Opinion: Carolina Beat

No. 727: Ignore the Hype About Government Deficits

Almost since the day President Bush first proposed tax cuts, politicians and political pundits on the left began arguing that the cuts would not work to stimulate the economy because of the budget deficits that they would create. Now, with both tax cuts and budget deficits, there are clear signs that the economy indeed has been stimulated.

So a different story about the deficit is beginning to emerge — the economy is surging, in part, because of the deficits and the “demand side” stimulus that they are providing. This brings to mind one of my favorite scenes from Fiddler on the Roof where Tevya finds himself agreeing with both sides in a political debate.

In frustration a bystander turns to Tevya and asks, “He’s right, and he’s right; how can they both be right?” But in this case, both arguments are wrong. Sound economics suggests that deficit spending is neither detrimental to the economy nor good for it.

The first argument, that deficits are harmful, goes like this: Government borrowing adds to the demand for private-sector saving; this added demand for “loanable funds” drives up interest rates and crowds out private investment. The “crowding out” effect reduces economic growth.

This sounds right until one considers the alternative — fully funding the budget with higher taxes. New taxes also are likely to drive up interest rates, not by increasing the demand for loanable funds but by reducing the supply. Income taxes are inherently biased against saving — as opposed to consumption. In addition, taxes on capital gains and dividends add extra layers of taxation on top of this bias. All of this implies less private-sector investment and slower economic growth.

The appropriate question is not, are deficits harmful to the economy, but are they more harmful than funding the spending with higher taxes? There is no pat answer to that question. Both have the same purpose, to transfer revenues from private sector to government control. Ultimately, this is what causes problems for the economy.

The opposite argument, that budget deficits stimulate growth, is even more wrongheaded. It is part of an approach to economic policy known as Keynesianism, named for the far-too-influential Depression-era economist John Maynard Keynes. Keynesian analysis includes the bizarre notion that spending is good for the economy, and that saving is bad. Deficit spending, therefore, stimulates the economy by absorbing money that is being saved and spending it. In Keynesian lingo, this increases “aggregate demand” and gross domestic product.

This approach has many problems, but there are two that are particularly egregious. First is the idea that it is better for people to spend than to save. This betrays a fundamental misunderstanding of saving. When banks receive new savings, they don’t simply put the money into a vault and wait for the depositor to claim it. The reason why banks are willing to pay interest on deposits is because they can lend those deposits at a higher interest rate to someone who will spend it. Saving doesn’t negate spending, but allows for banks to arbitrage a transfer of current spending from those who value that spending less to those who value it more. The latter may be an entrepreneur starting a new venture, an existing business attempting to expand, or a consumer getting a mortgage or auto loan. In allowing for the transfer of money from spending that people value less to spending that people value more, saving enhances economic productivity and generates real economic growth.

The second problem is that the “deficits are good” view is arrogant. Presumably, politicians and government bureaucrats will allocate saving and investment dollars more productively than consumers and entrepreneurs. There is no theoretical or empirical research to back such a proposition. When resources are transferred from the private sector to the government, whether through taxation or borrowing, economic efficiency is sacrificed and the economy is hurt.

Deficit spending should be opposed because it masks the true cost of government, leading people to think that they are getting something for nothing. An informed citizenry needs to understand how much their government is costing them. This information is conveyed through the tax system. Deficits, like the income tax withholding system, are a hidden form of taxation and inconsistent with an informed democratic process.

Cordato is vice president for research at the John Locke Foundation.