Don't Worry So Much About The Budget Deficit

The proposed constitutional amendment to require a balanced budget has been slain, but the deficit obsession continues to paralyze policy. For a decade, the deficit has upstaged other economic issues, reinforcing public frustration about government's inability to address accumulated problems. It has become a permanent migraine.

Although the constitutional move was narrowly blocked in the House, a new rough beast, "Gramm-Rudman IV," is being hatched by the failed amendment's prime sponsor, Representative Charles W. Stenholm (D-Tex.). Senator Warren Rudman of New Hampshire is retiring, but Gramm-Rudman seems destined to become a generic part of the political lexicon. A cynic might define a Gramm-Rudman bill as ironclad budget-balance legislation that somehow yields ever larger deficits.

ACCOUNTS DECEIVABLE. Conventional wisdom holds that the deficit, now estimated at $368 billion for fiscal 1992, is the font of most economic evil, and that government's inability to solve it epitomizes political incompetence. Both claims, I want to argue, are wrong.

One startling thing about this deficit is that it has little if any stimulative effect on the economy. Normally, one would expect a deficit in excess of 6% of gross national product to boost purchasing power and engender a mighty recovery, if not some unwelcome inflation besides. However, this deficit has coexisted with a lengthy slump, followed by a lethargic recovery. Neither is the deficit creating inflation, nor high interest rates, nor the "crowding out" of private capital by public debt. So the most convincing staple arguments for cutting the deficit are simply inoperative.

How can this be? How can a deficit this massive lead neither to economic stimulus, nor high interest rates, nor inflation?

Let's begin by looking at the composition of the deficit. One portion of it--about $70 billion this year--is the savings and loan bailout. Most economists agree that the thrift bailout has no stimulative effect, because savers never thought their money was gone. Having the government replenish the lost funds of the local s&l is simply an accounting entry; it does not cause savers to rush out and spend money they wouldn't have spent anyway. The actual stimulative effect of the real economic activity--the useless condos, office towers, and shopping malls that caused the s&l losses in the mid-1980s--was dissipated years ago. So adjusting for the s&l bailout whittles down the effective deficit to about $308 billion.

The second main portion of the deficit reflects the impact of the recession itself. In any recession, economic activity contracts, tax collections dwindle, and relief payouts increase. The Congressional Joint Economic Committee calculates that $100 billion to $110 billion of the deficit is simply the result of recession. That leaves about $200 billion--almost exactly the annual interest on the accumulated public debt. Interest on the debt flows out of the Treasury into the pockets of investors who hold Treasury securities. The majority of this interest income either sits in bank accounts or is invested in other securities. That also helps explain why there isn't much "crowding out"; mostly, the interest paid on the public debt cycles right back into private capital markets.

Of course, this is not to say that the deficit isn't a national problem. Interest payments on the accumulated debt represent $200 billion less the government has to spend on other public needs. And a $368 billion deficit for 1992 means another $368 billion on which interest must be paid. The point is rather that a panicky solution aimed at abruptly slashing the deficit would push the economy into free fall. The deficit does need to be reduced--partially and gradually--to the point where the national debt stops increasing relative to the real economy, or gently declines. But that means taking several years to cut the deficit to about $200 billion, not to zero.

SWEET SURPRISE. The second point is that the Federal Reserve needs to keep reducing interest rates. As the sick economy headed into the 1992 election year, Fed Chairman Alan Greenspan found to his (and George Bush's) delight that cheaper money did not trigger inflation. Every one-point cut in the rate the Treasury must pay on its bonds cuts government interest costs. Hence it cuts the deficit--by some $16 billion this year and $24 billion next year. It also cuts borrowing costs for industry, for homeowners, and for consumers.

So, the proper treatment for the deficit is moderate and gradual reduction, coupled with lower interest rates--and not just in an election year. And we still need to pay attention to those other serious economic problems that the deficit keeps crowding off the agenda: They include everything from badly managed industries to hostile corporate takeovers, an unbalanced trading system, inadequately educated and trained workers, decaying public infrastructure, and collapsing health insurance. Some of these maladies require public remediation. If we don't address them directly, a lower deficit won't help. And if we respond to the deficit with fiscal overkill, there will be neither the public funds to spend on our real problems nor a private economy strong enough to generate the needed jobs, investments, and tax revenues.