The Only Real Solution For Budget Deficits: Growth
May 12, 2011, 1:00am

By Dean Baker –

]People in Washington have incredibly bad memories. The last time that the United States balanced its budget was just a decade ago. Even though this is not distant history, almost no one in a policy-making position or in the media seems able to remember how the United States managed to go from large deficits at the start of the decade to large surpluses at the end of the decade.

There are two often-told tales about the budget surpluses of the late 1990s: a Democratic story and a Republican story. President Clinton is the hero of the Democratic story. In this account, his decision to raise taxes in 1993, along with restraint on spending, was the key to balancing the budget.

The hero in the Republican story is Newt Gingrich. In this story, the Republican Congress that took power in 1995 demanded serious spending constraints. These constraints were ultimately the main factor in balancing the budget.

Fortunately, we can go behind this “he said/she said” to find the real cause of the switch from large budget deficits to large surpluses. This one is actually easy.

In the spring of 1996, the non-partisan Congressional Budget Office (CBO), whose numbers are taken as being authoritative in Washington, projected that the government would have a deficit of $244bn in 2000 [2], or 2.7% of GDP. Instead, the government actually ran a budget surplus in 2000 of almost the same size. This amounted to a shift from deficit to surplus of more than 5.0 percentage points of GDP; an amount that is equal to $750bn given the current size of the economy.

The reason for picking the spring of 1996 as the starting point is that this is after President Clinton’s tax increases and spending restraints were all in place. It was also after all the spending restrictions put in place by Gingrich Congress had already been passed into law. In other words, the CBO knew about all of the deficit reduction measures touted by both political parties and it still projected a $244bn budget deficit for 2000. Furthermore, the changes to the budget in the subsequent years went the wrong way. According to CBO’s assessment, the legislated changes between 1996 and 2000 actually added $10bn to the budget deficit [3].

The trick that got us from the large deficit projected for 2000 to the surplus that we actually experienced in that year was, in fact, much stronger than projected growth. CBO projected that growth would average just 2.1%. It actually averaged almost 4.3%. Instead of ending the period with an unemployment rate of 6.0%, unemployment averaged just 4.0% in 2000.

It would be helpful if policymakers paid more attention to this history, since it should remind them that even if their primary concern is the deficit, and not economic growth and low unemployment, economic growth may still be the best way to reach their deficit targets. It is all but impossible to balance the budget when the unemployment rate is above 8.0%. By contrast, if we got the unemployment rate back down below 5.0% (where it was before the onset of the recession), we would get most of the way back to a balanced budget – even with no additional changes to the budget.

If the deficit hawk crew could remember back to the 90s, then they might be pushing more aggressively for measures to spur growth. This would include not only fiscal stimulus, but also more expansionary measures from the Federal Reserve board. The Fed has consistently been restrained in its measures to boost the economy because the whining of the inflation hawks.

The budget hawks should realize that if they really care about deficits, the inflation hawks are their enemies. They should be pushing for more expansionary monetary policy – steps like targeting long-term interest rates or even a somewhat higher inflation rate. There is no reason that the Fed should not be pursuing this path, at least until there is some evidence of inflation posing a problem.

The Fed, together with the Treasury, could also be pushing for a lower dollar. A monetary policy that is explicitly designed to reduce the value of the dollar would provide a boost to net exports and thereby to economic growth.

Finally, if the Fed opted to hold the bonds that it has purchased through its various quantitative easing programs, it could directly reduce the deficit. The reasoning here is that the interest paid on these bonds is paid to the Fed and then refunded to the Treasury. It therefore leads to no net interest burden to the government. If the Fed bought and held $3tn in government bonds, it would lead to interest savings of close to $1.8tn over the course of the next decade.

If the deficit hawks had better memories and a bit of creativity, they would be talking about items like faster growth and increasing the Fed’s holdings of government bonds. Unfortunately, our policymakers don’t do very well in either the memory or the creativity department. As a result, we are instead discussing the privatization of Medicare, the block-granting of Medicaid and cutting Social Security. That’s Washington for you.