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Published in the Financial Times on February 2, 2003
Did President Ronald Reagan really prove that deficits do not matter? Dick Cheney, the vice-president, seems to think so; or at least that is what Paul O'Neill, the former Treasury secretary, reports. While the vice-president may be right on the politics of deficits, he is wrong on the economics. He is wrong about the impact of the Reagan deficits and he is wrong about the impact of deficits today.
Voters may not care about deficits, but they should. The reason is that government spending and borrowing, both today and what is expected in the future, matter for interest rates. During the Reagan and George H.W. Bush administrations, from 1981 to 1992, the deficit averaged 3.75 per cent of gross domestic product, government expenditure ran at about 22 per cent of GDP and the inflation- adjusted real interest rate was in the neighbourhood of 4 per cent. In the 1990s, changes in policy brought the budget into surplus, peaking at 2 per cent of GDP in 2000, with expenditure below 19 per cent of GDP. With that came real interest rates closer to 2 per cent.
By lowering government spending, and especially by eliminating deficits, Bill Clinton's administration created an environment in which interest rates fell. Low real interest rates spur investment and increase long-term growth. Everyone should care about that.
In 2001 things changed. A combination of tax cuts and a sluggish economy led to a swift deterioration in the US fiscal position. The deficit now stands at 5 per cent of GDP. And expenditure is now nearly at the levels of the 1980s. As a result US government debt has risen by roughly $1,000bn.
The long-term picture is much worse. The net present value of the unfunded liabilities over the next 75 years - the amount we would need to have today to finance all the existing debt plus future deficits - is more than $50,000bn, five times US GDP.
The bulk of unfunded future liabilities are in the form of Social Security and Medicare programme expenses. Then there are the tax cuts and the new prescription drug programme. Every day brings larger estimates of how costly these are going to be, with no hint as to where the financing will come from.
An individual living beyond his or her means can either borrow or sell something to make up the difference between income and consumption. A country has a third option, which is to print money. No one wants the inflation that that would cause and the Federal Reserve is very unlikely to accommodate such a strategy. Instead, the US is borrowing from abroad. The increase in government debt since the Bush tax cut almost exactly matches estimates of the increase in net financial claims on the US held by foreigners.
The nearly desperate need to import capital is connected to the significant dollar depreciation over the past two years. Foreigners are getting nervous about prospects in the US. It is hard to believe that world financial markets are going to continue supplying the funds needed at the generous rates we have seen up to now.
The most apt comparison is with an emerging market country that must convince foreign lenders that its fiscal policy is on a sustainable path. Otherwise, interest rates on current debt rise to levels that make it obvious to everyone that repayment is impossible, interest rates rise even further and eventually the exchange rate collapses.While the probability of such a calamity afflicting the US may be small, it is not zero.
It is the job of policymakers to make sure that such bad things do not happen. They are the risk managers of our financial and economic system. Central bankers have known this for a long time and acted accordingly. It is time fiscal policymakers did the same.
The Bush administration does not seem to understand its role as risk manager. Bowing to criticism, the president yesterday, in the budget he submitted to Congress, proposed a "solution" to the long-term debt problem. It is to increase spending on current non-defence programmes, increase promises of future healthcare benefits and cut taxes even further. Somehow this will all lead to a halving of the deficit in five years. Even if it does, this just postpones the day of reckoning.
How about making a serious proposal to address the fiscal imbalance for the next 75 years, not just for the next five? Being honest about the size of the long-term problem may be politically risky, but the risks of doing nothing are even bigger.
Stephen G. Cecchetti is Professor of International Economics and Finance, Brandeis University, and Research Associate, National Bureau of Economic Research. He is a regular contributor to the Financial Times.
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