The Economist: when should we start worrying about the deficit?

The public … realizes that there is a significant adjustment to come, but they tend to think it can be solved by increasing taxes they don’t pay and cutting spending that they don’t benefit from.
– Robert Chote

Sooner or later we are going to have to deal with the issue of the federal budget deficit. One of my Ten Rules for Understanding the Economy – the second one, actually – is, “You can’t forever spend more than you make.” This applies to the government as well as to individuals.

I’m not of the school that screams for a balanced budget at all costs. There are times in the business cycle when deficit spending is quite appropriate. The government can borrow to help replace private spending when it collapses during a serious recession through increased infrastructure spending as well as expanded unemployment and welfare benefits. Many of the recent actions of the Treasury, the Federal Reserve and Congress were necessary in the face of the impending collapse of the international financial system in 2007 and 2008.

But deficit spending – having appropriations exceed tax revenues – during economic booms is not appropriate. Our federal budget has been in deficit for 46 of the last 50 years. Through good times and bad, through the three longest expansions in our nation’s history, we have spent more than we collected in tax revenues, leaving it to later generations to worry about paying off the debt.

In theory, since it is able to issue debt and print money, the government can run deficits indefinitely IF the deficit does not grow faster than the nation’s output of goods and services.

Unfortunately, when the spending and borrowing during the recent recession is added to the enormous Social Security and Medicare deficits facing the country as the baby boom moves into retirement, our debt to output ratio is set to rise rapidly for many years. In mid-2010, the federal debt was a bit more than $13 trillion, with about 66 percent held by the public and 34 percent held by government agencies such as the Federal Reserve. Based on current projections, this will double over the next 
10 years. You can watch it grow in real time on websites like www.usdebtclock.org .

Economists who think deficits don’t really matter often argue that Japan, which has run government debt totaling more than 150 percent of GDP for years, has continued to grow and prosper. There are two counterarguments. The first is that growth in Japan has been very sluggish for the last 20 years, punctuated by numerous recessions. The second is that Japan finances its own deficit through the savings of its citizens, who purchase the government securities.

In the U.S., with our very low personal saving rate, we count on the rest of the world to buy a large portion of our debt. The other side of our trade imbalance (imports substantially exceeding exports) is that these dollars flow back into the U.S. to purchase the debt issued by our federal government. Think about the consequences if countries like China and the OPEC nations conclude that they hold enough U.S. debt.

What if they began to exchange the dollars they accumulate from our purchases abroad into other currencies so they can diversify their financial portfolios? This will cause the value of the dollar to plunge, the price of Treasury securities to fall and interest rates to increase, not a pretty scenario.

Given the fragile state of the recovery, I don’t advocate immediate spending cuts and tax increases. But it is critical the president and Congress immediately adopt a multiyear program that will bring the deficit down and debt under control. Their fear, of course, is this will be a formula for not being reelected.

We, the voters, must be willing to accept higher taxes (a tax on consumption, not income) and fewer goodies, including an older retirement age and less generous health-care benefits. Otherwise, the economic outlook is bleak.
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