TCS Daily


The Deficit Club

By Kevin Hassett - February 6, 2003 12:00 AM

Back when my AEI colleague Newt Gingrich masterminded a Republican capture of the House of Representatives, many observers believed that his cleverest strategy was to publish a "Contract With America" that committed his party members to a number of solemn promises. Looking back on the document with an earful of today's debate, you might be surprised to find that the very first economic policy item in the contract was a call for a balanced budget amendment and a line-item veto. (Here is a link to the contract). This proposal took center stage at the time because of the increase in entitlements pursued by the Clinton administration prior to the 1994 election.

Here we are, almost a decade later, and Republicans seem to have wandered away from the belief that balanced budgets matter. Today, in the face of soaring deficits, they are proposing new tax cuts that will surely make the deficits larger in the short run. But the balanced-budget flag is not sitting in a closet somewhere. The Democrats are now carrying it into battle!

Why do the sides change over time? Have we learned something recently that has altered the debate?

To address these questions, we need to review a little economics. Higher deficits are a big problem if they increase interest rates. What do we know about that? Economist John Seater reviewed a vast literature on the impact of government debt on interest rates and the economy about a decade ago, and concluded that economist Robert Barro's famous theoretical result that government debt should have no effect on the economy seemed to be a fairly accurate characterization of the evidence. In Barro's model this holds because individuals recognize that in the end they (or their children) will have to pay higher future taxes if taxes are artificially low today. So they save more when deficits are higher.

Seater was careful to note that the fact that deficits did not appear to have much of an effect on interest rates was not necessarily a confirmation of Barro's model. There are many other reasons government deficits should have little effect on interest rates. My own view is that there are many close substitutes for U.S. government bonds in the world today (Fannie Mae's, corporate bonds, foreign government bonds) and that the historical swings in U.S. deficits are so small relative to the stock of existing debt that it would be miraculous if debt did have much of an effect on interest rates even if Barro were completely wrong.

Seater's review had a rather decisive effect on the economic literature. The result seemed more or less resolved, and new research on the issue dried up almost completely. A recent "re-review" by Brookings economists Peter Orszag and William Gale purports to find more compelling evidence of a link, but they do so not by providing new empirical evidence of their own. Instead they discard the vast majority of studies that find a negligible effect, and put an especially high weight on studies that do not. Since the methodologies across studies differ, there is certainly at the very least an argument.

Even if these gentlemen are correct, however, my intent is to draw out the underlying observation that this effect is incredibly difficult to find if it exists at all. Today, for example, deficit news has been terrible, yet interest rates are at about a 40-year low. Japan has a debt relative to GDP that is almost four times that of the U.S., and yet they have lower interest rates than we do. The changing of sides cannot be explained by loyalty to different literatures.

So even though economists may still find something to argue about, from a practical perspective, the deficit-interest rate nexus is something that has not clearly and identifiably jumped up to bite politicians in the past. Those who chose to run high deficits did not experience costly high interest rates.

Which brings us to the political debate. First, it is undoubtedly true that in the end we shall have to pay for anything we spend. Ultimately, the budget will have to approximately balance. If we enter a trajectory with ever-increasing deficits, then some drastic policy action will necessarily ensue. So it is sensible to be wary of things that take us too far astray.

But second, and more important, every voter recognizes that high debt loads expose a family to unpleasant risks. Political rhetoric that reminds voters of those realities can be quite effective. Which explains the ever-changing talk of the importance of balanced budgets. Republicans want to reduce marginal tax rates and hope that these will stimulate the economy and constrain the growth of government spending. The first step, cutting revenue, will always increase estimated short-run deficits. The second part, the economic and spending effect, will be experienced over many future years, and will not be in any official estimates of the budget effects of the tax reduction. So Democrats will always be able to oppose Republicans when they are in power with balanced-budget wails.

On the flip side, Democrats would undoubtedly accept higher deficits in exchange for their own pet spending programs. If Mrs. Clinton's health insurance plan had passed, we never would have heard of "Rubinomics." So when Democrats are close to accomplishing their political objectives Republicans use the best weapon they can find to attack them, the deficit.

Which suggests a final interesting conclusion. Since the "deficit club" is used by both sides over time, it must be the case that both sides propose things that are basically popular with voters. If Republican tax cut plans were truly unpopular, Democrats would fight them more directly. If Democratic spending plans were truly unpopular, the Republicans would fight them more directly.
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