Part I: The Opposing Schools
Politicians,
commentators, aunts and uncles, and other constituents of my favorite
demographic—the questionably qualified—have been telling us we have a spending
problem; they assert that we are running up a catastrophic deficit that will
compromise the future for our children and send us, inexorably, down the
ruinous path towards Greece.
Curiously,
few of these commentators have economic backgrounds. Or read economic journals.
Or participate in economic forums. Good gov’ner! Where then are these diagnoses
about our destructive path, and the prognoses for its reconciliation, coming
from! This whirlwind broaches two primary questions.
First,
is our deficit actually that
dangerous? Will we be able to service our debt obligations, or are we already
facing the imminent demise of the full faith and credit of the United States?
Second, if our deficit is indeed dangerous and requires immediate and
significant action, how do we curtail it?
We’ll
start by looking at question two. Whether its warranted or not, the federal
deficit is in the windshield of political discourse; it’s portrayed as the
steadily approaching iceberg that will debilitate our economic system. So let’s
pretend we’ve looked into question one and found that yes, we need to seriously
chip away at our growing national debt. So, how do we do it?
Fiscal
policy offers two approaches: We can cut spending and raise taxes. Through
these approaches, we could stem the tide of our growing deficit by spending
less, and pay down our debt by raising revenue through taxation. But this is
complicated by the fact that our economy is still depressed. Cutting spending
and raising taxes will curb growth, sending us further into depression. Thus, we
are faced with a difficult balancing act: how do we continue to stimulate our
economy while paying down our debt?
Harvard
professor Christina Romer asserts that both spending cuts and tax hikes will
damage our already frail economy. In deciding which fiscal policy measure to
employ, we need to ask: “what will hurt more, raising taxes or cutting
spending?” According to Romer, “both
tax increases and spending cuts will tend to slow the recovery in the near
term, but spending cuts will likely slow it more.” In her view “if federal policy
makers do decide to reduce the deficit immediately, reducing spending alone
would probably be the most damaging to the recovery. Raising taxes for the
wealthy would be least likely to reduce overall demand and raise unemployment.”
Romer cites a number of studies from economic
forecasters who “estimate that a tax increase equivalent to 1 percent of the
nation’s economic output usually reduces gross domestic product by about 1
percent after 18 months. A spending cut of that size, by contrast, reduces G.D.P.
by about 1.5 percent — substantially more.”
Tax cuts can be hoarded, especially in a deflation-prone
economy, preventing banks from greasing the wheels of investment. Moreover,
financial intermediaries are bogged down with bad mortgages and—skeptical about
demand—are hesitant to lend, thereby creating a self-fulfilling prophesy.
Government expenditure, on the other hand, is paid directly to firms, leading
to a larger and more effective multiplier.
Ultimately, Romer takes a balanced approach to
deficit reduction, focusing on a combination of spending cuts and tax
increases. She argues that to curb our deficit while simultaneously bolstering
the recovery, it is necessary to cut wasteful government consumption and to focus
on government investment in basic research, education and infrastructure. For
these activities are essential to future productive capacity. Furthermore, Romer
is unequivocal about taxation. “Nearly every economist I know agrees that the
best way to raise revenue would be to limit tax breaks for households and
corporations…the bottom line is that tax increases should be part of any
comprehensive budget plan.”
However,
her Harvard colleague and fellow economist, Alberto Alesina has a different opinion.
Alesina espouses comprehensive cuts in government expenditure, stating that curtailing
government spending is the essential ingredient for curbing the deficit and
catalyzing economic recovery. “Economic
history shows that even large adjustments in fiscal policy, if based on
well-targeted spending cuts, have often led to expansions, not recessions.
Fiscal adjustments based on higher taxes, on the other hand, have generally
been recessionary.”
Citing his research with Silvia Ardagna, Alesina
asserts that “over nearly 40 years, expansionary adjustments were based mostly
on spending cuts, while recessionary adjustments were based mostly on tax
increases.” Moreover, he argues that government spending signals impending
tax increases, which will cause investors and consumers to tighten their
purses. According
to Alesina, “Stimulus spending means that tax increases are
coming in the future; such increases will further threaten economic growth.”
According to Alesina, “Europe seems to have
learned the lessons of the past decades: In fact, all the countries currently
adjusting their fiscal policy are focusing on spending cuts, not tax hikes. The
evidence from the last 40 years suggests that spending increases meant to
stimulate the economy and tax increases meant to reduce deficits are unlikely
to achieve their goals. The opposite combination might.”
Romer and Alesina represent the polarized debate
among economists and politicians. Europe has tended more towards Alesina, whereas
North America has leaned more towards Romer. Part II will bring some more
economists into the mix and investigate to what extent our increased deficit
spending threatens future growth and prosperity.
