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Home | Library | The Budget Mess: Time to Get Serious

The Budget Mess: Time to Get Serious

May 4, 2011

Tags U.S. EconomyMonetary Theory

"Congress can raise its own official debt ceiling, but it cannot change the economic laws concerning the real effects of its policies on our lives."

The recent downgrading of federal credit by Standard & Poors and Egan-Jones reflects concern over mounting federal debts. While there are good reasons to doubt the long-term solvency of the federal government, politicians are now focused on a more immediate problem: raising the federal debt ceiling. Will Congress raise the legal limit on the total debts of the federal government?

Economists have been debating a different debt ceiling. Ken Rogoff and Carmen Reinhardt have published statistical analysis of the effects of national debts on long-run economic development. One study (2010) of 44 countries that spanned a 200-year time period found that when external debt reaches 90 percent of GDP, median growth rates fall by 1 percent and average growth rates fall by more. Growth rates in developing nations are cut in half once external debt goes over 60 percent of GDP. Another study of theirs (2003) of 100 countries going back to 1820 shows that some less-developed countries become "debt intolerant" with external debts over 15 percent of GDP. The ability to sustain growth with debt levels over 15 percent is correlated with a history of inflation and defaults in a country.

The standard textbook argument for public debt slowing long-run growth is that public borrowing "crowds out" private borrowing. Every dollar that the federal treasury borrows is one less available for private investment projects. This is what economists term "crowding out of investment." Less private investment translates into slower long-run growth.

The debt ceiling that Rogoff and Reinhart see in the data is ultimately more important than the legislated debt ceiling in Washington. Politicians can simply change their official debt ceiling through legislation; economic laws are not subject to such revisions. Raising the federal debt ceiling will not prevent growing national debts from impairing future economic progress.

While economic laws are ultimately immutable, the exact details of these laws in empirical matters are debatable. Krugman criticized the Rogoff-Reinhardt studies about a year ago. He thinks that they have misinterpreted a "crude correlation." The United States came out of World War II with debts in excess of 90 percent of GDP, and this did not prevent strong growth in the postwar years.

For once, I am in partial agreement with Krugman. He notes that there was slow growth in the immediate postwar period, but he attributes this to the dislocation caused by the transitions of American industry from wartime production to peacetime production. As a Keynesian, Krugman must deal with the fact that the dramatic decline in government at the close of the war did not cause the depression that many Keynesians had expected back then — but that is a separate matter. The national debt shrank as a percentage of GDP. The treasury ran occasional surpluses in the Truman-Johnson period.

"This is a simple matter in economic terms. We just need to shift from public spending to private spending.
"

Krugman is correct in pointing out that simple correlations have to be adjusted for specific historical circumstances. But it seems obvious that the big difference between then and now is that federal spending fell dramatically after World War II, stayed comparatively low in the 1950s and '60s, but is projected to impose crushing burdens now. Debt as a percentage of GDP fell in the Truman-Carter period.

However, a structural deficit emerged with escalation of the Vietnam War and the start of the Great Society programs. Deficits began increasing the ratio of debt to GDP in the period from Reagan through Clinton's first term. There was a brief period of fiscal discipline in Clinton's second term. However, fiscal discipline in the past decade has deteriorated to a point where investors should doubt the ability of taxpayers to cover federal debts.

Krugman's remarks from a year ago reveal a degree of naïveté on his part regarding the impact of Obama's record-setting structural deficits. The deficits of the early 1940s were the result of a crisis that ended in August 1945. The structural deficit we have now is the impending crisis of our time. The Eurosclerosis example is more valid than Krugman thinks; this example reinforces the concerns that Rogoff and Reinhardt have raised concerning the future prospects for the American economy. Krugman's inability to arrive at this obvious conclusion is odd.

I am in stronger agreement with Krugman's point on Eurosclerosis causing slow growth and higher debts in Europe. Slow growth in the economy does cause slow growth in VAT or income taxes. Krugman does not mention that Eurosclerosis typically refers to the effects of regulation and other forms of intervention on employment and economic conditions generally. Stephen Nickel's analysis of European labor markets reveals that high minimum wages and generous welfare and social-insurance programs resulted in high and persistent unemployment rates in western European nations.

Obama's policies on minimum wages and social insurance are clear: he favors European-style extensions to unemployment benefits and European levels of minimum wages. Obama also wants to follow western Europe in regulating markets generally, and is pushing towards western-European levels of public spending and debt. Krugman was right to point out Eurosclerosis as an example of how slow growth in GDP and the tax base might make budgetary problems even worse, and we are well on the way to following Europe's bad example.

Of course, the idea that the current fiscal imbalance is simply due to a lack of revenue has no basis in fact. Federal spending grew as a percentage of GDP in the early part of George W. Bush's presidency, and has risen even more in Obama's term. If federal spending continues to outpace GDP growth, the federal government will ultimately have to declare bankruptcy.

This brings us back to the federal debt ceiling. Large numbers of Americans appear concerned about the recent upsurge in the federal debt. Part of the reason people are concerned is because 78 million baby boomers are beginning to retire. People are rightly concerned about baby-boomer retirement. Scaling back the Bush-Obama spending surge of the past decade is not itself problematic. Cutting federal spending transfers control of labor and capital from public bureaucracies to private enterprises, which amounts to the crowding out of investment in reverse.

"As more money is spent privately, available labor and capital will shift to private enterprises.
"

Some economists try to argue that government spending can "crowd in investment" if this money is invested in public projects that improve overall economic efficiency (e.g., education, infrastructure). The Obama administration has committed itself to recovery and reinvestment. Hypothetically speaking, we could imagine public investment leading to economic development and ultimately higher tax revenues.

The actual record of federal spending indicates that little of this money is even intended as any kind of investment, and what little appears to be intended as investment has questionable value. Economic theory also indicates that public control of resources reduces economic efficiency. Public officials lack the ability to gather and make sense of practical economic knowledge that they would need to direct the use of scarce resources efficiently. Public officials also have strong incentives to cater to special-interest groups rather than to promote the so-called public interest.

We can gain much through cuts in federal spending. The recently announced spending cuts are, in fact, less than 1 percent of federal spending, a token sum that does nothing to fix the long-term budget situation. This is a simple matter in economic terms. We just need to shift from public spending to private spending. As more money is spent privately, available labor and capital will shift to private enterprises.

The retirement of baby boomers poses a more difficult problem. Projected increases in Social Security and Medicare spending are not merely a matter of private versus public spending. The labor productivity of the 78 million baby boomers will be lost as they continue to age, no matter what happens with entitlement funding. Private means of financing retirement generally work best, but this is due to productivity gains associated with long-term private saving.

Baby Boomers have saved less for retirement specifically because they have expected governmental support through so-called entitlements. Lower savings rates by Americans have meant less capital accumulation, less accumulation of financial assets, and more importantly less investment in many different types of capital projects.

What this means is that the impending loss of labor accumulated during the baby boom will be harder to bear than it should have been. There is little time left for investment financed by private saving and from baby boomers, but spending cuts by Congress would help move the United States from its spending and borrowing binge by enacting large spending cuts.

This brings us back to the other debt ceiling. Politicians have known about entitlement underfunding and growth in the federal debt for decades. These problems have been ignored precisely because the enactment of real solutions to these problems was, until recently perhaps, a political liability. Each spending program in the federal government has an interest group behind it, especially federal entitlements.

"Economic laws mean that federal spending, debts, and regulations have imposed a ceiling on future economic progress, and this is what should concern us most."

Some Congressmen and senators are voicing newly found concerns for the federal debt ceiling because part of the American electorate has taken notice of rising fiscal burdens. Yet even now politicians are bickering over trivial changes in spending and will raise the official debt ceiling instead of dealing with real problems. Politicians are still taking a shortsighted approach to fiscal issues that have made the other debt ceiling a problem.

Economic laws mean that federal spending, debts, and regulations have imposed a ceiling on future economic progress, and this is what should concern us most. Congress can raise its own official debt ceiling, but it cannot change the economic laws concerning the real effects of its policies on our lives. The debt and regulatory ceiling on future economic progress can be raised only by adjusting public policy to reflect economic laws, and this means that Congress must enact significant spending reductions and a return to free markets.

References

Krugman, P. "Bad Analysis at the Debt Commission," The New York Times, May 27, 2010.

Reinhart, C.M., and Rogoff, K. "Growth in a Time of Debt," The American Economic Review 100(2), pp. 573-578.

Reinhart, C.M., Rogoff, K., and Sevastano, M., "Debt Intolerance," NBER paper (2003).

He explains the difference between the competition among producers and a Marxian-type struggle. He shows how the relationships between labor and capital are essentially cooperative in that interests coincide over the long run — and so it is with all groups in a free society.

However, he goes further to map out a theory of what he calls castes, which form under interventionist systems. Here the privileged group really does live at the expense of the paying group in a manner that Marx suggests — but with the key difference that it is the state and not the market that makes this possible.

In this way, argues Mises, the state is the cause of social conflict; the more it intervenes in the market order, the more conflict it creates, as taxes, regulations, and legal privileges of all sorts begin to blot out the harmonious relationships that would otherwise exist on the market.

In his introduction, Rothbard explains the central importance of Mises's insight for understanding society and the market, and for providing a sound alternative to Marxian dialectics (which are still pervasive throughout academic departments today). Mises has unlocked many mysteries with this essay.

There does exist a clash of group interests — and it is the state that creates them. The only real resolution is to do away with all forms of statism.


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