Posted by: bmeverett | December 1, 2010

The Deficit Trap

I’m going to stray a bit off the energy path this week and try to warn Republicans that they are walking directly into a trap. The Obama Administration has engineered two separate and distinct transformations: (1) the federal government has grown in size and (2) the government has chosen to finance the growth through debt. The second appears at first glance to be the most troublesome. The federal deficit, the annual difference between spending and revenues, has risen to 11% of GDP, nearly twice the level of the next highest year (6% in 1983). As a result, the national debt is growing rapidly from a low of 30-35% of GDP in the mid-1970s to around 100% of GDP today. The natural reaction to this situation is to do exactly what the Republicans have been doing: demanding an urgent and immediate reduction in the deficit. The Republican Talking Points have been about the deficit, the deficit and the deficit.

In fact, the first problem is much more serious. During the 1950s and 1960s, federal spending held between 17 and 19% of GDP. During the weak economy of the 1970s, federal spending gradually increased to over 20%. The boom years of the 1990s, fueled by the Reagan era tax cuts and the massive productivity boost of personal computers, brought federal outlays back down as low as 18%. The fiscal indiscipline of the Bush years allowed the feds to creep back up to the 20% level. Overall, between 1950 and 2010, the federal government varied only between about 17 and 22% of GDP. With the recent recession, however, and the unconscionable multi-trillion spending of the TARP and Stimulus programs, the federal government’s share of GDP has skyrocketed to 25% – its highest level since World War II. This is the real problem – and the trap.

The increase in government spending can be financed in one of three ways: borrowing, increasing taxes or printing money. All of them are bad, perhaps equally so. In each case, funds are siphoned from the productive private sector to the wasteful government sector. To support bigger government is to argue that government can allocate capital as efficiently as the market can. Nobody with an ounce of common sense or historical perspective can believe this argument.

The Republicans should be making a different point: for robust economic growth to resume, the federal government’s share of GDP has got to be pushed back down under 20%, hopefully well below 20%. The deficit is a secondary issue. The Democrats would be delighted to work with Republicans on balancing a federal budget at 25% of GDP through tax increases. Unfortunately, increasing taxes will slow economic growth, resulting in revenues falling short of expectations, continued deficits and the call for more taxes.

The issue under discussion on Capitol Hill today is really between static and dynamic views of the US economy. The view of the Democrats seems be that the economy somehow generates $15 trillion a year of wealth on its own. Rich and powerful people then jump in and take more than their fair share. It’s interesting that President Obama tends not to make the argument that wealthy, successful people have an obligation to bear a larger share of the burden than their less fortunate countrymen. Instead, he argues that the rich and successful acquire their assets through nefarious means. Our problems are caused by Big Oil, Big Pharma, Big Banks, Big Insurance Companies, outsourcing corporations, union-busters and other bad actors. By implication, there would be no consequences to “holding them accountable” and reducing their share of “our” national wealth.

We are fortunate to live in a society where anyone who has a high school education and can avoid criminality, substance abuse and teenage pregnancy can live a comfortable middle class lifestyle. Some people, however, through a combination of intelligence, hard work and luck, generate more wealth than others. If productive people are not allowed to keep the bulk of the wealth they produce, they simply won’t produce it. The vision of the Democrats that our best and brightest should and will work hard and take risks to earn money for other people makes no sense. The argument that continuing the current tax rates for those making over $250,000 a year will “cost” the government $700 billion over the next ten years is silly. That argument assumes that confiscating people’s money has no impact on their behavior. Many states are discovering that attempting to confiscate the income of the wealthy causes millionaires to leave the state, leaving less revenue for government. Why is that a surprise?

The dynamic (and correct) view of the economy is that everyone (including the government) benefits from high rates of economic growth. When people are allowed to keep what they earn, they do all the right things: improve their skills, invest and work hard. As the economy grows, government revenue increases.

My advice to Republicans is to stay out of the trap. The issue is the size of government, not the annual deficit. Any tax increases, whether or not paired with spending cuts, will reduce economic growth and foster continued deficits at the same time. I’d love to see a balanced budget at 15% of GDP, but I’d rather have government at 15% of GDP with a chronic deficit than at 25% of GDP with a balanced budget.



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