The Economics and Politics of Cutting Deficits

The 2011 battle over the budget brings to mind the U.S.-Soviet nuclear arms talks of the 1970s and 1980s.  The issue is not whether the antagonists can settle everything at once, but whether each will accept modest concessions and keep on talking until the next round, when more incremental compromises can be reached, and so on into subsequent rounds.   The negotiations to contain deficits in the 1980s, early-1990s and latter-1990s all proceeded in just this way, one step at a time once the two sides had found a common frame of reference.  This week shows that any meeting of partisan minds is still a long way off, since President Obama and congressional Republicans haven’t found common ground to begin the process. 

Both sides agree that whacking away at deficits running at 10 percent of GDP is an economic necessity, but they remain far apart on what those economics actually portend.  The President sees the effort as part of the larger challenge of bolstering the competitiveness of American businesses and workers.  So, his administration’s case hinges on combining targeted public investments with targeted spending cuts and tax increases for upper-income Americans.  This “cut-and-invest” approach with a side order of taxes comes directly from Bill Clinton’s 1992 campaign program, and it’s no coincidence that Obama’s top economic adviser, Gene Sperling, helped manage economic policy in that campaign.  The approach is drawn directly from mainstream economics: Invest in things that support growth across industries and regions –basic R&D, infrastructure, and education and training – while gradual deficit reduction frees up capital for private investment.  As the public investments nudge up the returns on private investment, businesses will use the freed-up capital to develop new products and services, expand operations, and hire more workers.  Finally, the deficit cuts should come gradually so they don’t squelch the natural upswing in Americans’ demand for everything businesses produce. 

The best argument for the President’s approach is that it worked last time.  When Clinton followed this script, what followed included the longest expansion on record, as well as the strongest gains in business investment, jobs and incomes in 30 years.  To be sure, Japan demonstrated in the 1990s that waves of infrastructure spending for a slow economy can be wasteful, especially when powerful interests determine where that spending goes.  And the United States isn’t immune from that dynamic – the 2009-2010 stimulus had less long-term benefits than it might have, once Congress substituted its own parochial priorities for the broad public investments that Obama had laid out in his original plan.

The Republican budget proposals are targeted very differently.  Defense and entitlement programs are still off-limits; and since those two areas account for most federal spending, the GOP cuts for everything else are much deeper and don’t distinguish between public investments and other kinds of spending.  Moreover, the GOP economic logic doesn’t accommodate either higher revenues or a gradual glide path to lower deficits.  Much like David Cameron in Britain, they believe that without draconian cuts very soon, investors will give up on the United States and America could face a Greek-style default of its public debt.  

The trouble with the conservatives’ case is that the markets don’t buy it.  If investors believed that America’s credit worthiness is at any genuine risk, we would see sharp increases in the interest rate on long-term federal bonds as those investors demanded higher returns to offset that risk.  That’s simply not happening – though not because those investors don’t take deficit projections seriously.  Rather, based on the historic record, they still trust that the two parties will find a way to contain those deficits, just as they always did in the past. 

Despite this week’s threats by both sides, the markets are probably right that the economic costs of ignoring huge, unending deficits will eventually nudge the antagonists to the negotiating table.  The calendar suggests that Democrats may well blink first: The prospect that House Republicans may really refuse to raise the debt limit will likely extract larger spending cuts from the President and congressional Democrats, if only because they know that voters would probably hold the President responsible in 2012 for any economic cataclysm that might follow.  After that, it will be the Republicans’ turn to swallow higher taxes, much as Ronald Reagan did in 1982, 1983 and again in 1984.  The base will howl, but John Boehner and Mitch McConnell know that without more revenues, they’ll be forced to embrace program cuts that would make most Americans recoil.  And broad tax reform may give them some welcome cover -- for example, to bring down the corporate rate in exchange for measures to raise more revenues from the same high-income households that will benefit most from lower corporate taxes.  

All of this would be the prelude to a later round of even more consequential discussions, when entitlement reform takes center stage.  Serious talks on Medicare and Social Security almost certainly will require a foundation of trust absent today, built on prior agreements on other spending and taxes.  But if that trust remains unattainable, there will be no deus ex machina of the sort that finally resolved the nuclear arms race – the Soviet Union’s collapse under its own economic deadweight – to bail out the American economy in the next generation. 

For more on the budget, please join us at NDN on Friday at noon for a discussion of the budget and the economy. Details available here.