By Christopher Farrell
Is it déjà vu all over again? Back in the latter part of the 1960s and the early 1970s, Presidents Lyndon Johnson and Richard Nixon pursued a guns-and-butter fiscal policy to minimize the economic pain from waging an unpopular war. The budget deficit climbed higher, and inflation took off. A torrent of government spending was paid for by a depreciating currency.
Fast forward to today. A quick look at the budget numbers shows that fiscal policy is a mess. The federal budget has lurched from a surplus to a deficit -- a turnaround equal to 7% of gross domestic product -- in a few years. Panic about inflation is sweeping the market. Oil prices are in the $50-plus range, commodity prices are soaring, and the producer-price and consumer-price index numbers are coming in strong.
A recent survey of its members by the National Association of Business Economists rates the government's yawning budget deficit as a bigger threat to the economy than terrorism.
The surface similarities between the two eras are compelling. But the differences are even more striking. For one thing, the inflation figures may show a bad quarter or two, but prices won't see a sustained rise this time around. The Federal Reserve Board let the printing presses run overtime some three decades ago, especially under the bullying, incompetent leadership of then-Chairman Arthur Burns.
While the central bank under Chairman Alan Greenspan may stumble occasionally, it isn't about to let the current pressures toward a higher inflation rate translate into a spell of higher prices. Indeed, the Fed rattled the market when it emphasized its inflation-fighting resolve after hiking its benchmark interest rate by another quarter-point during last week's Federal Open Market Committee Meeting. The Fed will keep tightening the nation's monetary belt for a considerable period of time.
The other big difference? The Bush Administration's fiscal policy -- aided and abetted by Congress -- is far more irresponsible than either Johnson's or Nixon's. And that's saying a lot. Even with government revenues increasing as the economy grows stronger, the fiscal 2005 deficit is likely to be higher than it was last year. "I doubt that even a 20-year business expansion would bail the country out of the deficit hole dug with the policy of guns, butter, pork, and tax cuts," says Steven Leuthold, a market historian, longtime money manager, and head of Leuthold Group.
ONCE IN A LIFETIME.
So what? Fiscal policy has been careening out of control ever since George W. Bush took office, and he has paid no political or financial penalty. Bush was reelected. The dollar hasn't collapsed. Interest rates haven't skyrocketed. Foreign investors are still putting money into American assets. Was Vice-President Dick Cheney right in 2002 when he dismissed the concerns of former Treasury Secretary Paul O'Neill? "You know, Paul, Reagan proved deficits don't matter," Cheney said.
Well, the good times may end soon. Interest rates are starting to edge higher. Anxious foreign central banks are diversifying out of the U.S. dollar. Growing unease in Congress is starting to hamper the President's big policy initiatives, from overhauling Social Security to reforming the tax system.
But the main reasons for worry aren't the traditional ones. No, the problem is that the government is missing a once-in-a-lifetime opportunity to put the U.S. economy on a fast-growth path. America is at a moment in history when there's more investment money in the world than there are good investment prospects. Recent economic research, most notably by economists at the Federal Reserve, argues that the global economy is awash in savings (see BW, 3/28/04, "The Deficit: The Sky May Not Be Falling").
The main reason is the potent combination of aging populations in the industrial world and the fast-growing emerging markets such as China and India. The global savings glut helps explain why the financial markets have absorbed Washington's fiscal profligacy without forcing interest rates higher. Capital has to be invested somewhere and, while the returns on U.S. government debt may be low, at least it doesn't suffer from any credit risk.
Washington should tap into this savings glut to invest more in human capital and ideas, to pour money and effort into cutting-edge research and development, as well as beefing up our investment in pre-K through PhD education. Policymakers should be focusing their efforts -- and taxpayer money -- on increasing the supply of talent that transforms ideas and information into high-tech products and marketable services.
Forget subsidies to farmers. Rescind the tax cuts. By all means overhaul Social Security -- but only if the savings end up funding human capital investments that will pay off in faster economic growth and rising living standards.
Yet here's where the government deficit spending has been going: "New tax cuts and entitlements, a defense buildup, and more spending for farms, highways, workers, doctors, manufacturers, and everyone's favorite uncle breezed through Capitol Hill," says Eugene Steuerle, co-director of the Urban-Brookings Tax Policy Center in Washington, D.C. What a waste of capital!
The American economy is at a critical juncture. The rise of China, India, and other emerging markets is to be applauded. But their growing economic prowess signals an even more competitive global economy. U.S. companies can hire brainpower in the developing world for a fraction of the wages paid here at home.
Yes, let's run huge deficits as far as the eye can see in an era of too much capital. But we should put the money to work on improving America's human capital, not reward the Administration's constituents or Congress' pet project. The return on investment would be huge. And remember, the capital glut won't last forever.
Farrell is contributing economics editor for BusinessWeek. You can also hear him on Minnesota Public Radio's nationally syndicated finance program, Sound Money, as well as on public radio's business program Marketplace. Follow his Sound Money column, only on BusinessWeek Online
Edited by Patricia O'Connell