Editorial: The phoney war over US deficits

Editorial: The phoney war over US deficits
Copyright The Financial Times Limited 2010
Published: July 30 2010 19:22 | Last updated: July 30 2010 19:22
http://www.ft.com/cms/s/0/23f03456-9c07-11df-a7a4-00144feab49a.html


Washington’s recent trench war over two economic policy choices – extending unemployment benefits and making tax cuts for the highest earners permanent – is the latest clash in a larger debate about whether (and what sort of) deficits are good for the US economy.

Much of that debate is disingenuous. The bulk of the fiscal gap was caused not by the crisis but by Bush-era economic policy endorsed by many who now condemn deficits. Critics of last year’s fiscal stimulus gleefully point out that unemployment is now as high as the White House had warned it would be if the stimulus package had not passed – as if a forecasting blunder means that job losses would not have been even more dramatic without it.

As shown by last week’s austerity debate in the FT, a serious discussion is also under way, albeit one which illustrates that the state of knowledge in economics falls short of the degree of certainty expressed by its experts. The world’s best economists disagree on the effects of last year’s stimulus and of current and future choices about the US fiscal stance.

One cannot seriously dispute, however, that last year’s stimulus had some positive effect. The main reason why fiscal policy may be ineffective is that it can crowd out private investment by driving up interest rates. But in the depth of the crisis there was hardly any private investment left to crowd out, and interest rates hit historic lows.

Today, growth has returned, but it slowed in the last two quarters and could still peter out. There is still no sign of crowding out: the US can borrow long term at real interest rates below 2 per cent. Of course, markets are fickle and nothing is worse than a government which spends too much until suddenly forced to spend too little. So there is a case for deficit cutting even if it is true that deficits have buoyed the economy.

Given current growth rates, the administration’s plan – which cuts the deficit by 5 per cent of GDP in two years and stabilises the debt by 2012 – sets a sensible pace. But certain principles for smart deficit-cutting are worth heeding. First, tax and spending choices should be shaped to make the lingering effects of the recession less painful. Second, it is more important to target the structural parts of the deficit than the cyclical ones, which growth will take care of.

For both reasons, perpetuating the Bush tax cuts is worse for the economy and for public finances than a one-off extension of unemployment benefits. Washington should also continue to use its borrowing power to buttress credit-constrained state budgets.

Ultimately anyone serious about deficits should address long-term challenges such as health costs which continue to grow without bounds. Sadly, politicians prefer rhetorical phoney wars.