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Jon Talton

Analysis and commentary on economic news, trends and issues, with an emphasis on Seattle and the Northwest.

February 2, 2010 at 10:00 AM

Cheney’s ‘Deficits don’t matter’ becomes Obama’s hot potato

Top of the News: Much of the media yesterday kept repeating that President Obama’s budget includes the largest federal deficit in American history. This is not true. One must ask whether they are careless and ignorant — the same bunch that said in 2006 housing prices would always keep rising — or are they partisan?

The key measure is the deficit as a percentage of GDP. Washington’s deficit in 1943 was more than 30 percent; the current number is around 10 percent. We’ve now been embroiled in two wars lasting longer than World War II. The top tax rate then was 94 percent vs. today’s 33 percent, a product of years of tax cutting and loopholes. In addition, the worst economic downturn since the Great Depression has severely cut tax revenue and required a robust response.

One first is true: President Obama inherited the largest deficit in history.

Deficit projections are extremely fluid, dependent on such factors as how quickly the economy — and thus tax revenue — recovers, whether taxes are raised on the wealthy, etc. In the late 1980s and early 1990s, experts argued that eliminating the deficit was impossible. Yet it was done quickly thanks to the modest Clinton tax increases and the economic boom of that decade.

The real question is: When does a deficit matter?

It didn’t matter to Republicans when they were in power. Then Vice President Dick Cheney famously said, “Reagan proved deficits don’t matter.” Now all of Washington and the media have bought into the narrative that they do. So which is it?

Deficits matter when they negatively affect a nation’s currency and its ability to sell its debt, as seen in Latin America and parts of Asia in the 1990s, and lately in Greece. This is not the case for the United States, where the dollar is not in freefall and Treasury debt remains an international draw. Indeed, during the panic investors around the world fled into dollars. The dollar remains the world’s reserve currency, giving Washington enormous flexibility.

Deficits matter when they constrain foreign policy, and here we see warning lights. The huge debt and trade imbalance with China is putting American policymakers into a box. We essentially borrow money from China to help finance our wars; it’s in China’s interest for us to be the world’s policeman, exhausting ourselves. Yet on a host of fronts, Washington can’t play hardball with Beijing because of the need to keep our Chinese creditors relatively happy.

Deficits aren’t always bad. In classic Keynesian theory, the government runs a deficit during a recession to make up for lost GDP, then repays it during the good times. Unfortunately, the Bush tax cuts, two wars and the huge spending to maintain a worldwide military presence left a vast hole in the budget even before the great recession began. In addition, just as with individuals, it matters how the debt is spent. Does it build up infrastructure, improve human capital, seed research and new industries? If so, it’s likely to handsomely repay the investment. The return from military spending is much less, particularly if it is open-ended and in adventures with dubious chances of success. Yet another huge deficit engine is the broken for-profit health care system.

From the tea-partiers to President Obama, the remedy is to cut or freeze spending. This despite the disastrous experience in the states, or FDR’s mistake of 1937. There’s little talk of real tax increases or closing the loopholes that allow many major companies to avoid paying any taxes. This buys into the Reagan philosophy, that tax cuts and the lowest possible tax rates are necessary to economic growth, one that is highly disputed.

Obama’s budget will freeze or cut back many programs necessary to recovery. Military spending is sacrosanct. The result, estimates UC Berkeley economist Brad DeLong, is tightening worth 2.5 percent of GDP. This is a huge impediment to solving real unemployment of 17 percent or avoiding a double-dip recession. In addition, the president seems to lack the ability to think holistically about the deficit, and do such things as fix health care and open China to more American exports.

But the political narrative has turned, so that now it’s fashionable once again for candidates to even talk of privatizing Social Security. Deficits matter outside the realm of economics, too: They can take on a life of their own in the minds of many people, who see their own troubles of joblessness, foreclosures, stagnant wages and falling living standards — and attribute it to the deficit. That’s a powerful brew and could leave us in territory that would be unrecognizable to most Americans.

The current deficit is indeed unsustainable. But the snapshot of huge deficits into the future implies there will be no recovery, and that policymakers have no tools at their disposal to 1) Make investments that will enhance the economy, and 2) Raise taxes, reform health care and rethink our open-ended military commitments.

Today’s Econ Haiku:

Traders are churning

Derivatives, making bucks

Uncle Sam’s asleep

Comments | More in Deficit, Dollar, Politics and the economy, Sustainability, Tax policy

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