Photo: Wikimedia Commons
People who insist that the US has a gigantic “spending problem” are ignorant of what really drives the deficit and the national debt, as Henry Blodget easily demonstrated in a series of charts.Closing the deficit is not just about lowering spending, relative to GDP, but also about increasing revenue from our very low levels.
So how is that accomplished?
When people talk about the deficit, they almost always use the “pain” metaphor.
In almost any op-ed extolling the wisdom of the Simpson-Bowles plan, it’s pointed out that we’re going to need to take some pain. Obama has said that the Federal Government needs to tighten its belt, which is something that is painful. Conservatives say the government needs to go on a diet. Diets are painful. A recent USA Today headline was very standard: “Nation’s soaring deficit calls for painful choices.”
It’s understandable why the pain metaphor is so popular. One, it’s logical to think that the answer to big deficits is cuts, and cuts are painful. More importantly, it appeals to an innate sense that pain is frequently a long-run redeeming thing to experience. You go to do Crossfit, and you feel pain. But then pretty soon you’re a beast that’s never felt better. Some religious people used to mutilate their own flesh to show proper respect to The Lord.
So this is just a popular idea: Take the pain now, be redeemed.
The good news is that in economics and when talking about the deficit it doesn’t need to work that way! Fixing the debt is painless!
That’s because the primary driver of deficits is a lack of growth.
A chart that everyone needs to have seared into their brains is this one, which shows the deficit as a percentage of GDP (red line) vs. the unemployment rate (blue line).
For 60 years (!) the pattern has held. When unemployment drops, the deficit as a percentage of GDP drops. When unemployment rises, the deficit rises.
So now let’s break this down further, to address the idea that we need to increase revenue as a per cent of GDP, which is undeniably true if we want to prevent the national debt from growing. The answer there is, once again, improve the employment picture (i.e., increase growth).
This chart shows revenue as a per cent of GDP (red line) vs the unemployment rate (inversed). The chart isn’t quite as pretty, but as you can see, the primary driver of how much revenue we get as a per cent of GDP is unemployment. Want to get the red line up closer to 0.18? That will take getting the blue line closer to 6 per cent.
It’s the same deal with the spending side.
This chart shows spending as a per cent of GDP (red line) vs. the unemployment rate (blue line). Want to get the red line down to its historical range closer to 22 per cent of GDP? Improve the unemployment rate! This makes total logical sense, of course, since lower unemployment implies reduced spending on all kinds or programs.
These charts showing the connection between the unemployment rate and the deficit (and the drivers of the deficit) are especially powerful when you consider that they’ve held firm through a variety of different tax regimes.
Look how dramatically the effective tax rate has come down over the years on the top earners (which is where the fight is currently located).
Photo: Wikimedia Commons
It started going down in the late ’40s, jumped in the ’60s, went down in the ’80s, jumped again in the early ’90s, and then has been going down since then. And yet that hasn’t been the deficit pattern.
The deficit has been driven by unemployment, which means … Closing the deficit is painless. It’s not about belt-tightening, it’s about putting more people to work, which is something that everyone loves.
Consider: With zero actual “belt tightening” over the last few years, the deficit as a per cent of GDP has been falling at its fastest pace since WWII, all thanks to people re-entering the workforce, and the pain of the economy being reduced.
Now there are a few related points that need to be addressed here.
— Sadly achieving growth is not trivial. So although it’s the only meaningful solution to the deficit, there isn’t agreement on the magic answer to get there. In terms of what it takes to deal with the debt, there’s a widespread belief that the Fed could do more to juice nominal growth (real growth + inflation) and nominal growth is all you need to reduce our debt burdens. Furthermore, as this chart showing nominal potential GDP (red line) vs. actual nominal GDP (blue line) shows, we’re actually growing again on the same trajectory as we were pre-crisis. The problem is that we took an unprecedented dip during the crisis, and we haven’t overcompensated.
— In the debate over fiscal policy, you frequently hear liberals argue: “It’s not time to deal with the deficit, we need to fix the economy first and then fix the deficit when the economy is stronger.” While this has merit as a political concept, it’s actually giving into a false frame that dealing with the deficit and dealing with unemployment are two separate things that you do at different times. Steps you take to improve unemployment are deficit reduction measures, as the above chart from IBD shows. While the government has done, technically, nothing to address the deficit in the last few years, the deficit is shrinking (relative to GDP) merely because the economy has improved, and more people are going back to work. If unemployment drops to 7 per cent, or 6.5 per cent, or 6 per cent, we’ll get quite a bit of deficit reduction then.
— Even people who agree with all of the above analysis showing that growth and employment are the critical drivers of the deficit, will still point to charts like this one showing that the cost of Medicare is going to swamp the government, and set the deficit soaring unless there’s a change.
Here’s a famous chart from Paul Ryan showing the explosive growth of Medicare, and of course there are many others like it.
It’s natural to look at a chart like that and say: Yeah, that’s great about deficits being driven by growth, but clearly there’s this big structural problem that is coming up on us fast.
So a few things need to be said about this chart:
- As the economist James Galbraith explained in an interview with Business Insider, there’s an inherent contradiction to these charts in that they assume that medical costs will grow and inflate like crazy, and yet actual GDP growth will remain stable. If medical costs boom as the CBO (and others) expect, it’s likely that GDP and especially nominal GDP will be higher than people expect, meaning the ratios won’t be as dramatic as people expected.
- To the extent that medical costs are a problem, it doesn’t necessarily follow that the issue is actually about government spending. After all, shifting these costs to individuals doesn’t improve sustainability for the economy. What the huge red block means is that the country needs to address the root causes of medical cost inflation. Perhaps more private sector market mechanisms will help. Perhaps we need what Obamacare has, which is a board tasked with reducing costs. Perhaps it’s some blend. But the point is that what matters here is root causes, not the government spending per se.
- To some extent, the challenge isn’t about fixing medicine, but about demographics. Society is getting older, and that may place a strain on those who are of working age. That’s not ideal for growth (as Japan well knows) but again, this gets back to the growth challenge. The deficit/spending challenge is just a symptom of that.
- There are already reasons to be sceptical of the above chart, and how bad it could really get. Entitlement spending has already grown nearly 4x, as a share of the budget, in the last 5 decades, and yet still it’s the unemployment rate that’s the primary driver of deficits.
So in the near term, deficit reduction is painless, and in the long-term, there are a few good reason to be sceptical of the scare charts.
— So what about taxes then? If closing the deficit and getting more revenue as a per cent of GDP is all about growth, then why do we have to raise taxes on anyone?
Here it’s probably best to think of Fiscal Policy not as a tool to create revenue and close deficits, but as a tool to shape society by incentivizing some kind of activity (e.g. tax credits for R&D), disincentivizing other kinds of activity (sin taxes) and redistributing wealth (progressive taxation). All of this is controversial stuff, but there’s almost nobody on either side of the political spectrum at this point who doesn’t favour some kind of redistribution of wealth so as to ameliorate extreme inequality. It’s true that raising taxes on the rich to Clinton-era levels doesn’t raise much revenue (just $40 billion a year, perhaps) but with income inequality at historical extremes (it’s worse now than it was pre-crisis) it may still be a beneficial policy tool to smooth things out somewhat via taxes.
As the GOP has argued, tax rates don’t have much to do with government revenue collections.
But while that red line has gone down, another red line has gone up, and that’s the US Gini Coefficient, which is a statistical attempt to measure income inequality.
If this inequality is something that’s of concern, and something worth addressing, then taxes should be one part of the discussion in addressing them.
— The bottom line is that pain and belt tightening are associated with higher deficits. The great financial crisis saw an explosion of the deficit, and a historic belt tightening, as the savings rate more than tripled from under 2.5 per cent to over 7.5 per cent.
History has also shown that when the government makes a real effort at “belt-tightening” the same results happen. One of the most important charts in the world is Richard Koo’s look at what happened when Japan tried tightening fiscal policy prematurely during its slump and deficits widened.
Pain is entirely the wrong way to think about closing the deficit. If it’s important to make it go away, we need to find a way of doing the exact opposite, putting people to work and making the economy grow.
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