When Deficits Matter …

There’s a lot of misunderstanding in popular culture (most started during the Reagan years) about deficit spending and the public debt. Deficits tend to increase naturally during bad economic times due to what we economists call automatic stabilizers. These are spending programs (most of which were built into the economy during the New Deal) that adjust as the business cycle changes. Taxes naturally go down during a recession because less people are making money and business earn less revenue and sell less. Government expenditures go up because people rely on unemployment insurance and other government programs more during bad economic times.

Then, there is discretionary fiscal policy that the government undertakes to offset the business cycle. The Keynesian framework suggests that the government should deficit spend by increasing its direct spending or lowering taxes during bad economic times and then quit spending and decreasing taxes during good times.

Neo-Keynesian economists (like me) never suggest running perpetual deficits which build up our government debt over time. The debt accrues interest and it can eventually become a substantial part of current government outlays if the interest rates are high enough or the debt becomes a big enough percentage of current output (GDP). A huge deficit and/or debt can eventually impact a growing economy. We appear to be on the path to that result now.

The “deficits don’t matter” meme that came from the likes of vpResident Evil Dick Cheney is anathema to neo-Keynesians despite Republican falsehoods to the contrary. It’s pretty much why we saw Democratic President Bill Clinton try to address the excesses of the Reagan Administration (the real tax and spend president of the 20th century) during his administration. The deficit management program during the Clinton years was very much in keeping with what neo-Keynesians believe is a responsible approach to fiscal policy. When the economy is good, you increase taxes to suppress the tendency for the economy to create inflation and you take advantage of the incoming revenues to lower the debt and run a surplus.

The surplus does double duty since it is essentially “government saving”. It takes the government out of the bond markets and provides more money for the private sector to grow. Hence, there is a role for surpluses during boom times. Government surpluses tend to funnel money to private business and suppress any inflationary pressures in a fast growing economy. Plus, they can be banked in rainy day funds to be spent during bad economic times.

So, that’s the Keynesian fiscal policy theory in a tiny nut shell.

So what does this mean? It’s a link to a Reuters piece called “Obama to raise 10-year deficit to $9 trillion”.

The Obama administration will raise its 10-year budget deficit projection to approximately $9 trillion from $7.108 trillion in a report next week, a senior administration official told Reuters on Friday.

The higher deficit figure, based on updated economic data, brings the White House budget office into line with outside estimates and gives further fuel to President Barack Obama‘s opponents, who say his spending plans are too expensive in light of budget shortfalls.

The White House took heat for sticking with its $7.108 trillion forecast earlier this year after the Congressional Budget Office forecast that deficits between 2010 and 2019 would total $9.1 trillion.

“The new forecasts are based on new data that reflect how severe the economic downturn was in the late fall of last year and the winter of this year,” said the administration official, who is familiar with the budget mid-session review that is slated to be released next week.

“Our budget projections are now in line with the spring and summer projections that the Congressional Budget Office put out.”

The first thing I’m hoping it means is that the Obama administration is going to quit putting out rosier-than-rosy scenarios (and even more hopefully, quit using them for fiscal policy decisions). In other words, my fervent prayer is that they’re getting real. Second, it means this:

Record-breaking deficits have raised concerns about America’s ability to finance its debt and whether the United States can maintain its top-tier AAA credit rating.

Politically, the deficit has been an albatross for Obama, a Democrat who is pushing forward with plans to overhaul the U.S. healthcare industry — an initiative that could cost up to $1 trillion over 10 years — and other promises, including reforming education and how the country handles energy.

Why, after years of deficit spending by federal government, are we in danger of becoming a developing nation? Why are we seeing a continuation of what is essentially, Reaganomics (a failed economic hypothesis, but a popular ideological and political meme) instead of retreat to the proven theories of macroeconomics?

The Center on Budget and Policy Priorities has a really good piece written by James R. Horney that you should consider reading. It’s called “Five Keys to Understanding New 2009 Deficit estimates”. Here is point one.

1. Both reports will undoubtedly show that this year’s deficit will be the largest since the end of World War II, relative to the size of the economy. This is no surprise, since CBO and OMB projected a post-war record deficit for this year as long ago as January and February. The new projections almost certainly also will continue to show deficits improving over the next few years as the economy recovers, although the projected improvement will likely be slower than in previous recoveries and deficits will remain troublingly high.

This is important to understand. It’s not the dollar size of the deficit that matters, it’s its relative size to the economy because that indicates our ability to pay for the spending. That is why our Aaa credit rating is in danger which could lead to a much higher risk premium charged in the international market for public debt. This means more and more of our current spending would go to servicing the spending of years ago.

Our spending is not in line with the realities of our potential for economic growth. I have given you forecasts from many well-known, prestigious economists like Nourielle Roubini. Nearly every one of them suggests that we are in for a jobless recovery and that our economic growth rates will not be good. We have lost nearly 10 years of growth and value and the compounding that goes with this growth. It means we don’t have the slack to support higher spending priorities and because of the Bush tax policies, we have the only income classes picking up increased wealth and purchasing power, not providing increased revenues. This is a serious problem.

Another point that troubles me is number 3.

3. Whether the new estimates exceed $1.84 trillion will likely depend on the amounts recorded for a particularly volatile category of spending: assistance to troubled financial institutions. CBO’s March estimate of a $1.84 trillion deficit included more than $330 billion in spending for the Troubled Asset Relief Program (TARP) enacted last fall, plus $125 billion from legislation the President was seeking to provide additional authority for TARP activities. However, Congress has not considered the legislation providing new authority for TARP, and through July the Treasury Department had recorded only $169 billion in TARP costs under existing authorities for 2009.

Similarly, the costs recorded for the federal government’s support of two ailing government- sponsored enterprises — the Federal National Mortgage Association (Fannie Mae) and the Federal Home Loan Mortgage Corporation (Freddie Mac) — will substantially affect the deficit for 2009. Government-sponsored enterprises are privately owned organizations that generally are not considered part of the federal government; their transactions with the public are not included in the budget. CBO believes, however, that the decision last year to put Fannie Mae and Freddie Mac into conservatorship under the control of the Federal Housing Finance Agency essentially represents a federal takeover of the two organizations. CBO argues that the activities of the two organizations should now appear in the budget and that the long-term costs related to Fannie’s and Freddie’s commitments as of the takeover, as well as the full costs of their ongoing activities, should be recorded in the budget as a cost in 2009. CBO estimates these costs exceed $290 billion.

OMB, in contrast, continues to treat Fannie Mae and Freddie Mac as private entities that are not fully reflected in the budget. It includes only direct payments from the Treasury to Fannie and Freddie as a budget expense. So far this year, the Department of the Treasury has recorded just over $80 billion in such costs.

I think I’ve mentioned that we’ve barely scratched the surface of what’s out there in so-called “Troubled Assets” . They’re not being reported correctly. They’re not systematically dealing with the root causes of the problems. These assets and the wicked processes that enabled their troubled status are sitting out there, ignored, like a ticking time bomb. These estimates may not be correct (given banks are not marking them to market and under-accounting for them). Also, nothing has been done to correct the deficiencies in Fannie and Freddie and the upcoming troubles with FHA/VA loans due to the fact that we are and still will be experiencing high levels of unemployment for some time. We have yet to see the peak numbers of defaults.

Of course, this is only in the residential mortgage area. This does not include any coming trouble in the commercial mortgage area. The fat lady has not sung her last on this topic and as far as I can tell, they put on the Opera before they finished the score. I’m not even sure they have any composers sitting at the White House, finishing the libretto at the moment, let alone the musical finale. We appear to just be repeating the last act of the Dubya/Cheney/Paulson mess.

Which leads me to fifth and really concluding point.

5. The only clear conclusion that should be drawn from the new deficit estimates is the continued need for action on long-term deficits. The new estimates should not spur efforts to reduce deficits in the next few years beyond what Congress has already endorsed in its budget resolution for fiscal year 2010. The extremely high deficits projected for 2009 and the next few years largely result from the most serious economic downturn since the Great Depression and the steps taken to keep it from becoming even worse. Trying to reduce deficits in the short run would be counterproductive to those efforts and could stall or reverse the economic recovery.

The estimates should, however, reinforce the message that the current fiscal path is unsustainable over coming decades. (The policy path was unsustainable before the economic downturn; in fact, the downturn will add relatively little to the size of the long-term problem. Changes in current policies — such as to ensure adequate revenues and help slow the rapid growth of public and private health care costs — must be made to keep deficits from growing rapidly in coming decades to levels substantially higher than this year’s, even if the economy is operating at full capacity. The President and Congress should begin immediately to demonstrate they are serious about bringing deficits in the medium term (five to ten years from now) down to reasonable levels and avoiding an explosion of deficits in the longer term.

You notice there is a realization that reducing deficits right now would simply throw us back into a deeper recession. This is exactly what happened in 1937 when there was a reaction to similar conditions and concerns about the deficit. We don’t want to repeat that mistake and stall or reverse an economy trying desperately to recover.

However, in the concluding paragraph you will see that Horney believes these estimates show an unsustainable fiscal policy in the long run. Most of this comes from another attempt at Reaganomics from the Dubya/Cheney years when we once again had rampant military spending coupled with an unrealistic revenue stream. This means, at some point, we will have to return to higher taxes. This is especially true if we want to continue the current program levels for two wars, social spending, and any infrastructure improvements we plan to make. Something, simply has to give here. We are not the economic growth machine that we used to be because of the choices we have made over the last 30 years.

This is a very difficult position for any politician but especially one that really hasn’t got much grounding in governance. Any governor who has held the reins of a state budget for at least two terms should be able to provide this administration with better advice than even La-La Summers and Timmy-in-the -Well Geithner at this point. This would include former President Clinton who had to deliver services and programs to a very poor state during the Reagan years. He also has successful federal fiscal policy experience. Obama would be well-advised to bring in some of the most successful Democratic governors of the last say 30 years and ask them for advice on spending priorities, taxing schemes, and what it takes to have political brass balls.

If all else fails, he should call in a real neo-Keynesian economist like Joseph Stiglitz. This is a mess and I would hate to see amateur hour continue to prevail in the beltway.

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