Home to Roost

It has become politically impossible for President Obama to pursue more stimulus spending to sustain the economic recovery.  Part of this is due to his opponents’ resolve to seize on every opportunity to block what the President wants.  Part is due to the understandable discomfort many people feel at the idea of deficits and debt accumulation.  But the main reason it is impossible today to pursue active fiscal policy is that the capacity for it has been undermined by twenty years of fiscal mismanagement.   Like the mouse that failed to store food for the winter, we have arrived in hard times with the federal borrowing margin severely damaged by twenty years of unnecessary fiscal profligacy.

In 2002, shortly before he was fired as Treasury Secretary, Paul O’Neill warned President George W. Bush that the tax cuts of 2001 would have to be paid for with spending cuts or else deficits would continue to be unmanageable.  Vice President Cheney’s much publicized response to the warning was “Reagan proved deficits don’t matter.” 

The idea that deficits don’t matter may not have been the official policy of the Republican Party since the Reagan era introduced “supply side economics” and a dedication to tax cuts, but de facto, “deficits don’t matter” was the guiding principle of Republican fiscal policy under presidents Reagan, Bush the elder and Bush the younger.

After World War 2, in 1946, the national debt in the United States stood at 122% of GDP.  For the next 35 years, without exception, every administration left office with the national debt lower (relative to GDP) than when it arrived.  Under presidents Truman, Eisenhower, Kennedy-Johnson, Nixon-Ford, and Carter debt accumulated more slowly than income (GDP) until in 1981 the debt/GDP ratio reached a low of 33%.

This bipartisan fiscal consensus that brought us the decline in the national debt relative to GDP was torpedoed by the first Reagan tax cuts of 1981.  Between 1981 and 1993 (under presidents Reagan and Bush) and again between 2002 and 2009 (under President George W. Bush) the debt/GDP ratio rose every year.  Whether times were bad or good, boom or slack, debt rose faster than GDP.  President Clinton – like every president between 1946 and 1980 – left office with the debt burden reduced from when he took office (in 1993 it was 66% of GDP; in 2001 it was 56%).

The Republican strategy to “starve the beast” of government by cutting taxes was not accompanied by the politically more difficult spending cuts that would have been needed to shrink government.  Instead of starving the beast, the Reagan-Bush-Bush strategy of cutting taxes ended up as a strategy to “feed the debt.”  Even in boom years, taxes were not enough to cover spending, to say nothing of reducing the debt/GDP ratio.  For twenty years, the federal budget was run as if deficits don’t matter.

It’s payoff time.  The chickens have come home to roost.  Government leaders cannot peddle blather year after year without consequences.  Today, the public does not even know what sensible fiscal policy is. 

The worst part of all this is that good fiscal policy is not rocket science or even hard to understand.  In normal good times, the deficit should be low enough so that the debt/GDP ratio changes little.  In the long run, there should be no steady upward trend in the debt/GDP ratio. 

In an abnormal year, deficits should help mitigate the business cycle.  If the economy is overheated, in a manic euphoria, the deficit should be smaller.  If the economy spins into a recession, the deficit should be larger, to stimulate the economy.   When the economy recovers, the debt/GDP ratio gradually should be brought back in line.  This is the core of good fiscal policy.

It is important to control the national debt in good times so that financial markets will be confident that the government has its financial house in order.  If this confidence should fade, first the government will face higher interest rates and then it might face a sudden crisis as wealth holders rush to dump their tainted bonds.

Now we are in bad times; the economy needs a government stimulus.  We need temporary tax cuts and public works projects to provide the demand for goods and services that the private sector is holding back on.  But because we have such a history of fiscal double talk and debt growth, the confidence in our commitment to long run sensible management of our debt is in question, although central banks have shown no hesitation in accumulating Treasury debt.  The weakness of the Euro increases the attractiveness of dollar debt, but ultimately bond holders expect sensible US fiscal policy, which once again will lead to a falling debt/GDP ratio. 

We do not need to introduce austerity measures this year or next, and certainly not recovery-busting strict austerity.  But the flexibility of U.S. fiscal policy has been severely compromised by the legacy of “deficits don’t matter” philosophy of the Reagan-Bush-Bush administrations and their practice of running big deficits in boom times.

Years of mismanagement of taxation policy means that the federal government today – when times are tough and we need a government with a free hand to lift the economy – finds that hand being held back, entangled in the fiscal legacy.