part II, I will address specific policy responses to rising debt.

14 comments to Deficit Hawk, Progressive Style, Part I

  • roger erickson

    This line of reasoning doesn’t mention the momentous impact of going off the int’l gold std in 1971. We can’t easily go back to post WWII gold-std conditions, and shouldn’t. Meanwhile, the role of taxes has completely changed. Taxes are no longer revenue at all, they’re simply managing agg demand by recovering some of the currency distributed by public (federal gov) spending of a purely fiat currency.
    A more useful suggestion profile? First, go back to adequate group investment in public purpose, in the form of adequate social spending, and taxes LOW ENOUGH to maintain adequate aggregate demand? Second, simply quit selling Treasury notes altogether, or sell only enough at less than 30 day maturity ONLY to help the FOMC meet interest rate targets. Finally, manage floating Fx rates indirectly, and ENTIRELY by collectively managing WHERE both private and public spending is directed, not how little.

  • To elaborate on the defense conundrum, money borrowed to spend on the military ends with the military. Once you’ve bought a bullet, there’s nothing it can contribute to the economy. With entitlements, money circulates. People buy goods and services, keep their neighbors employed, and continue to consume. A dollar spent on a bullet is the end of the chain. Even highly valued, complex products are dead ends; the market for used tanks is quite thin. So while increased stimulus spending may have negative effects overall, continued military spending has a negative multiplier effect, dragging the economy down faster than it’s worth. It is through rampant military spending that most empires decline and die, by draining otherwise productive wealth out of the economy.

  • If any stimulus is needed, it should be in the form of a per-capita grant to all Americans, so they can afford medical care and whatever “education” they need. It should be funded entirely from a tax on economic rent, so it won’t increase public debt nor discourage productive work. One hopes that part II will recommend this.

  • Much of the economic jargon helps move the conversation away from reality into a place where Alice (in Wonderland) would feel at home. My perception of reality is that a national economy is strong, like a company, when it has a strong balance sheet, it has a positive cash flow, it is productive and building value.

    The United States, both Government and the Nation, have interesting balance sheets. The long term trade deficit has weakened the national balance sheet, and Government deficits have weakened the government balance sheet. But the underlying real estate is strong … but lack of infrastructure investment has made it low in productivity.

    R&D expenditures have mixed results. Some of this has produced amazing value adding … some much ends up not very useful.

    The metrics used to keep economic score miss almost everything that is important. There needs to be a reset of the scorekeeping, and then there will be a change in the way the game is played!

    Peter Burgess
    Community Analytics

  • Carter

    Very insightful post! I never thought about how rising national debt could lead to less investment for SMB’s.

  • I agree with the principle of per-capita grants and taxing only economic rent–but how do we get there from present institutions?

  • Robert Zevin

    The observation that variations in levels of outstanding national debt are positively correlated with variations in economic inequality is an outsatnding insight. Like all counter-intuitive discoveries, it calls for some careful research and analysis to see how we need to change our conventional wisdom about national debt. Perhaps the correlation is spurious and really has more to do with the end of Bretton Woods, or the increasing debt leverage of the private and parrticularly the financial sector, or the growth in the already large influence of money in politics. I agree with polycle and David Wineburg on the perverse influence of military spending on economic growth and equality. I think polycle should acknowledge the predominant importance of falling tax revenues in the growth of debt during and after severe contractions. With regard to taxpayer’s comment and polycle’s reply, I recommend Peter Barnes’
    book, Who Owns the Sky.

  • There’s a good reason, all else being equal, why increases in debt should worsen inequality. That’s because debt crowds out lending to borrowers with the least collateral–small business. Small business provides the most employment per dollar invested, and especially the most low wage employment. When Clinton paid down debt, the top decile to bottom decile ratio fell, because wages rose in the bottom decile.

    I would love to see some serious statistical tests of this hypothesis.

    Peter Barnes is on the right track. I use his Capitalism 3.0 in my courses.

  • […] The “Keynesian” paradigm completely disregards the quality of government spending, borrowing and taxation. We need policies now to get production back on track. Priority should go to supporting small business, which provides the most employment and production per dollar invested. That means at the least making credit available and mitigating that great job-killer, the payroll tax supporting Social Security. (See my prior pieces on “Deficit Hawk, Progressive Style.”) […]

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