Unbalanced Economics

Newt Gingrich was asked recently whether his drive to eliminate federal deficits by slashing government spending might increase the risk of recession. Alluding to an axiom of classical economics, the House Speaker suggested that a private enterprise system can generate full employment and economic stability without government intervention. "If the market really does believe that we are going to balance the budget," Gingrich said, "the drop in long-term bond [rates] will more than offset the loss of fiscal stimulus." Commenting editorially on Gingrich's vision, Business Week added that "once the markets are convinced of the surety of fiscal discipline, the gains will come fast and furious. ... The payoff is huge." Here's how the payoff is supposed to work: Federal deficits swallow up private saving, namely that part of current income that households do not spend on goods and services but instead put in the bank where it becomes available for potential borrowers. As federal deficits shrink from year to year, less saving will flow into government bonds that finance the debt and more will become available for private business to use for investment. This increased supply of saving will, according to Business Week, push interest rates down "about two percentage points lower than they would otherwise be." Lower interest rates will then encourage business investment and lead to vigorous growth in incomes, jobs and exports. In other words, whatever is saved will be invested, and whatever that investment produces will be consumed. Lower interest rates will ensure that any further increases in saving will be absorbed by larger volumes of investment, guaranteeing continuity of economic growth. It's as though John Maynard Keynes never lived. Yet the message has been picked up and uncritically transmitted, in terms much like Business Week's, by media voices across the land. The Philadelphia Inquirer's R.A. Zaldivar, for example, writes that "to understand why the pain of balancing the federal budget might just be worth it, picture a baby girl. With a balanced budget, as the baby grows, her parents would be able to finance a home, their cars and her college education all at interest rates lower than today's. That's because less government borrowing would mean less demand for loans." Even a Democrat like Brookings Institution fellow and former Congressional Budget Office Director Robert Reischauer has joined the ranks of the believers. "In the very short run the fiscal restraint [from lower deficits] could prove to be a small drag on the economy," Reischauer recently conceded. But, he added, lower interest rates will eventually prevail: "The increased investment that will result from higher national saving will increase the nation's economic potential. As a result, the economy five to 10 years from now will be stronger and larger than otherwise would be the case." The idea that virtually any amount of investment will be forthcoming if only we can get interest rates low enough is belied by experience. Business responded weakly to the repeated interest rate cuts of 1933-37; outlays on plant and equipment recovered slowly and by the end of the decade had still not returned to the level they had reached in 1930, the first full year of the Great Depression. Another example is 1981-86, when interest rates fell steadily but business investment grew at a tepid rate of 1.9 percent per year--and this during the peak years of the second longest economic expansion in U.S. history. And in 1992, at the end of a two-year period that saw 14 short-term interest rate cuts and retreating long-term rates, real business investment was 4 percent below its 1990 level. These case histories indicate that, at best, the stimulative effect of any interest rate reductions is less robust, and less predictable, than that of changes in government spending or tax rates. They appear to support the darker conclusions of many economists over the years, most recently Washington University's Steven Fazzari, who finds that private business investment is "quite unresponsive to interest rates" and instead is driven by sales growth and cash flow -- in other words, by expectations of high profitability. The economic history of the 1980s also suggests that there is no strong causal relation between federal deficits and interest rates. While federal deficits were exploding in the wake of Reagan's 1981-83 tax cuts, interest rates headed sharply lower. Here, too, the lesson seems clear: Large deficits probably have some effect on interest rates, but that effect is small. Interest rates in the United States and other high-income nations are basically determined by central banks like the Federal Reserve and not by the level of government borrowing. Throughout the 1980s, large deficits coexisted with generally declining interest rates and sluggish corporate investment. Any remaining possibility that the deficits "crowded out" private investment collapses in the face of an additional fact: During these years corporate America had no trouble finding hundreds of billions of dollars for mergers, buyouts and the highest executive pay scale in the world. Indeed, without the stimulative effect of the deficits on economic activity, the expansion of the 1980s would undoubtedly have petered out well before the recession of 1990-1991. As James Savage noted in his 1988 book Balanced Budgets & American Politics, "The economy's astonishing capacity to accommodate the federal government's deficit spending overwhelms the position that balanced budgets are required for a healthy economy." The most likely effect of balancing the budget by the year 2002 will be to brake an economy that has long exhibited a tendency to operate below its potential and to reach full employment only under exceptional circumstances. Recessions, or more likely stagnation, will recur, as withdrawal of federal fiscal support for the economy outweighs any stimulus from lower interest rates. These depressive effects will be intensified by block-grant proposals that will shift Medicaid and other costs to the states, which are ill-prepared to assume fiscal burdens handed down from a shrinking federal government. Governors everywhere are likely to react by cutting other programs and opting for various back-door tax increases. As worrisome as these long-run implications of budget balancing may be, the shorter-term effects may be more dangerous. The "automatic stabilizers" that make swings in the business cycle less severe -- such as government relief programs and progressive income tax scales -- have been targeted for cutbacks and, in some cases, elimination. But the cushioning effect these stabilizers provide is crucial. During recessions, outlays automatically rise for unemployment compensation, food stamps and welfare assistance; simultaneously, as incomes fall, so do individual income tax payments, as people drop into lower tax brackets or lose their incomes altogether. Deficits rise, but more spending power is pumped into the economy, helping to stem the recession before it turns into something far worse. Combined with high levels of spending by federal, state and local governments, the automatic stabilizers have accounted for the greater stability of the economy since the Second World War -- precisely the era of "big government" so detested by the Republican majority. For example, Assistant Secretary of the Treasury (and Harvard economist) Bradford DeLong estimates that without the automatic stabilizers the 1990-91 recession would have been more severe: National income would have fallen 37 percent more than it actually did. A complementary estimate by Yale's Ray Fair is that for every $10 billion decline in national income during a recession, the federal deficit rises by $2 billion, as the stabilizers trigger higher spending and lower tax collections. These figures would be bigger were it not for the cuts in unemployment compensation and welfare programs made during the Reagan years. And now they will be even smaller, thanks to Armey, Archer, Gramm and company. The era of "small government" ended not with a whimper but with a bang in 1929. Of course, history does not repeat itself chapter and verse, but this may be the scariest prospect of all -- the thought that free-market capitalism, in its stage of unregulated global finance, is preparing new calamities for us, the dimensions of which we cannot imagine and against which we will have fewer tools to protect ourselves.

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