The Deficit Gambit

Their main substantive point seems to be that somehow budget deficits are going to send us all to recession. Their logic is that deficits have returned because of the Bush tax cuts, so any future tax cuts must be repealed and certainly no new ones passed. Otherwise we will get bigger and badder deficits that will cause interest rates to rise and render the economy less able to grow enough to be able to afford its long-term liabilities (e.g., Social Security).

Nonsense (and we're being polite here). The current deficit is the result of a swoon in revenues due to the recession and a surge in government spending. The Bush tax cuts, which amounted to no more than 15% of the shortfall, probably moderated the recession and thus also the fall in revenues. More culpable is the upswing in government spending that started several years ago; discretionary spending has risen more than 8% a year of late, well above inflation.

The current deficit -- at 1.5% of gross domestic product -- and those projected for the next couple of years are small by recent historical standards; the deficit peaked at 6% of GDP in the early 1980s. It is also way below the 27% of GDP during World War II. By the way, the deficit relative to the economy is even under the 3% ratio mandated by the European Union.

Nor are deficits, especially of this magnitude, dangerous. The notion that deficits cause interest rates to rise is a fiction first argued by Robert Rubin, President Clinton's Treasury Secretary. There wasn't any empirical evidence to support this argument when Mr. Rubin trotted it out, and there still isn't.

In 2000, when the budget surplus reached its peak of $236 billion, the average interest rate on 10-year government bonds was 6.03%. As the surplus dwindled into a deficit, interest rates -- guess what? -- went down. Currently the rate on 10-year government securities is a tad over 4%. (See the nearby chart on Rubinomics' recent market failure.) Even the most masterful tickling of the data show such a modest raise in long-term interest rates as to be trivial.

In any case, the best way to control deficits is with fiscal policies that move the economy to a higher growth path. One of the most effective ways to do that is with a tax cut, especially a cut in marginal income-tax rates. Rather than being frozen and forgotten, the Bush tax cuts should be accelerated to this January 1 and made permanent.

Lower marginal rates will create incentives for more saving, investing, risk-taking and working. In short, a virtuous chain reaction in which higher productivity translates into faster growth and a bigger economy so that the slice taken out when we redeem pension and health promises is smaller relative to the size of the available resources.

Tax cuts also exert an inherent discipline that is good for growth. The less revenue government has to spend, the less government spends. We aren't arguing against spending for the war on terrorism (including homeland security), but against inefficient and ultimately unproductive spending such as farm bills that only slow growth. In that sense, if tax cuts create modest budget deficits that inhibit government spending, the economy gets a double boost to productivity.

The broader point here is not that the government's long-term liabilities can be ignored or minimized. They will have to be met one way or another. Our view is that Social Security and health care programs (Medicare, etc.) ought to be reformed to put them at least on firmer financing ground, but that argument is for another day.

The point for now is that the current media squawking about "the deficit" has nothing to do with these liabilities, or for that matter with the economy. It has everything to do with trying to stop Mr. Bush's tax cut plans. We trust Messrs. Snow and Friedman will ignore all of this and listen to the President who just hired them.

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Updated December 11, 2002