Despair: What Comes Next?

So, we've had another failed terrorist attack and the Obama Administration has agreed to suspend the Miranda Warning in order to avoid the frightful results that didn't happen when we read the Miranda Warning to Richard Reid and Umar Abdumatallab. So why haven't I had any posts on the War on Terror lately? Despair, mostly. Glenn Greenwald enjoys flailing wildly in impotent rage. I do not. But what other options are open when the Obama Administration:

Orders the extra-judicial killing of a US citizen;

Retroactively legalizes telecom reps setting up shop in FBI office to bypass usual warrant requirements;

Prosecutes two whistle blowers when the Bush Administration never prosecuted any;

Issues procedures for military commissions the presiding judge describes as "only a marginal improvement, and which go beyond the Bush rules by forbidding credit for time served;

Escalates covert operations against Iran and resorts to new tricks to keep them unaccountable;

Makes no changes to Bangram prision in Afghanistan which is Bangran: worse than Guantanamo, and where two-thirds of the 600 prisoners are estimated to be innocent;

Etc. Etc.

It's not that I blame Obama exclusively. At least he's not quite as bad as Congress, which is passing legislation to prevent lawyers for Guantanamo detainees from offering any effective defense, seeking to forbid the release of any detainee even if proven innocent, and even discussing legislation requiring terror suspects (including US citizens) to be locked away forever in military detention without a trial.

Any one of these developments would once have inspired me to an outraged post. But now what is there left?

The unfortunate fact is that terror suspects have no political power, and are up against the combined might of the military, the intelligence community, and much of our domestic security apparatus. There is no political upside in acknowledging they have any rights the white man is bound to respect, and much in proving how "tough" you can be. Matthew Yglesias describes the dynamic well, "If you have an incumbent administration being urged by the opposition to seize more power, and the public wants the administration to seize more power, then you get what we have today." The current escalation in jihadi plots can only escalate this dynamic.

So is there any alternative to despair? Any at all? I see only one, and it is a weak one. But if more right-wing terror plots are thwarted, although it will not convince anyone that Arabs have human rights, it might at least convince right wingers to limit Obama's power lest it be used against them.

Mostly, though, I can only think of despair.

Postscript

I will admit it. Although I cited Congressional Budget Office (CBO) figures in my last post, I did not read the report in any degree of detail. Having now looked over the figures in some detail, I am more sympathetic to people who are alarmed at our long-term financial system and Obama's big-spending ways and warn that they are unsustainable. But I am not prepared to let Bush off the hook either.

My old assumption was the Bush inherited a balanced budget and intentionally destroyed it with his tax cuts, creating a structural deficit. (The wars and Medicare D didn't help either). Then in 2008 the economy fell into severe recession, exploding the cyclical deficit. Obama added some short-term stimulus spending that temporarily raised the deficit even higher. But with the expiration of the stimulus and economic recovery, we will be back to the same structural deficit we had before recession hit.

In this I was not entirely wrong, but only partly right. The Bush Administration long disguised the full extent of the structural deficit they had created by claiming that its tax cuts would expire on January 1, 2011. The CBO dutifully made its deficit projections by assuming that this would happen. Not surprisingly, deficits were projected to drop considerably beginning in 2011.

The Obama Administrtion proposes to let the tax cuts on incomes over $250,000 a year expire, but to keep the tax cuts on all other incomes. This substantially increases the structural deficit, though not as much as if all the tax cuts were extended. This is not the only action that increases the deficit, but it is, the CBO comments, by far the biggest ticket item.

There are other changes as well. The most obvious one is health care reform but, if the CBO is to be believed, taxes to pay for it will essentially match expenditures (with a small deficit some years and a small surplus others). The Obama Administration also wants to index the Alternative Minimum Tax (AMT) so that middle income people will not slowly be pushed into the AMT by inflation. Let the record reflect that bracket creep is a regressive and oppressive way to raise taxes and I support indexation. Fortunately, the revenue loss from indexing the AMT is offset by various minor proposed tax increases, so the net effect is essentially zero.

Another accounting gimmick to disguise the full extent of the structural deficit is to mandate cuts in Medicare reimbursement rates. The Obama Administration eliminates this, acknowledging (in effect) that it will not happen. This raises the deficit by a modest but growing amount, reaching $45 billion by 2020. Various other spending increases are proposed, none all that large, but they add up. To partially disguise the full extent of the increased spending, the White House makes unrealistic assumptions about cuts in defense spending. Its proposals to freeze discretionary non-defense spending in the near term do not make even a minor dent in the deficit.

Still, treating health care reform as a wash and the AMT and other tax tweeks as a wash, the other spending increases don't seem all that large or disturbing. And, in fact, in the earlier budgets, the bulk of Obama's deficit increase seems to be holding onto the Bush tax cuts. Without them, the earlier deficit increases don't seem so large at all. But over time, they increase because of one deadly, deadly item -- interest on the national debt.

The most baneful effect of sustained deficits is the interest they run up over time. Ronald Reagans tax cuts did, in fact, starve the beast, but not in the way he intended. Government spending did not drop as a result of his tax cuts, but his large, sustained deficits did change its composition. As more and more of the budget became devoted to paying interest on the national debt, less and less was available for social programs -- or anything else. Of course, interest rates were higher in the '80's. Currently, interests rates on US Treasury Bonds are at all-time lows. Too low, in fact. They are a sign that investors are afraid of taking risks and fleeing to safety. But this will not continue. Sooner or later, the world economy will improve, and rates on US Treasury bonds will go up.

According to CBO estimates, if the Bush tax cuts are allowed to expire in their entirety and no other change is made in the budget, structural deficits will run between 2% and 3% of the GDP. Under the Obama projected budget, structural deficits will be between 4% and 5%. And, the CBO estimates, structural deficits in the 2-3% range are sustainable, while deficits in the 4-5% range are not. In effect, if the deficit stays at 2-3%, debt will stabilize between 60% and 70% of GDP because we will be able to pay off old debt as quickly as we accumulate new. Interest payments will remain stable. At 4-5%, however, debt will continually escalate, reach 90% of GDP by 2020 and then -- who knows. The result of this escalating debt is that more and more of the budget will be eaten up by debt service and less and less will be available for anything else. Bruce Bartlett estimates that debt service will consume 20% of revenues before 2020, causing interest rates to rise and forcing drastic budget cuts.

So, while I continue to defend Obama's current profligacy as necessary to jump-start the economy, once the economy is jump started, he needs to do a great deal more to cut the deficit. Allowing all Bush tax cuts, not just the top rates, is a good first step. We desparately need the revenue, and the Tea Party crowd will be more willing to let rich people be taxed if they know they have to pay too. ;-). Once that is done, it should be possible to get structural deficits down to a sustainable 2-3% with not-too-drastic modifications.

And what else do I suggest, either to bring the deficit down to 2-3%, or to eliminate it altogether? Off the top of my head, raise the ceiling for paying Social Security taxes, or eliminate it altogether. Raise the retirement age, phasing it up to 70. And, despite howls of protest about death panels, consider applying effectiveness research to Medicare.

But mostly I think I need to take the Budget Simulator.

WWKD (What Would Keynes Do?)

So, if if the Keynesian view divides deficits between "structural" and "cyclical," what does it propose to do about the alarming budget deficits we are running today. For the time being, nothing. Why? Look at the chart again.
Yes, the chart makes clear that deficits are at unprecedented heights, about 10% of the GDP. It is also undisputed that such staggering deficits are unsustainable. But it is also clear that the explosion of deficit is cyclical, rather than structural and will diminish with recovery.

But what if the recovery stalls out (as may well be the case)? The Keynesian prescription is even more profligacy. Is that crazy? No crazier than the (essentially Keynesian) claim that Ronald Reagan's tax cuts spurred growth that recovered about 30% of their lost revenue. When an economy operates below capacity, government that pays out more than it takes in stimulates economic activity that, in turn, lowers the deficits. It's a dirty little secret, but Obama's stimulus has alread done just that. Quite famously, he came into office facing a $1.2 trillion deficit. With his added stimulus spending, the deficit was projected to reach $1.8 billion. Instead, it came in at $1.4 trillion due to the beginnings of a recovery which most experts do, in fact, attribute to the stimulus. This amounts to saying the stimulus recovered two-thirds of what it put out. The return on Reagan's tax cuts seems paltry by comparison!

Similar trends hold for this year. 2010 began with a $1.35 trillion projected deficit. This rose to $1.6 trillion in February, with additional requests for tax cuts to promote jobs. By April the estimate was back down to $1.3 trillion with continued economic improvement. Where do we go from here? Stay tuned.

Congressional Budget Office projections on future deficits, both in terms of dollars and percentage are revealing. It estimates the deficit will peak at $1.5 trillion or 10.3% of the GDP in 2010, then fall to $1.342 trillion or 8.9% of GDP in 2011, $914 billion or 5.8% of GDP in 2012, and $747 billion or 4.5% of GDP in 2013. (After that it stabilizes and begins a disturbing increase around 2019). Of course, CBO projections are often wildly inaccurate, but they make clear that half or more of the deficit is cyclical and can be expected to end with recovery.

A structural deficit of 4-5% of GDP is a whole lot more sustainable than one of 10%. Indeed, as the chart above shows, such deficits have been quite common for the past 30 years. It is, nonetheless, a serious problem, and will only get worse as an aging population consumes more and more Social Security and Medicare. So Keynes would agree -- unlike our cyclical deficits, which can be safely ignored or even encourages, the structural deficit is a serious problem that must be addressed. But a severe recession is the wrong time to address it.

Furthermore, even with a solid recovery under way, to try to get rid of the entire deficit in a single year. Trying to cut federal spending amounting to 5-10% of the GDP in a single year amounts to cutting out 5-10% of the GDP. By contrast, the current recession, the worst since the 1930's, amounted to a GDP drop of closer to 4%.

So when will the economy be strong enough to start serious work on balancing the budget? And what should we do? It's hard to say, but the budget balancing of the 1990's is the most obvious model. In 1993, the US was about two years out of a mild recession, with unemployment beginning to fall, but still feeling weak and shaky. President Clinton pushed through an across-the-board tax increase, focused especially on the upper brackets. Republicans howled in protest, warning that the tax increase would be economically ruinous. The economy ignored them. Republicans also deserve credit after they took control of Congress, firmly holding the line on spending, but without making any dramatic cuts. Between the tax increase and holding the line on spending, balancing the budget turned out to be easier than anyone anticipated.

So, if the economy continues to recover (yeah, I know, a big "if"), by the middle of next year we should be officially out of the recession for about two years, with unemployment starting to fall. That would be a good time to restore Clinton's tax rates and start freezing discretionary spending. Of course, just because a certain level of tax increase and a freeze in spending balanced the budget in the '90's doesn't mean it would work again. After all, the '90's were an unusually prosperous decade, and vigorous growth helped a lot. We can't count on it happening again. Conventional wisdom is that the severity of the finance crisis means that credit will be tight, inhibiting growth, for the foreseeable future. But Clinton made an important discovery, although it seems obvious in retrospect. When growth takes place primarily at the top, even modest changes in tax rates at the top can have a dramatic effect on revenue. Conventional wisdom further has it that growth will take place primarily at the top for the foreseeable future.

So there's my recommendation for addressing the deficit. It probably won't turn out to be enough, and we may have to try something more later on. But the point is not to act prematurely. Only when cyclical deficits are clearly falling will it be time to address the structural deficit. That will be when it is most tempting to ignore it.

It's Agreed: Not All Deficits Are Equal

Budget deficits appear to be like the weather -- everyone talks about them, but no one does anything about them. The political will just isn't there.

At least one reason political will is lacking is that although everyone deplores the immense deficits we are running, no one deplores all deficits equally. Conservatives (at least movement conservatives) and liberals (at least economically literate liberals) see different kinds of deficits as qualitatively different.

Conservatives divide deficits into two types -- deficits resulting from tax cuts and deficits resulting from spending increases. While all deficits resulting from spending increases are deplored, (movement) conservatives don't see deficits resulting from tax cuts as a problem for two reasons:
(1) Starve the beast. Tax cuts choke off government revenue, precipitate a future budget crisis, and ultimately force spending cuts and reduction in total government.
(2) Supply side. Tax cuts spur so much economic growth that they ultimately increase revenue and avoid the need for spending cuts. Needless to say, these two theories directly contradict each other.

It should go without saying that the two conservative concepts of why deficits caused by tax cuts are acceptable are mututally contradictory, and that holding both of them in your head at once calls for a certain exercise in doublethink. As such, it's probably too much to ask for any one conservative to refute both of them. But recently two dissident conservatives have written two fine separate articles criticizing the two alternate theories.

Bruce Bartlett, writing for Forbes, takes on starve the beast. Although he briefly acknowledges the supply side view, he does not appear to take it very seriously. Rather, he hearkens back to the good old days when conservatives opposed any tax cuts not paid for by spending cuts and sees the embrace of tax cuts now, spending later as a mixture of political opportunism and hopes of starving the beast. Reagan justified his tax cuts in such terms and the junior Bush urged them as "a fiscal straightjacket for Congress." But so far attempts to starve the beast by running up deficits have signally failed.* Bartlett argues that deficits were only effective in forcing spending cuts in the past because people feared that the only alternative was a tax increase. But once conservatives adopted the dogma that taxes could never be increased, no matter what, all incentive for fiscal discipline ended. He goes so far as to suggest that tax cuts, by reducing the bite from spending, actually encourage spending increases.

Meanwhile, Kevin Williamson of the National Review wearily explains why tax cuts do not increase revenue. Tax cuts, by spurring growth, can partially pay for themselves. The Reagan tax cuts recooped about 30% of their revenue. This is a far cry from the supply side claim today that all tax cuts reclaim over 100%. Proponents grossly exagerate the value of tax cuts by assuming that any growth that follows a tax cut is caused by the tax cut. And, like Bartlett, Williamson acknowledges the basic problem: everyone hates government spending in the abstract, but no one wants to cut any particular program.

Both men do a fine job of refuting the respective theories of why deficits causes by tax cuts don't count, yet each leaves a little anomaly. Bartlett is left with the oddity that spending actually increases when taxes go down. And Williamson defends supply side economics as partly true -- tax cuts partially recover lost revenue. And here I would suggest that liberals who follow Keynesian economics would fully anticipate both outcomes.

Like movement conservatism, liberal (Keynesian) economic theory also distinguishes between different types of deficits. It divides budget deficits into "cyclical" and "structural." A cyclical deficit is the result of shortfalls in revenue and increases in payouts as a result of an economic downturn. Cyclical deficits will resolve themselves once the economy improves. Any attempt to cut them is undesirable, requiring either increasing taxes when the economy can least afford them or cutting services when the economy most needs them. Structural deficits, by contrast, are gaps between revenue and expenditures that remain even in good times. These are a problem and do need to be reduced, although the middle of a severe recession is the wrong time to address them.

This chart confirms Bartlett, that tax receipts and government expenditure rise and fall in almost perfect opposition to each other:
But the simplest explanation is a cyclical one. Revenues fall and payouts rise during economic downturns. Revenues raise and payouts fall in good times. As for Williamson, he failes to note that Reagan's tax cuts were made during a severe recession.** Keynesian theory predicts that during a recession, the economy is operating below capacity and deficits provide stimulus. It would, indeed, predict that tax cuts would partially pay for themselves during an economic downturn. It does not logically follow that they would be equally effective during good times. In fact Reagan's supply side economics were really just Keynes by another name.

Next post: Keynesian approach to the current deficits.
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*At least at the federal level. States, which have balanced budget requirements in their constitutions, can be forced by lost revenue to cut spending, or at least to shift it off onto municipal governments.

**Not quite as bad as the one we're having now, but until the current downturn it was often referred to as the Great Recession.