The U.S. Congressional Budget Office has just reported that this year's budget deficit will reach a record-breaking $422 billion in 2004. Predictably, Democrats accuse the Bush administration of gross mismanagement and, just as predictably, the White House says there is nothing to worry about because the economy is beginning to recover. Who is correct?
Whether a deficit is a problem depends on how far the economy is from its full productive capacity, whether future deficits are likely to grow or shrink as the economy moves toward full capacity, and the likely effect of taxes and spending on the growth of that productive capacity over the long term. By this real-world test, the deficits accumulated over the past four years are nothing to worry about because the U.S. economy has had lots of spare capacity. But beware the future.
A central purpose of fiscal policy is to complement monetary policy in making full use of the nation's productive capacities. As John Maynard Keynes well understood, this may require running deficits when neither consumer nor business spending is adequate to the task of maintaining adequate aggregate demand for all the goods and services that can be produced. Bush and company have denied they're Keynesians and would like to credit the Bush tax cuts alone for keeping the economy going through difficult times. But the fact is, it was the combination of the tax cuts and extra spending on the military and other discretionary items, plus the Federal Reserve's expansionary monetary policy, that has got us out of the soup.
But only just. America still has a lot of spare capacity, which is something neither Republicans who want to brag about a vigorous recovery nor Democrats who want to tut-tut over this year's budget deficit will fully admit. Payroll jobs grew by some 350,000 over the last three months, while the population of eligible workers has grown by at least 450,000. The nation still has a record number of long-term unemployed. Much factory and office space is still up for grabs. It's safe to assume lots of extra capacity for another year or two, at least until American consumers have paid down more of their personal debts and have more money to spend, and until businesses feel demand heating up enough that they want to invest in new inventories and upgrade their technologies and facilities. In the meantime, it's perfectly appropriate for government deficits to take up some of the slack.
But some time after that, the U.S. is likely to hit a capacity wall. This is when the tax cuts and spending programs that are more or less locked into future budgets will create a lot of mischief because they bang straight into that wall. Put simply, the nation just won't have the productive capacity to do everything government, consumers, and businesses want to do. With demand outstripping capacity to meet it, prices will be bid upward, including that of capital. If we're not careful, we could be back in the soup.
Democrats are right to emphasize this danger, and point out that the only way Bush can do all the things he says he wants to do over the long term -- make his tax cuts permanent, provide continued relief from the Alternative Minimum Tax, pay for his ten-year $530 billion Medicare drug benefit, offer a new health insurance tax credit, and continue to fight a war against terrorism that may or may not ever be winnable -- while cutting the deficit in half, is to make scathing cuts in everything else the government does. But this prompts the more basic question of how big a deficit America should aim to have. The answer depends, in part, on what happens over time to the nation's productive capacity.
Look beyond the business cycle and what do you see? Deficit hawks see the specter of 77 million baby boomers being let down by bankrupt Social Security and Medicare systems as the rest of the economy sinks under the dead weight of massive debt. Alan Greenspan recently told Congress it can't count on increases in the nation's productive capacity to finance the boomers' retirements. But why not? If America's capacity expands substantially, it can do that and much more. The question is how much the nation is likely to invest in order to build such capacity.
Republican supply-siders have told us for years that tax cuts alone will generate enough private investment to grow the economy, and that growth will dwarf the budget deficits which the tax cuts contributed to. So far, their prediction remains only a prediction. Based on the records of the Reagan administration and that of George W. Bush so far, I have my doubts. But there's another case to be made on the other side of the political aisle, by what we might call liberal supply-siders. It is that public investments in education, job training, infrastructure, and basic research and development would more than pay for themselves as they spurred growth of the nation's productive capacity. Indeed, deficits induced by these sorts of investments shouldn't be worrisome. What is worrisome is the nation's declining investments in these fundamentals. Available data aren't exact, but a quarter century ago the federal government's expenditures on schools and job training equaled about 1 percent of domestic product; now, they're under half of a percent. Spending on roads, highways, bridges, airports, and water purification systems was 0.8 of domestic product then; today, it's under 0.3 percent. And investment in basic research went from over 0.5 percent of GDP to about 0.2 percent today.
The question of how we induce enough private and public investment to build the productive capacity we need in the years ahead is worth a vigorous debate. But dogmatic responses to budget deficits are not conducive to this sort of examination. Republicans who insist that deficits don't matter are as subversive of careful thought as are Democrats who think they're always bad.
Robert B. Reich is co-founder of The American Prospect.
