Posted by: bmeverett | October 22, 2009

Deficit Neutral

The health care debate tells us a lot about the Obama Administration’s overall views on macroeconomics. As we look forward (some of us with dread) to the upcoming climate change discussions in Copenhagen in December, we ought to clarify some basic misconceptions.
Much of the health care debate has centered on the concept of “deficit neutral.” Health care plans that are deficit-neutral are good, but plans that add to the deficit are bad. The President promises not to sign any bill that adds one dime to the deficit. This is a false distinction. Government can pay for its spending in one of three ways: taxation, borrowing or inflation. The critical issue for our economic future is the size of government. The method government chooses to pay for itself is a strictly second-order effect.
Let’s suppose that the government needs an extra trillion dollars, not much by today’s standards but just for discussion. If the government decides to borrow the money, as it’s doing now, that money will be diverted from capital markets where it could be employed doing other productive things. Furthermore, future government spending would have to increase to pay interest on the debt. If government inflates the currency to pay for new spending (or to diminish the value of the debt it owes), the cost will be borne by everyone through inefficient allocation of resources but especially by anyone who owns fixed-income investments. If government increases taxes by a trillion dollars, these funds are no longer available to the private sector to buy things or to invest. Unless you believe that the government is a more efficient spender or investor than private individuals, the net result of higher government spending will be lower economic growth – regardless of how the government chooses to finance the additional spending.
According to the Congressional Budget Office, at the height of World War II, when the country was fighting for survival, the federal government spent about 44% of GDP. By 1950, federal government spending had dropped back to 15.6% of gross domestic product. The share had risen to 19.3% by 1970 and 21.8% by 1990. For a while, we enjoyed the “peace dividend” with the federal government falling back to 18.4% by 2000. Since that time, thanks to a determined bipartisan effort, the government has gradually crept back over 20%. For 2009, following the TARP program, the Stimulus Bill and other federal actions, we are on track for federal expenses to exceed 26% of GDP. Even with an optimistic economic growth forecast of 2.5-3%, the federal government would still account for over 23% of GDP by 2019.
This assessment doesn’t include state and local governments, which are by and large unable to run deficits and which, altogether, have increased from 5% of GDP in the late 1940s to about 10% today. We have also not yet encountered Obamacare, the value-added tax (VAT) now being bandied about Washington and the upcoming explosion of existing entitlements in Social Security and Medicare.
Overall, we may be headed very soon for governments at all levels in the US to take 40% or more from the economy. That’s moving us clearly in the direction of Europe, where government takes 45% of GDP in the UK, 52% in France and around 55% in the Scandinavian countries.
Conservatives (and even some Republicans) seem to be falling into a political trap. If they continue to criticize government spending proposals, such as health care, based on their potential to add to the deficit, they’re making the wrong argument. Deficits can easily be closed by raising taxes. The proper question to ask is how much bigger is government going to get?
Watch for this issue in the climate change debate coming up in Congress. Supporters of cap-and-trade will argue that selling carbon emission permits will be a source of government revenue that helps to reduce the deficit. True, but meaningless. Selling carbon emission permits will be a way of making government larger. If that’s what you want, fine, but be careful what you wish for.


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