Sensible Deficit and Debt Reduction Will Require Investment

Henry Aaron of the Brookings Institution makes the sensible suggestion that current proposals to balance national revenues and expenditures over both the short and long-term suffer from a "temporal mismatch." Aaron suggests that we first tackle deficit reduction and then turn to the longer term problem of debt reduction:

Deficit reduction should stop debt from growing faster than gross domestic product — and do so within the next decade. But closing the projected long-term gap between Social Security spending and revenues and materially slowing the growth in Medicare and Medicaid spending will take much longer.

I think the best feature of his perspective is that it sees the current trend to "all or nothing" thinking for what it really is: an approach likely to produce nothing. His suggestion makes sense because deficit reduction eliminates or reduces future debt, thus also contributing to the goal of reducing national debt to a level that is commensurate with our national output and expected growth rate. In principle, closing the deficit gap should be easier to achieve. In addition, our success or failure at it would have some impact on how we decide to tackle debt reduction and the longer-term moral and economic obligations of Medicare, Medicaid and Social Security.

Stabilizing the debt must begin as soon as economic recovery is well established and must be accomplished over the next decade in order to prevent the ratio of debt to G.D.P. from becoming excessive. Timely deficit reduction is therefore urgent. Asking Congress simultaneously to reform three of the most important and complicated government programs only jeopardizes the solution of the more immediate problem.

He also rightly notes that the Patient Protection and Affordable Care Act (PPACA) of 2010 is aimed on several fronts at reining in health care costs, yet its provisions are not fully in place until 2014. Therefore, jumping ahead and attempting to tinker with Medicare and Medicaid without a better sense of whether or not the cost curve will be bent and by how much seems premature.

To slash Medicare and Medicaid spending before reforms to the health care system bear fruit would mean reneging on the nation’s commitment to provide standard health care for the elderly, the disabled and the poor. The only realistic way to realize big savings in the two programs is to reform the entire health care payment and delivery system in a way that will slow the growth of all health spending. The Affordable Care Act is intended to initiate such systemic reforms. The best way to rein in growth of spending on Medicare and Medicaid is to put the provisions of that law into action, but this will take many years.

Aaron concludes by urging the Administration and Congress to adopt a three-stage program to reduce the deficit, to reform social security (I would add, if needed and if morally and politically feasible), and to "resolutely carry out the Affordable Care Act," thereby enabling the slowing of growth of health care costs and reducing the drain of Medicare and Medicaid on US taxpayers and federal coffers.

What I like most about Aaron's proposal is his one-thing-at-a-time approach that is informed by the intertemporal interconnectedness of any changes we make and their likely impact on the larger economy. I also like the emphasis on the temporal sequencing of the likely impacts of any changes. It explicitly acknowledges the interconnectedness of deficit reduction and debt shrinkage and the potential dangers of doing too much, too fast in a rather scatter shot approach.

What I don't like about Aaron's approach is that it doesn't really acknowledge that sometimes you have to spend money now in order to reduce expenditures or increase revenues in the future. Remember that government debt in and of itself is not necessarily a bad thing, nor is personal or corporate debt. The judgement of "good" or "bad" will depend on many things, including the expected returns from any investment made with the borrowed funds, the terms under which funds must be repaid, and the financial health of the borrower, which will influence the likelihood of repayment and (I suspect) the quality of the investment.

After all, leadership of a thriving, growing business that did not borrow to fuel continued growth would be judged incompetent. By the same token, leadership of a hard-hit business in the middle of a economic downturn that focused only on debt reduction without some thought and investment (at record low costs) devoted to building a solid platform for recovery and future growth would also be judged incompetent.

The leadership of a hard-hit country in the middle of an economic downturn has additional economic and moral obligations. One economic obligation is to compensate for contractions in consumer demand by stabilizing and (in the case of a severe downturn) stimulating aggregate demand. A government stabilizes demand by providing and extending unemployment benefits and by enacting programs like Medicaid, Medicare, social security as well as other safety net programs like food stamps and Temporary Assistance to Needy Families. Cuts to any of these takes money out of the pockets of poor, working class, and middle class Americans and is likely to contract demand further.

A government can stimulate aggregate demand by accelerating investments in infrastructure, research, and defense. By borrowing at record low rates, it can bring those necessary investments that it would have made in the future forward to the present, thereby maintaining and also creating jobs that otherwise would be lost because of the current downturn. Such investment has the effect of stimulating demand now and keeps the economy from sinking deeper into recession or depression. It has the added advantage, if done wisely, of creating better health, education, and economic infrastructure that benefits our grandchildren and their grandchildren. The historically low cost of borrowing means that the cost to our grandchildren of repaying the loans for these investments are likely to be lower than the benefits they will realize from the investments, if they are made wisely.

It took us at least 30 years to dig the hole we're in. Pretending that we can fill it up in two years or ten is not only silly, it's dangerous. We need a long-term perspective that combines strategic deficit reduction and strategic policies aimed at output growth and expenditure reductions that over the long-run reduce the debt. A willingness to incur new debt that contributes to future output growth and efficiency by increasing human and health capital, infrastructure, and energy efficiency, must be part of any such plan.

Comments

[mrrunangun]

Thirty years of unwise policy has been the consequence of short election cycles and the popular appeal of policies combining tax reductions with increased government expenditures. Reversing the policy arouses opposition from the beneficiaries of those policies, i.e. today's voters-the only voters today's officeholders need to please. The champions of tax cuts and the champions of tax dependents have been buying votes with tomorrow's money for thirty years. That tomorrow will be here soon, and it may already be here without us having faced that yet.. The public re-elects officeholders who appear to deliver something for nothing. That is what passes for wisdom with the voting public.

[Ralph Musgrave]

“It took us at least 30 years to dig the hole we're in. Pretending that we can fill it up in two years or ten is not only silly, it's dangerous.” Don’t agree. Here’s how to fill the hole in a few years.

Print enough money over the next two or five years to buy back the entire national debt. That would be too stimulatory and/or inflationary, so balance that with a deflationary method of buying back, i.e. raise taxes and or cut government spending. Assuming the above stimulatory and deflationary effects cancel out, there’d be no net effect. Or alternatively one could go for a bit of stimulation by having the stimulatory effect exceed the deflationary effect.

Can anyone spot the flaw in the above?

The above solution is also superior to Maxine’s suggestion that ALL stimulation come via the public sector (she cites infrastructure, research, and defense). That is, there is no good reason, when coming out of a recession to distort the economy towards one sector (public or private). Buying back a large chunck of the national debt over the next five years would put extra cash into the private sector’s hands which would result in raised spending on a wide range of products (public AND private sector).

[Richard H. Serlin]

I agree absolutely. As I wrote in a post on this subject (http://richardhserlin.blogspot.com/2010/09/optimal-level-of-governemnt-investment.html), today total government spending on basic scientific and medical research is approximately $34 billion per year. So for the cost of the portion of the Bush tax cuts for the rich we could triple -- triple -- government spending on basic scientific and medical research. Which would do more for long term growth and for our children, that or spending the money on yachts, mansions, and $20,000 suits for the rich?

[reason]

Ralph Musgrave,
yes there is a flaw in the above. Why - what makes you think that you COULD buy back the whole debt? Why would those parties that hold it sell? Some of them may not even be allowed to sell (due to regulatory requirements). And pushing long term yields so low, would hit some vulnerable people (pensioners for instance) very hard. You need to think hard about the distributional effects of what you are doing, if combined with tax rises, spending cuts the effect could overall just be deflationary, with the money sitting unused in bank accounts.

[Ralph Musgrave]

Reason, It’s true that debt holders don’t HAVE to sell. On the other hand a proportion of national debt reaches maturity each year, at which point the holders have no choice but to sell. That proportion is roughly 12% a year in the U.S., and much less in the UK (about 4%). So my “two to five year” figure above is unrealistic for the U.K., but might just about work in the U.S.

I agree there are serious distributional effects to think about, but these problems are soluable. E.g. if the national debt shinks to near zero, then a proportion of pension schemes would have to switch to being “pay as you go” rather than investment based.

[English taobao]

Education is a progressive discovery of our own ignorance.