The Politics and Economics of Deficits

Edward J. Dodson

[An unpublished paper, October, 1984]

Our nation's political leaders have for some time now been engaged in a major theoretical debate, each supported by an array of professional economists armed with historical and statistical analyses. At issue is the impact of rapidly expanding Federal government deficits on the economic health of the nation. The cause of all the alarm is a $1.5 trillion national debt and Congressional Budget Office estimates that project the figure at $2.66 trillion by 1989. Should that debt expansion occur the interest payments might absorb as much as 16% of the Federal budget. Even now, interest payments to holders of this debt account for 15-20 cents out of every dollar of revenue collected by the Federal government.

HARD CHOICES ARE AHEAD

The cost of funding our national debt can be lowered in only two ways*: Either the Federal government must secure the means for a balanced budget, thereby retiring the debt as principal comes due; or, somehow effect a significant drop in the rate of interest paid on new issues of government securities. The policy options under debate center on whether the economy1s rate of growth over the next several years will enlarge the tax base, producing more revenue and reducing government borrowing. If the economy fails to grow as hoped, the American public and its businesses may be in for a renewed bout of '1revenue enhancement' (i.e., tax) programs.

Although still a political dark horse, support at the grass roots level continues to grow for a Constitutional amendment limiting government spending. Among professional economists, the leadership role for this measure has been taken by Milton Friedman.[1] The seriousness of the issue is reflected by the real possibility that a constitutional convention might be approved before the decade ends. The balanced budget issue is sure to be on the agenda.

This battle over runaway government spending, deficits, national debt and heavy taxation offers a perfect example of why so many of its practitioners have called economics the 'dismal science.' No where else in the pursuit of knowledge does man intervene so materially with scientific laws as when the powers of government are invoked in the marketplace. Some recognition of the source and scope of those powers is, therefore, central to this discussion.

REFLECTIONS ON THE CONSTITUTION

The historian Charles A. Beard concluded that the original Articles of Confederation were abandoned by our founding fathers in large part because they insufficiently protected the economic interests of those who had ri3ked all in support of the break with England. The Articles provided for no executive -- only a legislature -- and gave the Federal government no power either to regulate commerce or to tax the citizens directly.[2] As a result, those who financed the revolutionary government and received government securities in return had no way to enforce payment. Obviously, from their perspective a new government empowered to raise revenue had to be formed to protect what they felt were legitimate interests; and so it was. However, like any contractual agreement the framework for the new government -- our Constitution -- was a document of compromise. Some of the revolutionary leaders, John Adams and Thomas Jefferson included, felt the Constitution so compromised the purpose of the revolution that they opposed its adoption. Yet they later served as President under its charter. Some insight into the Constitutional sources of our problems today is offered by historian Ferdinand Lundberg:

"The government can in fact do most of what it does under the narrowest possible interpretations of the Constitution, which is a very broad-ranging document, although it can operate further afield under broader or fanciful official interpretations -- of which history records many. But owing to its divided powers it cannot always develop a coherent policy. As a consequence it sometimes wallows uncertainly. "[3]

Should the American public decree that its government be accountable for its spending habits and the problems caused, those involved in the fight will find themselves up against a Constitution that Lundberg finds heavily weighted against popular action:

"Contrary to the political myth of myths, the United States is not subject to government by a majority of the citizenry, passive or active. Once installed, the government and every single elected official is completely independent of any section whatever of the general populace. Each elected individual, in a very real sense, is a distinct and separate political party. it is this that accounts for the repeated wails of winning electoral majorities when they see elected officials doing the precise opposite of what they had solemnly promised ... "[4]

In terms of what we have experienced as economic policy, Lundberg concludes that Constitutional weaknesses "also account for the government ignoring, year after year, decade after decade the reasonable demands of 70 to 90 percent of the people as revealed in public opinion polls -- for ... much greater tax equity, for a halt to government-induced inflation that erodes the savings of the prudent, for an end to palpably reckless government borrowing and spending ... and for effective measures against a bewildering variety of other widely deplored transgressions contrary to popular common sense."[5] I am inclined to agree with Lundberg that until our Constitution is further amended to prevent or reduce such abuses, the basis for constructing sound economic policy will find great difficulty in the face of self-serving politicians and vested interests. Indeed, since the political process discourages moral constraints or principled action, it is almost a certainty that government spending will continue to grow unabated absent Constitutional restraint.

A POLITICAL RESPONSE TO A POLITICAL PROBLEM

Given the political origins of massive deficits, the challenge to economists is to push for fiscal and monetary policies that produce growth and thereby reduce the political justification for spending programs. First, however, they must conclusively prove that deficits are causing serious harm to the economy. At issue is the question of whether inflation and high interest rates are connected to rising deficits.

Some idea of the growing concern among economists over deficits is expressed in this recent Wall Street Journal report:

"Economists had always been able to persuade themselves that Federal debt wasn't too bad a problem because the ordinary growth of gross national product would produce enough revenue that we'd be able to cover the interest bill without really noticing it (but) with projected interest payments rising much faster than projected taxes, that is no longer true,"[6]

Perhaps we should not be too surprised at the failure of economists to react to this crisis. Double-digit inflation and skyrocketing interest rates are only a very recent part of the American experience. Our first exposure to the problems started with the effects of O.P.E.C. induced rises in the price of oil, which quickly spread throughout the economy causing a rise in the general price level and, almost simultaneously, a crash of the real estate industry. The 1970s seem almost to be the era of experimentation with economic policies. The government had been increasing spending continuously on social programs and in the Vietnam War, entering the credit markets with government securities to fund these programs, raising tax rates and imposing surtaxes as well. President Nixon abandoned the fixed exchange rates for gold and attempted wage and price controls to tackle worsening inflation. During the Carter term in office the country experienced two additional shocks: the beginnings of decontrol in the financial services industry and a change in Federal Reserve policy that lifted controls on interest rates in favor of monetary aggregates.

The entrance of money market funds into the financial arena shifted from the commercial banks and savings and loan associations over $100 billion in low cost deposits into much higher yielding money market accounts. Accomplished in less than three years beginning in 1979, the traditional source of "saver subsidized" fixed rate, long term mortgage financing disappeared.[7] The housing sector took a second dive in less than a decade. The country dropped deeper and deeper into a recession, private sector demand for credit dropped, massive layoffs occurred and government spending took another quantum leap upward.

Meanwhile, the world's money center banks were holding a hot potato in the form of the financial reserves accumulating because of the capital flows to the oil-producing nations. So much money was coming in that they could not think of ways to spend it fast enough.

With private sector borrowing slack and a recession under way, one might expect to see a drop in interest rates. Instead, rates continued to climb. Cash flush lenders found willing borrowers in Poland, Mexico, Argentina, Brazil and other so-called "developing" countries. And, of course, the Federal government of the United States. The high interest rates weren't crowding out private sector demand because there wasn't any. Moreover, what investment spending that did occur was concentrated on energy and labor-saving measures; as a result of this adjustment process the demand for imported oil dropped even further than that caused by the recession. And, significantly, laid off workers started to realize they would never be called back to work as old and inefficient plants were shut down for good or upgraded to operate with a fraction of the work force. The drop in worldwide demand for oil and other raw materials hit the heavily-indebted nations like a hammer. Their ability to meet debt payments hinged on the value of exports, and the worldwide recession created a buyers market. This situation was further aggravated by tremendous flights of capital to "safe harbors" in the industrialized nations and the austerity measures imposed by the International Monetary Fund (and the creditor banks), resulting in heavier taxes on wages and consumption, further crippling d6mestic demand and weakening international trade for those countries greatest in need of foreign reserves.

In my view, all of these factors combine under the international economy to produce a continued upward pressure on real interest rates, even as the recession contributed to a drop in commodity price inflation.

Not to be discounted is the Reagan administration's role since 1981. The recession was doing its part to slow inflation, the financial industry was adjusting to deregulation by introducing adjustable rate loans to borrowers and money market rates to depositors, government began issuing revenue bonds to subsidize the housing industry and the Federal Reserve pledged to keep a tight reign on the money supply. The Reagan administration made two major contributions to the United States' recovery. First, it pushed for reductions in the maximum tax rates on both long-term capital gains and on ordinary income. With inflation leveling off the tax cuts (and other favorable tax treatment, such as rapid depreciation and investment credits.) increased business and personal income for a significant number of Americans. Second, it adopted another policy over which economists argue -- funding increasing government spending by borrowing rather than by increasing tax rates or inflating the currency (i.e., having the Treasury exchange its notes for Federal Reserve Notes created by simply turning on the printing presses). On the surface, the program has shown some successes.

Under the Reagan policies interest rates remained high enough to attract foreign investment in U.S. government securities but not so high as to offset the investment and consumption incentives offered by the tax cuts, or the increased earnings Americans received on higher yielding deposits. In July the Wall Street Journal reported that "Since the first of the year, interest rates have risen about two percentage points. In the process, they have added $23.8 billion to Americans" personal income contributing to the roaring recovery."[8] Here again, a key factor is the international economy and the pressure on so many countries to export to earn foreign currency reserves. The downward pressure on prices is protecting Americans from renewed inflation, while tight money policies have made foreign imports even cheaper for the American consumer.

DO WE KNOW ANYTHING FOR SURE?

As the budget deficit issue gained momentum during 1982, two Federal Reserve economists offered their analysis of the relationships we have discussed:

"We argue that the deficit is not a reliable indicator or government's drain on credit markets. The Federal deficit is an incomplete measure of government 'borrowing because it does not include all government borrowing. More importantly, all government borrowing must be adjusted for inflation before it can be used as a gauge of government's competition with private borrowers. An alternative measure which we call 'government net borrowing' accounts for all government borrowing and is adjusted for inflation to do a better job of gauging government's drain on the credit markets."[9]

The article from which the above quote is taken is worth reading, if for nothing more than its success in detailing all the problems inherent in any attempt to actually measure "Federal debt." (The authors' explanation of how inflation affects real versus nominal interest rates is valuable for its succinctness; I have excerpted it in its entirety as Appendix A to this writing.) Their conclusion?

"... the meaning of the Federal deficit is distorted by inflation. The inflation of the last decade caused interest rates to rise and therefore caused budget deficits to balloon. These large deficits do not represent necessarily a drain on the credit markets.[10]

Note the use of the word "necessarily." With economists there are seldom absolutes.

Despite what for many Americans has been an easier time in terms of making ends meet, the economic recovery has neither been complete or felt by many at the bottom of our economic ladder. The balance between our continued economic growth and the sacrifices being made by such a large portion of the world's population seems to me to be precarious. There have been no permanent structural changes made to our economic system; rather, we have seen deregulation in some areas, protectionism in others.

Those of us who must operate in the marketplace under the rules set down by all levels of government -- municipal thru international -- are faced with an enormously complex set of dynamics in our day-to-day decision-making. Certainly, the United State's is a major player in the world economy and in many ways sets the stage for what happens elsewhere., What I have attempted to substantiate is my conviction that since our economic problems are significantly political in origin, solutions cannot be found outside the political process9 As economist Milton Friedman puts it, "deficits are bad -- but not because they necessarily raise interest rates. They are bad because they encourage political irresponsibility. They 'enable our representatives in Washington to buy votes at our expense without having to vote explicitly for taxes to finance the largesse. The result is a bigger government and a poorer nation. Friedman is one of those economists who have come down from the ivory tower of academia to enter the political fray, leading the fight for a Constitutional amendment.

CONCLUSION

A final measure of just how dismal is the prospect of solving all the problems touched on in this paper is a statement made by Karen N. Horn, President of the Federal Reserve Bank of Cleveland in its annual report:

"While the Federal Reserve has made substantial progress toward its goal to end inflation, that progress is being complicated by record-level federal budget deficits9 As the recovery proceeds, it should become increasingly clear that our economy cannot provide unlimited resources to meet both public and private credit demands. In light of the hardships caused by inflation in the last decade, we would only be fooling ourselves if we thought that the stimulus provided by fiscal policy would be sufficient to produce the economic environment that we are seeking."

That statement was published in June of 1984. The Federal Reserve is now contemplating slight adjustments in its monetary policy to expand the money supply in the hope of reducing interest rates. President Reagan has argued there is no justification for the continued high interest rates because of the dramatic drop in inflation. Lenders do not seem to be very secure in believing government's pronouncements that inflation will stay down. And, besides, one reason the Federal government has been able to finance its deficits has been the foreign reserves attracted by higher real interest rates than can be earned in other countries.

I honestly do not know what will happen over the next few years. I do know, after researching all the facits of this situation, that the economic players are scrambling to protect themselves as best they can.

As always, there have been winners and losers among the economic players. Many American farmers have gone bankrupt or are in deep financial trouble as a result of heavy loan payments, made worse by the reduced ability of foreign consumers to purchase their production. Not only the smokestack industries have lost their competitive ability either. More and more U.S. manufacturing firms -- high technology included -- are moving offshore to escape the high costs of labor, land and government regulation. Those remaining pressure government for import quotas and tariffs to "protect" them from 'overseas competition. The real question is how long this can go on before Americans experience a decline in our standard of living. Meanwhile, the cost of caring for those who fall into Reagan's "safety net" escalates. Under these political conditions, there can be no rational expectation of limiting spending by the federal government without the constraints imposed by a Constitutional amendment.

This paper has not attempted to address the moral questions that naturally arise. Mainstream economists have described "the economic problem" in terms of how to allocate scarce resources, with general agreement that government revenue will always run short of funding both "guns and butter." From the perspective of social progress we seem to have nothing but hard choices ahead. Those debates may seriously test our will to preserve the democratic principles on which our society has grown and matured.

NOTES

*A third strategy, inflating the currency, has been a mainstay of the Federal government since the 1960s. This permits government to repay its debt with dollars having reduced purchasing power. Further comment on this tactic is found on page 8 of this paper.

[1] A proposed amendment form is included as Appendix B to Milton and Rose Friedman, Free To Choose, Harcourt Brace Jovanovich, New York, 1980, pp. 313-314.

[2] Charles A. Beard, An Economic Interpretation of the Constitution of the United States, The Free Press, New York, 1965, pp. 52-53.

[3] Ferdinand Lundberg, Cracks In The Constitution, Lyle Stuart, Inc., Secaucus, New Jersey, 1980, p. 175.

[4] Lundberg, p. 176.

[5] Lundberg, p. 176.

[6] Paul Blustein, "Climbing Federal Debt Is Inexorably Raising U.S, Interest Burden," Wall Street Journal, June 22, 1984.

[7] Source: "Burgeoning Money Funds Gain Attention of Government," Savings & Loan News, U.S. League of Savings Associations, Chicago, March 1981, p. 27. In this article House Banking Committee member, Jim Leach (R, Iowa), was quoted, saying that: "As traditional, private-sector lenders are deprived of funds, borrowers are forced to turn to the federal government to step in and provide credit for the purchase and operation of farms, home mortgages and other needs." Conclusion: even greater deficits.

[8] Alan Murray, "U.S. Growth Is Likely B3ing Fueled By Interest Payments to Individuals," Wall Street Journal, July 3, 1984.

[9] Brian Horrigan and Aris Protopapadakis, "Federal Deficits: A Faulty Gauge of Government's Impact on Financial Markets," Business Review, Federal Reserve Bank of Philadelphia, March-April 1982, p. 4.

[10] Ibid., pp. 13-14.

[11] Milton Friedman, "The Taxes Called Deficits," Wall Street Journal, April 26, 1984.

APPENDIX A

INFLATION AND INTEREST RATES

Interest rates, including those on government debt, are influenced by inflation because interest involves payment in the future, and tomorrow's dollars may be worth far less in terms of goods and services than are today's dollars. For example, if a $100 loan today is repaid with $102 a year from now, the nominal interest rate on that loan is 2 percent. If there Is no inflation, the 2 percent is also the real interest rate -- real because $102 buys 2 per-cent more goods than $100 does. But if there is inflation, the real interest rate differs from the nominal interest rate. Inflation causes the purchasing power of the dollar to depreciate; future dollars buy fewer goods than current dollars. Lenders want compensation for any expected depreciation of their dollars caused by inflation. If anticipated inflation rises from zero to 10 percent, for instance, the nominal interest rate must increase by 10 percentage points (to 12 percent) just to hold the purchasing power of the principal constant. Only in this way will the real interest rate remain at 2 percent; 12 percent more dollars ($112) buys 2 percent more goods after the price level rises by 10 percent. The additional $10 of interest payment (the inflation premium) doesn't represent real income, because it only offsets the lost purchasing power of the $100 principal.

Brian Horrigan and Aris Protopapadakis, "Federal Deficts: A Faulty Gauge of Government's Impact on Financial Markets," Business Review, Federal Reserve Bank of Philadelphia, March-April 1982, p. 8.