“Helping the economy” – The Three Myths of Deficits, Entitlements, and Supply-side Economics

There is one issue on which Republican and Democrat politicians have come to an agreement: deficit spending is acceptable. This is a fine example of the tradeoff between short-term political gain and long-term economic growth. Leaders in Congress and the White House have made too many promises for programs and wars that have led to our current national debt. These politicians try to convince the public that there is nothing wrong with deficit spending. They are wrong.

When the government budget is larger than tax revenues, the government borrows money from social security and issues bonds to pay for its operations. Anybody can purchase these bonds. Many of them are purchased by other government organizations. Others are purchased by Americans. Still others are purchased by foreign investors and even governments (and sovereign wealth funds). These bonds have to be paid back on a rotating basis with interest.

A key to long-term economic growth is investment in physical capital. Capital influences labor productivity, a key to economic growth, and catalyzes innovation. How much a nation saves determines how much can be invested in physical capital. If a nation doesn’t save enough, savings has to be imported from elsewhere (again, with interest flowing out of the domestic economy). Government spending crowds out private investment, and government deficit spending decreases national savings. In summary, deficit spending hinders long-term economic growth – Bush2's tax-cutting and spending habits alone may have reduced GDP by as much as 2% over the next decade at current deficit rates, or up to $3000 per household (from a study by economists William Gale and Peter Orszag), magnified further as time goes by. The long-term costs of deficit spending far outweigh the short-term political and economic benefits.

There are also national security issues with deficit spending. Ron Paul likes to say that we borrow all of our money from China. He is wrong, but it is true that roughly 25% of our national debt is owed to foreign entities. That means interest flows out of our economy. This also affects the value of the dollar. The largest holders of foreign-held US debt are Japan, oil producers, and China. Our spending, much of which goes to national defense, is financed partly by countries that could pose a threat to us in the future.

So where do the parties stand on this important issue? As usual, politicians and candidates fail to demonstrate a sound understanding of economics.

The Democratic candidates have negligible differences among each other. The populist rhetoric commonly used by democrats promises increased entitlements. Costly government programs promised by the candidates don’t bode well for the deficit, despite justifications based on “fixing the economy.” Substantial increases in taxation would be required to pay for these kinds of programs. The candidates, of course, plan to pass these taxes to what they call the “wealthy,” which they often define as people making over $75,000 per year (hardly wealthy). This kind of disincentivizing of production stifles economic growth in the short-term and the long-term.

The expanding entitlement programs are a huge threat to the economy, and they guarantee expanding deficits and debt. While Social Security is usually considered the biggest issue, expanding health care costs should be the topic of debates. In the study by Gale and Orszag, projections of entitlements over the next 70 years (at current levels of entitlements) show social security, currently at almost 4.5% of GDP, leveling off in 30 years to around 7% of GDP. Pegging Social Security to inflation instead of wages would go far to increase its solvency, and privatization as advocated by Greenspan and others would solve the problem (but the Democrats politicized it when it was proposed by Bush – if your opposition fixes a problem like that, you stand to lose considerable political capital).

Healthcare, however, shows steady rises with no sign of leveling off, approaching 12% of GDP in the next 70 years. The promises of Democrats to further socialize healthcare threaten to expand entitlement projections dramatically, crippling our economy and making us wholly dependent on significant debt financing (I’m not even going to consider the other negative effects of socialized healthcare). But the 4 to 8 year windows of candidates don’t necessitate consideration of these kind of things.

What about the Republicans? Promises of tax cuts, unaccompanied by specific promises of spending cuts, in addition to continued neo-conservative defense aspirations, promise an equally dismal future for our debt and our growth. Along with this rhetoric, every Republican candidate has endorsed the myth of supply-side economics. Advocates of this theory argue that tax cuts shock aggregate supply (rather than just aggregate demand as in classical models) in such a way that government revenues increase. The most extreme advocates (including, by implication, our candidates) argue that the increase in government revenues offsets the decrease in revenues from the tax cut. This is false. Gregory Mankiw (a first term economic advisor for Bush2 and supply-side advocate) published a paper in which he found that the steady-state (over the next 50 years) compensation ratio for tax cuts is at best 50% – meaning that for every dollar of lost revenue, 50 cents will be regained. In other studies, the ratio was found to be as low as 4%. Short-term ratios are much smaller (around 10% for Mankiw). The ratios also depend on the nature of the cuts – capital gains cuts compensate better than wage cuts. Therefore, even with supply-side effects, cutting taxes increases deficits by about 90% of the value of the tax cut in the short term and max out at half the value of the tax cut in the steady state. When Republicans advocate tax cuts, they should also be explaining what kinds of spending they will cut to maintain solvency – but they don’t.

These three myths – deficit spending is not bad, entitlements help the economy, and supply-side exaggerations – give politicians license to continue out-of-control spending. Essentially, deficit spending means that the current power brokers are mortgaging the futures of young and unborn generations. Most politicians know better, but since progress of party and person is more important than benefits to country, these problems are unlikely to be fixed. Alan Greenspan, in his new book (which I highly recommend), tells of his pleadings to Bush2 and Congressional leaders to fix spending. Obviously, the expert went unheeded at the expense of long-term economic stability.

Politicians on both sides cannot be trusted to be fiscally responsible. The only way to curb deficit spending is to make it law – with a Constitutional amendment. The amendment should prohibit deficit spending except in times of war, times of recession/depression (when government revenues decrease naturally and temporary tax rebate stimulus is sometimes needed), and perhaps for infrastructure spending (which will benefit future generations). This is the only path to fiscal stability. But, will any politicians have the guts to propose such an idea? Unlikely. In the meantime, we will continue to be inundated from both sides by pitches to “help the economy” that will only hurt it - another evidence of a broken party system.

Read my update to this essay.