Policymakers in Washington are in a quandary—one that has arisen before at this early, fragile stage in a recovery—over what to do about the federal deficit. An unprecedented amount of fiscal stimulus has been brought to bear to prevent another Great Depression, but it has driven the deficit to more than 11% of GDP, a post-World War II high.
The headline-grabbing size of the deficit makes the case for reducing it a compelling one, and many voters, members of Congress, and investors are convinced that now's the time to strike. According to the most recent Office of Management & Budget estimates, even with a strong recovery, annual deficits will average about 5% of GDP over the next decade, and total debt will climb to nearly 77% of GDP, its highest level since 1952. Persistent deficits of this size will put upward pressure on long-term interest rates, crowding out investment and stunting long-term growth. Interest payments on the debt will be onerous—by 2019 they will exceed defense spending. And investor anxiety about the huge borrowing needs of the U.S. government could trigger a sharp decline in the dollar and another crisis in global financial markets.
As frightening as all that sounds, it fails to capture the immediate challenges facing America. Joblessness is at a 26-year high and rising. And there is a significant probability the country will slip back into recession next year as stimulus spending dies out. Without an economy that's fully up and running, deficit reduction will be a much more difficult task down the road.
Concerns about a double-dip recession have a strong foundation in history. The U.S. economy fell back into recession in 1937 when policymakers throttled back fiscal support too fast, and Japan slid back into recession in 1997 for the same reason. According to a recent study by Alan Auerbach of the University of California at Berkeley and William Gale of the Brookings Institution, policymakers often err on the side of too little stimulus during major recessionary crises. As long as the U.S. economy is operating far below its potential, private demand is weak, and long-term interest rates for government borrowing remain low, continued fiscal stimulus is the wise bet.
The economy is currently caught in a negative feedback loop: Job losses are causing income losses, which in turn are constraining private demand, reducing tax revenues and causing higher deficits. And for the millions of unemployed and underemployed Americans, joblessness means much more than lost income—it means losses in health care, pensions, job experience and skills, and of course lost homes. It also means dashed hopes for young Americans now trying to enter the workforce. Faced with massive unemployment during the Great Depression, President Franklin Roosevelt made putting people to work his primary task. That should be Job One today, too.
There are several things that should be done soon. Some elements in the current stimulus package should be extended—including unemployment benefits, health-care subsidies for the unemployed, and the provisions for accelerated depreciation and tax breaks to businesses for operating losses. Funds should be channeled into loans for small businesses, as President Barack Obama recently proposed. A National Infrastructure Bank should be created to increase infrastructure financing and encourage public-private partnerships. A new program to encourage energy-efficient retrofits for homes should be designed based on what we learned from the success of cash for clunkers. Obama is holding a meeting with his Economic Recovery Advisory Board to discuss these and other ideas for job creation on Nov. 2. He should cooperate with Congress to get a jobs bill passed—one with triggers that link spending to changes in the unemployment rate—before this session of Congress ends.
Now is not the time to begin cutting the deficit. But it is the time to craft a multiyear plan for gradual reductions in the deficit once the economy is on solid ground. Since fast-rising health costs are a primary source of future deficits, health-care reform with credible cost containment would be an essential first step. And passing legislation soon to spell out a long-term deficit-reduction plan would assuage voter and investor anxieties about runaway debt, ease upward pressure on long-term interest rates, and reduce the risks of another financial crisis sparked by a loss of confidence in the U.S. government and the greenback.