The Budget Surplus: Don't Blow It

When the Federal Reserve, the Office of Management & Budget, the Congressional Budget Office, the Democrats, the Republicans and the nation's top economists all agree, it is time to declare victory for the notion of a New Economy. Whether it's the debate over interest rates or the negotiations over the budget surplus, policymakers now start their discussions with the assumption that the economy can grow significantly faster with less inflation and lower unemployment than it could for the past two decades. Corporate CEOs, investors, and anyone living in Silicon Valley, of course, have been saying this for some time, as information technology and globalization transformed their lives. Now a torrent of tax revenues from higher incomes and stock market gains is converting Washington--so much so that a certain giddiness is taking hold and a windfall mentality is in the air. Our advice is to take a moment for some sober reflection.

The soaring surplus will alter the nation's mix of monetary and fiscal policies in ways yet unforeseen. Before Congress and the Administration indulge in hasty election-year decisions that lock in new spending or tax cuts well into the next century, it might be worthwhile to ask what are the right policies for nurturing a high-growth, high-tech economy? American history suggests that in periods of technological change, such as the rise of railroads in the 1870s and autos in the 1920s, growth is fast but often volatile. Downturns can be vicious and extended. Mistaken government policies can easily turn booms into busts (witness the Fed's tightening in 1930). As a nation, we've actually been here before. The right mix of policies is crucial to long-term success. But what are they?


Right now, Washington fiscal policy is being forged in a political battle over the $6 trillion in surplus tax revenues expected in the next 15 years. Both sides have legitimate points to make. The Democrats want to use most of the surplus to finally solve the Social Security and Medicare underfunding shortfalls and pay for the boomers' retirement. This would also allow the government to pay all of the national debt and reduce interest rates. What could be better for growth than lower rates?

The Republicans have an answer--lower taxes. The GOP would also fund Social Security and Medicare, albeit at a lower level, but would add a giant $1 trillion tax cut to their package. Where the Democrats would retain the Entitlement State, the Republicans would shrink it and return a sizeable part of the surplus to the private sector. What could be better for growth than lower taxes?

The answer to both parties is flexibility and balance. Both Democratic and Republican proposals lock away the surplus at a time when the economy is making a delicate transition from industry to high technology. No one really knows how the New Economy will evolve and what it will take to sustain it. The Federal Reserve has shown an amazing seat-of-the-pants flexibility in recent years in guiding monetary policy around the shoals of conventional economic wisdom to greater New Economy growth. Fiscal policy will have to show similar innovativeness if it is to succeed.

Yet the Democrats are proposing a geezer budget for the next century that will spend 80% of all federal revenues on retiring old boomers. It expands entitlements, such as subsidized drugs, to everyone regardless of need. The New Economy requires a more balanced approach. When it comes to fostering growth, it is better to allocate more to educating the young and training the workforce and less to the retiring elderly. Just taking 5% of the $6 trillion surplus and devoting it to Head Start, school vouchers, and guaranteeing college for every qualified student would have an enormous impact. Raising the level of spending on pure research and development is also a good idea. More money for R&D would keep the U.S. at the leading edge of technology. Finally, paying off the national debt sounds great, but taking that step would basically dry up America's capital markets and erode liquidity. Blind embrace of the gargantuan surplus may be pushing policymakers toward bad fiscal policy that could harm monetary policy.


The Republicans are playing true to form by locking out as much of the surplus as they can in the form of a tax cut. In an older economy suffering from inadequate demand, tax cuts are an appropriate policy. But the New Economy runs much hotter than the old, driven by capital investment. By raising interest rates, Fed Chairman Alan Greenspan clearly believes that at 4% a year, the economy is growing too fast. A deep tax cut anytime soon could add fuel to inflationary fires, sending interest rates higher.

Talk of trillions of "extra" dollars is making policymakers drunk on programs that lock in spending or tax cuts for decades to come. Yet key components of the economy are playing new roles that may require new government responses. The stock market, for example, is clearly acting as a public venture capitalist, changing notions of what it means to be "overvalued." Business models are morphing, changing the idea of adequate profitability. And the business cycle may be taking on a new shape. The next downturn could be just as different as the upturn, perhaps unexpectedly severe because of the concentration of investment in a single area of the economy--high tech.

All this argues for flexibility in policy. Policies on regulation, taxes, exports, privacy, and litigation must evolve as the economy evolves. The Fed is struggling mightily to understand the New Economy and it is feeling its way. The White House and Congress as well must take the time to understand and to husband some of its newfound fiscal resources to deal with the opportunities of tomorrow, not just the problems of yesterday.

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