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?

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