Ending the Deficit Blame Game

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By Deborah Solomon

As the U.S. stands on the precipice of another recession, policymakers continue to quibble over what caused the ballooning federal deficit rather than taking steps to fix it.

Republicans accuse the Obama administration of busting the budget with economic stimulus programs. Democrats blame the Bush administration for pursuing a guns-and-butter strategy of simultaneously financing tax cuts and two wars.

As convenient as policymakers may find this debate, they're missing the main culprit: A shell-shocked U.S. economy. A new study by Christopher Payne, a Bloomberg Government economist, estimates the economic downturn accounted for more than half the deterioration in the deficit as a percent of gross domestic product.

The reasons are simple. The recession sapped individual, corporate and payroll tax receipts even as spending grew to accommodate millions of Americans who turned to safety net programs like food stamps, Social Security, Medicaid and unemployment benefits to weather the downturn.

Payne's findings should help guide policymakers who (we hope) are trying to figure a way out of the fiscal mess. If the economic downturn was the primary cause of the deficit, then policymakers should resist moves that will stunt economic growth (such as broad tax increases) and tough austerity measures (Draconian spending cuts). The Federal Reserve, which is considering additional stimulus  measures, may also want to take note, particularly given Federal Reserve Chairman Ben Bernanke's warnings about the deficit.

That leaves the U.S. with some pretty tough choices, as today's sobering Congressional Budget Office report makes clear. Allowing tax cuts to expire and the spending cuts mandated by the Budget Control Act to take place would shave the budget deficit by $487 billion, but such severe fiscal tightening would almost surely plunge the U.S. into another recession next year.

Alternatively, continuing down the current path where tax cuts are extended and spending cuts avoided will inflate the debt and deficit to  levels that increase the risk of a fiscal crisis within the decade. Investors would either be unwilling to finance the U.S. deficit or demand such high interest rates that it would become prohibitively expensive for the U.S. to sell debt.

The solution lies somewhere between those two scenarios. The U.S. will need to temporarily extend some or all of the expiring tax cuts while keeping spending constant -- or even increasing it -- in the short-term, while laying out a clear, definitive path towards long-term deficit reduction. Any cuts and tax increases -- which are clearly coming -- should be phased in gradually, when it's clear the economy has recovered enough to absorb austerity without risking more fiscal damage.

Payne's research found that from 2005 to 2007, the U.S. budget deficit averaged 1.9 percent of  GDP each year. Post-crisis, from 2009 through 2011, it averaged 9.3 percent. That 7.4 percentage point gap was primarily caused by a declining economy, which was responsible for 4.5 percentage points of the deterioration (or 60.8 percent). Another 1.8 percent of the deficit-GDP gap was caused by stimulus measures, such as extending unemployment benefits. The rest was fueled by plain, old, non-stimulus government spending.

As Payne write: "Wrongly timed austerity measures may worsen the economic environment, leading to larger deficits. If the economy begins to strengthen and the housing market improves, tax revenue will increase."

The upshot: It's time for lawmakers to stop fighting about what caused the deficit and actually take steps to boost the economy in the short-run while preventing it from collapsing in the long-term.

(Deborah Solomon is a member of the Bloomberg View editorial board. Follow her on Twitter.)

-0- Aug/22/2012 20:35 GMT