I normally don't dive into politics or economics too seriously on this blog, primarily because my blog entries normally take five minutes and five minutes is not enough time to form a logical, coherent, defensible political or economic statement. The recent debate on the immigration issue caused me to think back to a paper I wrote while I was in business school. Remember that this was written in 2004 and that some of the numbers have changed and Greenspan is no longer at the Fed. Although not my best work, I thought that the topic was fairly interesting. My paper, probably not so much, but here it is. My position has changed a little, but not by much. The original paper had citations in it, but because this is a personal blog, I'm excluding them.
‘You know, Paul, Reagan proved deficits don’t matter.’ Whether or not Dick Cheney said this to Paul O’Neill is a matter for debate, but the underlying question remains. Do deficits matter? Is a large public debt a threat to a nation’s economy? Because the question is rather nebulous, I’m going to interpret the questions thusly, should the U.S. be concerned with the size and projected growth of its current debt? Our simple answer is no and our more sophisticated answer is also no, as long as certain criteria are met. Within this paper, we will address the risks and potential benefits of large deficits, why the current size of the debt does not matter, and why it will not matter going forward as long as certain conditions are met.
The opponents of a large public debt argue that the long-term economic health and social stability of a country are put at risk by this debt. Crowding out, a regressive distributional impact, a burden on future generations, and the diversion of revenues from social programs to interest payments are all familiar arguments against running large deficits.
Those in favor of a large public debt argue that the debt stimulates the markets, creating new ones in some cases, acts as a tax smoothing instrument, injects capital into the economy and provides a stimulus for growth, improves the infrastructure, and acts as an automatic demand stabilizer.
The question is who is right. Let me share a little story. One day at the Chateau Fuller, high up in the Sierra Nevadas overlooking Lake Tahoe, an enterprising young snowboarder surveyed the valley below and the mountain above. He reflected on his previous day’s ride through the valley and how nothing, not moguls, not rocks, not skiers, not newbie boarders got in his way. He was one with the mountain. Then he began to wonder what it would take to go up the mountain, aside from a ski lift, helicopter, or Snow Cat. He wondered about a magic snowboard that would defy the law of gravity and allow him to blaze up the mountain unabated; a magic snowboard so strong that he would be able to tow his friends along as well.
Obviously, or maybe not so obviously, this is an economic metaphor. The snowboarder is the U.S. economy. The velocity of our young friend is the well being of the economy or growth. The obstacles are, well, obstacles to growth. What about the magic snowboard? It represents policies that stimulate growth. Policies that promote and actually result in growth are the key in ensuring that deficits do not matter. As long as growth continues, deficits will not matter. And, as we discussed previously, one of the key benefits to a large public debt is its ability to stimulate growth. The question then is how does the U.S. ensure that when it is running a large deficit that growth continues? The answer is that it avoids the obstacles and provides stimuli.
Generally speaking, obstacles to growth include higher interest rates and higher taxes. The argument that many take as a wizard’s, or in this case, economist’s first rule is that deficits lead to a rise in interest rates and a rise in interest rates lead to the crowding out of the private sector and slower growth. Let’s take a look at some work that Robert J. Barro did in looking at the effects of deficits on interest rates in non-wartime periods. In 1833, the United Kingdom freed its West Indian slaves. As compensation to the slaveholders, the government provided the former slaveholders with a one-time payment. This compensation was funded primarily through debt. In addition, in 1909, legislative deadlock prevented the United Kingdom from levying any taxes. Again, the government was funded through the issuance of debt. In both of these cases, the large deficit that was created did not result in increases in the interest rate. A more recent example is the past twenty years. During the Reagan, Bush I, and Bush II years, large deficit spending occurred and interest rates were not affected. Currently rates are near all-time lows and the deficit as a percentage of GDP is lower today than it was during the Reagan and Bush I years. The argument here is that deficits do not lead automatically to rises in interest rates, which are analogous with slower growth.
During wartime, Barro’s evidence points to deficits in fact leading to a rise in interest rates. However, the debt that is issued during wartime is principally long-term debt. Today, the U.S. is primarily issuing short-term debt. 72% of all current debt issued by the U.S. is short-term, defined as being under five years. Regardless of whether the U.S. is considered to be in a current wartime state or not, Barro’s long-term debt and corresponding rise in interest rate evidence does not apply.
We come back to a possible rise in interest rates on the U.S.’s short-term debt. If a rise did occur, the U.S. could be under pressure to use inflation as a tool to lighten the burden on itself. The question hinges on whether or not this will happen. The simple answer is no. It is a political economy question. Alan Greenspan says inflation is under control. Inflation has been under control the past 25 years, times of large deficits included. Greenspan’s word is as good as God’s. Governments and people believe him as he pronounces his edicts from on high. If governments and people believe him, then they will not ask for higher interest rates on the U.S.’s short-term debt. As long as the economy continues to grow, demand for higher rates will not happen. In addition, Asian governments such as Japan’s have a vested interest in keeping the U.S. economy going. Their insatiable demand for U.S. debt, as a result of their desire to keep their currencies from rising against the dollar, is crowding out any type of crowding out.
We’ve discussed the obstacles to our magic snowboard. Now, let’s discuss the stimuli. Deficits and tax cuts are the stimuli that will keep our snowboard out of harm’s way. When the government injects capital into the economy and cuts taxes on corporations and people, it spurs growth. Companies have more cash to invest and rely less on debt. This growth leads to higher tax revenues, which in turn enable the U.S. to pay back its debt and lower the deficit.
As we can see, deficit spending and lower tax cuts go hand in hand with growth. They create a positive growth feedback loop. So what is the big deal? Why have the CBO and every other economist worth his or her salt projected huge deficits at current tax levels beginning in 2014? It’s the boomers. The boomers will begin to retire. They will generally begin to leave the tax-paying workforce, move to Florida, and begin to collect social security. This is potentially a huge problem. Without the tax receipts from these boomers and with entitlements going to more people, the U.S. could be in big trouble. To pay these entitlements, taxes would need to be raised, which again, will slow down growth. The deficit will widen. However, taxes won’t be raised and the deficit will not widen.
The CBO projections account for stable population growth. Immigration growth is not included as a major contributing factor. Maybe the CBO should have spoken to the Center for Immigration Studies. The Center for Immigration Studies (CIS) and the Census Bureau estimate that by 2050, the U.S. population will increase to 550 million. That’s almost double the current population. Why will people from other countries be coming here? Supply and demand. The growth of the U.S. economy leads to job creation. Job creation leads to the need for more workers. People immigrate to the U.S. to take these jobs. In addition, the boomers will be retiring and replacements will be needed. These are additional taxpayers that will fund the additional entitlements the retirees are due.
There are 76 million baby boomers. Let’s divide them into two main groups. 39 million will be eligible under current social security rules for benefits in 2021. 37 million will be eligible for benefits in 2039. Based on the CIS and Census Bureau data, let’s assume 100 million additional tax paying Americans by 2021 and roughly 200 million by 2039. Granted not all are tax payers, but the numbers are there to support the boomers. It will not be a crisis. Immigration solves the problem of possibly having to increase taxes to pay off the debt and to pay the boomers what is due to them.
The population increase leads to the normal deficit cycle of deficits going up and down as the business cycle goes up and down, funding recessions with deficits and paying them back when we have surplus.
Deficits and low taxes go hand in hand with our friend growth. Do deficits matter? They can, but under the right conditions, which are being fostered now, they will not.