Sunday, July 16, 2006

Bumper Sticker Economics: Are Budget Deficits Sustainable?

In Part 4 of our series, prompted by Dave at First State Politics, we look at the question of how long we can continue the current deficit spending.
One interpretation of Dick Cheney's comment that deficits don't matter is that cutting taxes can provide a short term benefit and that the long term consequences can take years to be felt. Put another way, real men cut taxes and leave the job of cleaning up the fiscal mess to the next guy, providing he's a fiscally responsible wimp like
Bill Clinton or the first President Bush.
My macroeconomics textbook was authored by Gregory Mankiw of Harvard, who also served in the younger Bush's White House. Let's see what Professor Mankiw had to say about Reagan's fiscal policy, from page 64 of Macroeconomics (Fourth Edition):
One of the most dramatic economic events in recent history was the large change in U.S. fiscal policy in 1981. In 1980 Ronald Reagan was elected president on a platform that promised increases in military spending and reduced taxes. The result of this combination of policies was, not surprisingly, a large imbalance between government spending and revenue. The federal budget deficit skyrocketed in the 1980s and the government borrowed at a rate unprecedented in peacetime.
As our model predicts, this change in fiscal policy led to higher interest rates and lower national savings. The real interest rate (as measured by the yield on government bonds minus the inflation rate) rose from 0.4 percent in the 1970s to 5.7 percent in the 1980s. Gross national savings as a percentage of GDP fell from 16.7 percent in the 1970s to 14.1 percent in the 1980s.
The real interest rate (using May's CPI of 4.2 percent and Friday's 13 week t-bill) is 0.7 percent. While not an alarming figure, keep in mind that the national debt has climbed from $5.6 trillion in 2000 to $7.9 trillion last week. As for the national savings rate, we are getting numb to news stories about our negative national savings.
One reader mentioned the work of Boston University economist Laurence J. Kotlikoff, who sounded the alarm in the July 2 issue of Time magazine:
Let's face it--Uncle Sam is broke. The gap between the U.S. government's future expenses and tax receipts is $63.3 trillion.
The piece is more about the need forpersonal savings rather than fiscal policy. This projected gap, which makes forgreat headlines, can vay greatly depending on the methods used to calculate future expenditures and revenues. For instance, if future revenue and obligations are calculated in perpetuity, the numbers become very large indeed.
In a more practical sense, the U.S. government is not bankrupt in that it has the cash to meet current obligations and can easily borrow money at reasonable rates. The problem is that borrowing money will eventually become more expensive as the national debt grows.
Tomorrow: How did we balance the federal budget in the 1990s, and can we do it again?

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