Introduction to Economics
by Stephen Stamos, professor of economics and international relations
As Kerry, Edwards, and Clark compete for the Democratic party's nomination to challenge George W. Bush in the November presidential election, each challenger has charged the president with fiscal irresponsibility. When Bush took office, the fiscal surplus was 2.4 percent of the GDP and in 2004 it will reach a deficit of 4.3 percent of the GDP.
Bush unveiled a $2.4 trillion budget for 2005 with a deficit of $521 billion. Critics warn that hidden and ignored additional costs not included in the Bush projections will add more than $3.3 trillion to the budget in the next 10 years and possibly as much as $5 trillion. This makes the promise of cutting the budget deficit in half over the next five years a veritable joke.
The Congressional Budget Office expects a deficit of $1.4 trillion over the next decade. Critics suggest that a more realistic appraisal of the budget must include these considerations:
• Extending the Bush tax cuts would add $1.9 trillion;
• Reforming the Alternative Minimum Tax would add $690 billion;
• Making spending more realistic by assuming that spending rises in line with nominal GDP growth rather than just inflation adds $1.6 trillion;
• Expanding Medicare.
Officials understate the cumulative deficit by about $5 trillion. There will be no surplus in 2012. There will be budget deficits that will likely average 3 percent of the GDP over the next 10 years. This emerging reality neither sounds nor looks good for the United States nor its citizens.
In introductory economics, we learn about budget deficits since the Great Depression and World War II. Our economy has produced economic growth in cycles of expansion and prosperity followed by periods of economic slowing and recession. This cyclical instability has been characterized by this business cycle behavior. The government's responsibility has been to produce economic growth with full employment without inflation.
The government has used its fiscal policy tools of spending and taxation to pursue this objective. (The Federal Reserve likewise uses its monetary policy tools to produce price stability.) In this context, if the economy is slowing or has entered a recession, it is natural and appropriate to increase government spending and reduce taxes to add economic stimulus to a weak economy until it begins to grow again.
To incur a cyclical deficit in this context is logical. The deficit is added to the nation's accumulated public debt ($6.7 trillion today) and servicing this public debt (by paying interest on it) becomes part of the annual budget and reflects an opportunity cost (money spent on interest could have been used for other national needs).
This raises the question, what is the structural deficit spending for? Is it for education, healthcare, infrastructure or technology that can make the economy stronger and more productive, or other items that will not really improve the long-term productive base of the economy?
Borrowing by the government to finance a deficit, in theory, puts pressure on interest rates as the government's demand for credit competes with the private sector (called crowding out). This typically occurs when the economy is growing strongly and the demand for credit is also vibrant.
This situation can become more complicated when the nation is also running a large trade and current account deficit that must be financed by foreign investors who would be buying U.S. assets like stocks, bonds, and property. These investors will want higher rates of return in the U.S. to reward them for their risk. They will be leery of U.S. asset markets if the U.S. is running excessive fiscal deficits and trade deficits in the context of building inflationary pressures and strong economic growth. This is more problematic with a declining U.S. dollar and unusually low interest rates.
So, where are we today? The Bush administration argues that the growing deficits are due to economic slowdown and recession beginning in 2000, costs associated with Sept. 11, the war on terrorism, wars in Afghanistan and Iraq, and homeland security.
There is merit in this argument, but the Bush administration ignores the dramatic run-up in spending not only in defense and homeland security but other areas of discretionary spending. And, there is no discussion of the deficit consequences of the massive tax cuts.
The economic recovery has been a disappointment and did not generate job growth that was promised. An interesting question is what happens if we have another recession? What fiscal policy choices would we have? More deficit spending and more tax cuts? Hardly. We are pushing ourselves into a corner.
The U.S. is fortunate there is significant slack in the economy; interest rates are low, and corporations have plenty of cash on hand so that the textbook crowding out dynamic of a deficit is not in play and that there is no inflation. The administration is being criticized for fiscal irresponsibility and the budget proposal by fiscally conservative Republicans as well as Democrats.
The trajectory of defense spending and homeland security is going to clash with these other competing forces. There are too many imbalances that need to be addressed. Most economists agree that we cannot grow our way out of this reality. Raising taxes and reducing spending (cutting and reducing future benefits?) will be the hard policy choices confronting the winner in November.
Stephen Stamos may be reached at email@example.com.