The difference matters.
It's hard to watch political talk shows these days and not be struck by the guests' deep faith that a Grand Bargain to reduce the deficit will shock the economy into hyper-growth. Trillions of dollars among large U.S. corporations are just sitting on the sidelines waiting for the certainty that only deficit reduction can bring, Honeywell CEO David Cote argued Sunday on ABC's This Week. The panel rushed to agree. On Meet the Press, pundits and politicians sang in unison: Deficit reduction is the espresso shot our lethargic economy needs.
And they might be right. The future is another country, and nobody can say for sure that deficit reduction won't unleash a herd of boisterous animal spirits, first in the stock market, second in the housing market, and finally on Main Street. But they're probably wrong. Deficit reduction isn't stimulus -- borrowing from tomorrow to accelerate growth today. It's the opposite -- sacrificing a bit of today's growth to protect tomorrow's health.
So, let's take a step back and consider why deficits matter, when they can be healthy, and when they can be dangerous.
A SHORT DEFENSE OF TALL DEFICITS
Each year that the government spends more money than it collects in taxes, it borrows the remainder from various sources, including foreign investors, at a certain interest rate. That interest rate goes up and down for many reasons, among them (a) inflation expectations and (b) the relative desirability of U.S. debt. Today, our economy is growing slowly, with little inflation, and we're borrowing in our own currency while many of the safe havens where cautious investors used to park their money before the crash (e.g.: mortgage-backed securities and European bonds) have set themselves on fire. Upshot: The U.S. is financing big deficits at historically cheap rates.
Big deficits are like strong medicine -- necessary when you're sick; unnecessary, even harmful, when you're healthy. Today, the economy is still wheezing faintly -- 1.8% GDP growth for the last two years with ~8% unemployment -- and the Congressional Budget Office has repeatedly said that keeping taxes low and spending high could add up to three points to economic growth by the end of next year.
We won't be sick forever. We're adding 150,000 jobs per month, state-government austerity is over, and housing really appears to be making a comeback. When the economy gets going, inflation expectations will rise, interest rates will rise, and so more of our taxed income will leave the country as interest payments to foreign investors if we don't reduce our deficits. That's bad. Also, there is the outside risk that interest rates could spike, which would force us to choose between high inflation (to make the debt more affordable) or a self-administered recession. That's even worse.
Deficit reduction is an insurance policy against that sort of calamity. We don't know when a debt crisis is coming, or even that it will come. But if we pay a small annual premium with higher taxes and lower spending, we can reduce its likelihood dramatically.
Insurance can be good. Insurance can be important. But insurance isn't stimulus. Paying for flood insurance doesn't make your richer in the short-term. In fact, it reduces your take-home pay. Similarly, deficit reduction takes economic activity out of the economy. So you have to be careful when you choose to adopt it as a policy. If you want to see what austerity does to a weak private sector, look at Europe.
Chief execs claim a Grand Bargain will lay a runaway for the economy's 2013 takeoff. Most job creation comes from rapidly expanding small companies, whose most important concerns are health care costs and local demand. Deficit reduction doesn't really address either right now: Reducing government health care spending probably isn't enough to bend the cost curve, and raising taxes is more likely to hurt demand in the short term, or have no effect. There is always the possibility that a spectacular display of bipartisanship from Capitol Hill will inspire business leaders push billions of dollars off their cash piles into the economy. But I wouldn't hold out much hope. Multinationals all around the world have been stock-piling trillions in cash for years now, and even the most optimistic deficit hawks can't expect to move global trends.
If we're going to be serious about the deficit, we should be serious about the reasons to reduce it. Growing the economy in the short-term probably isn't one of them. Protecting growth in the long-term is. That's why the best time for taxes to rise and spending to fall is during periods of strong growth, when employment is full, and the economy can stand to lose a bit of steam. Today, however, it is precisely because of our high deficits that U.S. growth has out-paced most of the largest advanced economies despite getting crushed in 2008 (see graph to right). Let's agree to keep deficits very high for at least another year. And then let's buy an insurance policy against that debt crisis when we can really afford it.