Friday, May 21, 2010

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.

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