Commentary: The Wrong Way To Balance The Budget

In the early days of the American republic, financial panics often led to steep declines in economic activity. Yet the last time a financial crisis triggered an economic collapse was the Great Depression. In the half-century following World War II, financial blowups have had minimal impact, and the economy has enjoyed a relatively smooth ride.

Now, Congress confronts the possibility of returning us to the chaotic days of yore. In the coming weeks, after years of debate, the Senate will decide whether to require the federal government to balance its budget. Many GOP lawmakers back the amendment. They shouldn't. The Balanced Budget Amendment would strip away much of the government spending that cushions the economy in hard times--just when disinflation and the prospect of deflation are raising the odds of financial crises.

The U.S. economy is a remarkably stable system, in large part because of the government's expansive safety net. Federal deposit insurance, for example, prevented the collapse of the savings-and-loan industry in the late 1980s from turning into a depression of the 1990s. A market collapse in Mexico sparks jitters in the U.S. but not much more.

NEEDED NET. Impose the Balanced Budget Amendment, however, and the system breaks down. Today, as soon as the economy begins to slump, government tax collections fall, and government transfer payments, such as food stamps, increase. The result is higher deficit spending during recessions--but these automatic stabilizers also put more money into the hands of Americans precisely when they most need it.

A Balanced Budget Amendment, by contrast, would require an explicit vote of Congress to run a larger deficit to counteract an economic slowdown. Given the current climate against deficits, politicians may be reluctant to approve large-scale deficit spending until a recession is well under way. The result? Bigger swings in the economy and a far more volatile financial system.

This at a time when changing economic conditions are creating a world where stability will be particularly in demand. For years, the powerful interaction of inflation hawks at the Federal Reserve Board, bond-market vigilantes, and the new world economic order have been exerting a firm downward pressure on prices. As a result, "we are a lot closer to the edge of deflation than we have been in some time," says Edward E. Yardeni, chief economist at C.J. Lawrence Inc.

The Fed, for one, is pursuing an austere monetary policy toward its goal of wringing inflation out of the economy. By almost any measure, the U.S. money supply is growing at an anemic rate--hardly fertile ground for price increases. Similarly, bond-market investors send interest rates sharply higher on any hint of inflation news. "The bond market will do whatever is necessary to make sure inflation won't take off," says Charles I. Clough Jr., chief investment strategist at Merrill Lynch & Co.

Meanwhile, with the collapse of communism and the embrace of freer markets by much of the developing world, the supply of goods, services, capital, and labor is soaring. White-hot domestic and international competition helps explain why last year's inflation rate in the U.S., measured by hourly compensation, was the lowest since 1949--easily offsetting price increases of many commodities and crude-materials prices. Disinflation is here to stay.

VICIOUS CYCLE. So what? In a world of low inflation, the risk from unexpected financial crises soars. A stock market crash, a bank failure, or a drop in the dollar's value could send asset prices plunging. Suddenly, interest payments become onerous. Credit contracts. This is the sort of vicious cycle that was common in the pre-World War II era--and that deficit spending later eased. "The stability of our economy is drastically diminished when the federal government is powerless to intervene to prevent a disastrous debt deflation," says Hyman P. Minsky, an economist at the Jerome Levy Economics Institute at Bard College.

The Balanced Budget Amendment wouldn't leave us completely defenseless. The Fed always can open the money spigots to offset the immediate impact of a financial panic, much as it did following the stock market crash of 1987. But monetary policy is a tool best used to control inflation, not to counteract the cyclical ebbs and flows of the economy and financial markets. Getting the government's finances in order makes sense. But the Balanced Budget Amendment is a dangerous step back into the 19th century.

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