The Deficit Game

There has been more silliness expressed both in the media and by Obama's political enemies about our national debt and the budget deficit than one would expect to see coming out of Washington, even though the District is famous for its ability to spew out silliness in nearly unlimited quantities.

There should be a substantial fine assessed against any politician or media pundit decrying the size of the federal budget deficit who does not in the same breath--if he or she has the breath remaining--also at least makes an effort to explain WHY the deficit is currently so large. This is not a mere intellectual exercise. Understanding the cause of the deficit both suggests a solution and conditions an appropriate response.
This year the deficit will be somewhat north of 1.5 trillion dollars. Even in a 15-trillion-dollar economy, this is too large and not sustainable. In the post-war years the deficit has averaged about 2% of GDP. Nonetheless, as paradoxical as it sounds, our current deficit is probably not a bad thing, and is almost certainly a good thing. How can this be?

Before answering this question, let's review why we are currently hemorrhaging so much red ink. How did we go from a 236 billion dollar surplus in 2000 to a 1.5 trillion dollar deficit in 2010? There are four reasons:

• The Bush administration and Republican Congress passed two large tax cuts in 2001 and 2003.
• The Bush administration and Republican Congress passed a new and completely unfunded Medicare prescription drug entitlement in 2003.
• The Bush administration and Republican Congress decided to wage wars in Iraq and Afghanistan without raising any revenue to support them.
• Finally, and most importantly, in 2008 the country experienced the worst financial crisis we have seen since the Great Depression.

That's it. It is not because of earmarks. It is not because an explosion in non-defense discretionary spending. It is not because of TARP or the bailout of the car companies or NPR. If these four events had not occurred, we would not have a budget crisis. Period. The tax cuts and the financial crisis guaranteed lower tax receipts. The new Medicare entitlement and the financial crisis (a two-fer!) guaranteed larger outlays. Less money coming in and more money going out and you get a large deficit. There's no magic to this. Our current rate of taxation is the lowest it has been since the Eisenhower years, about 15% of GDP. Our current level of spending--driven by the items itemized above--is approximately 25% of GDP.

How can this be a good thing? The explanation requires appreciating the difference between short-term and long-term concerns. In the short-term, according to classical economic theory, high deficits are exactly what the doctor ordered. Facing a severe shortfall of private sector spending, the government should step in and make up the difference with higher levels of spending. However, as I said before, as helpful as it is in the short run, it is not sustainable in the long-run. Furthermore, in the long run the effect of the financial crisis will begin to wane and the wars will end. That leaves the lingering effect of the Bush tax cuts and the unfunded Medicare prescription drug benefit. Middle class entitlements in general--Medicare and Social Secuirty--play only a small role in our current deficit but will begin to play an increasingly large and eventually commanding role in the out years.

The policy prescription is clear. The Bush tax cuts should be allowed to expire in their entirety in 2012 and there should be a bipartisan consensus on what to do about reigning in the costs of entitlements, primarily Medicare. Social Security is self-funding and requires only a small adjustment to ensure long-term solvency. Medicare is a much bigger problem. The country is getting older AND medical inflation continues to outstrip inflation in the general economy. The 2010 Patient Protection and Affordable Care Act (PPACA) offered a modest step in this direction, but more is needed.

If our political system were rational, the cost containing aspects of the PPACA would be enhanced, Social Security would receive a small adjustment (I favor changing how the COLA is calculated, indexing the COLA to price inflation instead of wage inflation), the Bush tax cuts would be allowed to die a graceful death, and all of our concern about the deficit would focus upon long-term trends instead of the current short-term spike.
Unfortunately, our political system is anything but rational. In particular, the GOP approach to PPACA is to treat it as the End of Freedom and the American Way is bizarre, given that the plan basically borrows from old Republican ideas. Bob Dole had proposed an individual mandate as an alternative to the Clinton health care plan, and Mitt Romney's health care plan in Massachusetts is a twin to the dreaded ObamaCare.

But what is even worse is the spectacular Republican hypocrisy on the deficit. Recall, it was Ronald Reagan who made large fiscal deficits a trademark of Republican policy. Dick Cheney famously remarked that "Reagan taught us that deficits don't matter." Most of the Republicans who are now ranting and raving about the debt also voted for the Bush tax cuts and the unfunded Medicare entitlement, and the unfunded wars. The recommendations of the Simpson-Bowles deficit reduction commission were originally intended to be voted on by the Congress without amendment. However, six Republicans who originally sponsored legislation requiring this ended up voting against their own proposal.

The depth and intensity of partisan anger towards the Obama administration  is very real. Trust me, it has NOTHING to do with the deficit.