A Balanced Budget Amendment Could Unbalance The Economy

The proposed constitutional amendment requiring a balanced federal budget, now facing an early vote in the new year, is fiscal overkill. For one thing, there already has been enough deficit reduction to put the all-important ratio of national debt to gross domestic product on a downward course. If the current deficit and debt load are a problem, the financial markets certainly don't detect it.

The public debt in the U.S. is now about 51% of current annual GDP, well above the postwar trough of 24%, but far below the 1946 peak of 120%. As long as the real economy is growing at a faster rate than the debt, the real debt load will decline. In the fiscal year just ended, the deficit was just $107.3 billion, or 1.4% of GDP. During the same fiscal year, the economy grew at a rate of 2.3%. So the economy grew faster than the debt.

Why require budget balance as a national principle? Some common rationales are: to reduce inflation, to reassure financial markets, to discipline public spending, and to raise savings rates. However, inflation is blissfully under control. Financial markets suffer from euphoria, if anything, not deficit aversion. Congress and the White House, though they agree on little else, are entirely committed to fiscal discipline. And while deficit reduction indeed increases national saving rates, there are other paths to higher savings, and absolute balance by constitutional mandate creates other problems.

ESCAPE CLAUSE. A balanced budget requirement, especially one locked into the Constitution, would deepen recessions. Federal spending now provides countercyclical elastic to buffer business cycles automatically. In recessions, state and local revenues fall, and the demand for public expenditure rises. Increased federal outlays operate as automatic stabilizers, rising as state income falls. A constitutional amendment mandating budget balance would throw that process into reverse.

In recessions, the federal government, like the states, would have to reduce its own spending to match reduced revenues. Federal fiscal policy would become pro-cyclical instead of countercyclical. In principle, an amendment could include an escape clause allowing suspension during recessions. But recessions often are regional. As Treasury Secretary Robert E. Rubin recently declared, there is no such thing as a good escape clause to a balanced budget amendment; the whole concept is bad.

Moreover, if government could not borrow, it would have to finance capital outlays out of current expenditures. No state or city government and few businesses or households do that. If families had to pay for homes and cars out of current income, far fewer people would own them. State and local governments typically have capital budgets. Professor Richard Briffault of Columbia Law School observes in a paper for the Twentieth Century Fund that state general-fund spending (subject to budget balance requirements) totals 48% of spending. So more than half of all state expenditures are not subject to annual budget balance requirements.

REALISTIC TARGET. Herewith an alternative proposal: Instead of a budget deal, much less a constitutional amendment, to bring the deficit down to zero, we need a realistic long-term deficit target--about 1% to 1.5% of GDP. If the economy continues to grow at the trend rate of 2.5%, a deficit in that range will bring the debt level down to its postwar low within two decades. Actual deficits would be higher during recessions, lower during booms.

Our public debt relative to GDP is already one of the world's lowest. The Maastricht criteria of the European Union require member countries to have a debt ratio of no more than 60% of GDP and an annual deficit of no more than 3% of GDP. The U.S. is one of the few economies that would qualify today.

Public discourse about the deficit is now out of sync with fiscal reality. With Congress and the White House moving toward balancing the budget via the appropriations process, the great deficit crisis is ending. It was a product of the fiscal imbalance of the '80s and early '90s. That, in turn, was a monument to the failure of supply-side economics. But thanks to the deficit reduction of the Clinton years, the budget is now on a sustainable path. We are nearly back to where government can again use fiscal as well as monetary policy as tools of economic management.

The deficits above 3% of GDP, typical of the 1980s, reflected the excess of one brand of conservative zealotry. As a remedy, a constitutional amendment requiring absolute budget balance would yield a different brand of conservative excess--with even longer and more destructive consequences.

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