Fiscal Policy, the Long-Term Budget, and Inequality

The American Prospect deserves credit for sponsoring this forum. It gives progressives an opportunity to engage in a serious discussion about many of the key economic, social, and political issues facing the country. At least as important, it allows us to tie them together in a way that generally is not done but is essential in a serious discussion.

Asserting that budget policy, fiscal policy, and inequality are integrally linked is not just rhetoric. In fact, they are inextricably tied through economic relations that are too little appreciated. The failure to appreciate these ties often leads to policies that are ineffective or even self-defeating. This essay describes how the policies are necessarily linked beginning with fiscal policy and macroeconomic policy. It then turns to a discussion of social insurance programs and inequality and the long-term budget.

Macroeconomics and the Iron Truths of Accounting Identities

Most college-educated people have been through an intro econ class where they were punished with the basic macroeconomic accounting identities. They then quickly forget them as soon as the class was over. Unfortunately, this appears to be as true for people engaged in economic policy debates as for the larger public.

The good or bad thing about accounting identities is that there is no way around them: They must be true. One of the basic macroeconomic accounting identities is that net national savings must be equal to the trade surplus. This means that the total of private and public savings, net of investment, must be equal to the trade surplus. For algebra fans this means that:

(S -I) + (T-G) = X-M;

Where S is the sum of all private savings, both household and corporate. I is investment, which means both corporate investment and the construction of residential housing. T is taxes and G is government spending, so T-G means the budget surplus. (Since we have been running large deficits in recent years, T-G has been negative.)

X is exports from the United States, while M is imports into the United States. This means that X-M is the trade surplus. This number has also been a large negative in recent years, as the country has been running a large trade deficit.

I apologize for the detour to intro macro, but it is important that people understand the logic of this accounting identity. If the country has a trade deficit, then it means we have negative national savings. There is no way around this fact.

If we have negative national savings then either the government must have negative savings, the private sector must have negative savings, or both sectors can have negative savings. Again, there is no way around this fact.

Currently our trade deficit would be between 4-5 percent of GDP if the economy were at full employment. This comes to $650 billion to $800 billion a year in the current economy. This means that the budget deficit, plus whatever negative savings we see on the private side, must sum to between $650 billion to $800 billion.

If the deficit hawks got their dream and we somehow balanced the budget, and the trade deficit stayed the same (I'll come back to this), then it would mean that the private sector would need to have negative annual savings of between $650-$800 billion. In most of the post-war period private sector savings have been close to zero, with households providing the savings businesses needed to finance investment.

The two notable exceptions were during the years of the stock bubble at the end of the 1990s and the housing bubble in the last decade. In both cases household savings plummeted as the wealth generated by the two bubbles led households to increase their consumption at the expense of their savings. Both bubbles also led to an increase in investment. In the stock bubble years, the uptick was in corporate investment. In the housing bubble years, residential construction reached post-war highs measured as share of GDP.

It is difficult to imagine that anyone would actually advocate bringing back bubbles to sustain the economy. Furthermore, since their main impact was on boosting consumption at the expense of savings, one result of the bubble driven growth of the last two decades was that households did not save as much as they would have otherwise, leaving them less well prepared for retirement. That can hardly be a desirable outcome.

The alternative way to have negative savings on the private side is to have an investment boom. That might be wonderful, but that is not a story for the real world. The investment share of GDP has varied little over the last 50 years. Even at the peak of stock bubble years, when concerns over the Y2K problem spurred software investment and people threw money at every crazy Internet start-up, non-residential investment rose by just 1.4 percentage points above its 12.7 average share of GDP over the past 40 years.

If we can't expect private savings to turn negative in a big way, and we keep the government budget balanced, then there is one other way for the income accounting identity to hold. If the economy shrinks due to insufficient demand, then savings will fall more than investment. At some point, this will give us a large enough excess of private investment over private savings for the national income accounts to be in balance.

If it is not clear, we are bringing the national accounts into balance in this story with a shrinking economy and rising unemployment. That is what happens if we run a balanced budget in the context of having a large trade deficit. The deficit hawks may yell and scream that they don't want to shrink the economy and have mass unemployment, but this is what they will get if we have deficit reduction without a clear plan for reducing the trade deficit.

Of course, the trade deficit is not a law of nature. The trade deficit exploded in the years following the East Asian financial crisis. It fell back substantially in the years from 2006 until the recession. The main factor in both cases was changes in the value of the dollar: first a sharp rise following in the wake of the crisis and a gradual decline in the years after 2002. The trade deficit clearly responds to changes in the value of the dollar. The high dollar that we saw after the East Asian financial crisis made U.S. goods less competitive in the world economy. When it fell back to more normal levels, the trade deficit began to shrink.

Many actors in policy debates have argued for alternative methods of reducing trade deficits, such as new trade agreements or industrial policy. In fact, the former have often increased the trade deficit. Well-designed industrial policy can raise productivity and increase competitiveness, but even in a best-case scenario this is a long-term outcome. Even with optimistic assumptions, currency adjustments will swamp the plausible impact of industrial policy.

This means that if we want to see a substantially lower trade deficit, we should want to see a lower valued dollar. This should be front and center of every progressive's agenda.

If we don't see a drop in the dollar, then we should anticipate that the large trade deficit persists. In this case, our alternatives are large budget deficits or unemployment. That's it: Those who are not prepared to push for a lower valued dollar and also want a balanced budget, want more unemployment.

Flipping this over, we can attain full employment by running large budget deficits. Given the size of the current trade deficit, budget deficits of the size needed to bring the economy back to full employment would probably be in the neighborhood of $1 trillion a year or 6 percent of GDP. The U.S. government can certainly run deficits of this size for a very long time.

In the downturn financial markets have shown little reluctance to hold U.S. government bonds at extraordinarily low interest rates, in fact the real interest rate on long-term bonds has been close to zero. This makes borrowing for both short-term stimulus and longer-term investment measures attractive. This would mean not just physical infrastructure (including retrofitting buildings to make them more energy efficient) but research and development in a wide range of sectors.

Since the main point is to stimulate demand, we can also experiment in various areas. For example, we could allocate money to allow some cities to offer free bus fares for two years. It would be interesting to see the extent to which bus travel can be encouraged if it were simple, quick, and free. The potential reduction in greenhouse gas emissions would be substantial.

We could also use public funds to encourage shorter work weeks/work years. It is important to realize that our central problem right now is too much supply, not too little. Traditional stimulus addresses this problem by increasing demand. We can also address the problem by giving employers an incentive to reduce work hours in family friendly ways. We work 20 percent more hours on average than do people in Western Europe. If our work years were comparable in length to those in Western Europe, unemployment would be immediately eliminated.

Of course such a transition could not be accomplished overnight, but there is no reason that government funds could not be used to provide incentives for shortening work hours with policies like paid vacations, paid family leave, and paid sick days, rather than paying workers unemployment benefits. There is already a short-work program attached to the unemployment insurance system in 25 states (including New York and California), but the take-up rate on this program is low. If the problem is that we don't want all the goods and services that we are capable of producing then a simple answer would be to produce less and let people share the leisure.

If this discussion seems dismissive of deficit concerns, it is because it is based in economic logic and not Washington generated hysteria. We are not and cannot be Greece. That is not a subjective assessment of the relative strength of the U.S. and Greek economies, where we could turn out to be Greece at some point in the future. It is a statement about the fundamental differences in our currency regimes.

The United States has its own currency. Greece does not. If we actually saw the investor panic that the Washington deficit hawks crave, we could always have the Federal Reserve Board just buy up U.S. debt. Greece did not have this option with the euro. This could create inflation, but only in a context where the country was seeing a serious problem of excess demand – too many dollars chasing too few goods and services. Inflation does not just drop out of the sky.

This means that the idea that we have to fear investors turning on a dime and running from the dollar is nonsense. We could envision scenarios in which we overheat the economy and have serious problems with inflation, but that will not happen overnight and it certainly will not happen in a context where we are 9 million jobs below the trend level of employment as is the case presently.

There is one other crucial point about the need to get to full employment. Low levels of unemployment disproportionately benefit those in the bottom half, and especially the bottom third of the income distribution. There is no better policy than to ensure that those at the middle and bottom share in the gains of economic growth. In fact, the decision to have fiscal and monetary policies that do not bring the economy to full employment can be viewed as a decision to run policies to redistribute income upward, since that is their clear effect.

Long-term Budget Deficits and Social Insurance

While there may be no reason to worry about the budget deficit in the near or even intermediate future, the longer-term projections showing large deficits should provide some cause for concern. It is worth noting that even these longer term projections show much smaller deficits now than they did a few years ago due to the slower projected pace of health care cost growth. Nonetheless there are still substantial, if manageable increases in spending projected over the next two decades. The main sources are, of course, Social Security and Medicare.

It is difficult to see how anyone can get be too concerned about the projected path of Social Security spending. It went from 4.1 percent of GDP in 2000 to 5.1 percent in 2013. It is expected to rise by another 1.1 percentage point of GDP over the next twenty years. It's not clear why anyone would view this as a major problem.

It is also worth asking if we think the problem is that seniors have too much money now. Their median income is less than $20,000 a year. With the collapse of the defined benefit pension system and only a small fraction of the population able to accumulate significant assets in 401(k) or other retirement accounts, we should be asking whether benefits should be raised rather than lowered. Ideally, we would have a second leg to the retirement income system where middle- and moderate-income people can accumulate savings to help support themselves in retirement, but we don't have that now for most retirees or near retirees.

Unless and until we do have a system that allows most workers to supplement their retirement income, we must recognize that Social Security is the only real retirement system for much of the population. (It provides more than 90 percent of the income for 40 percent of seniors.) The program is projected to face a shortfall in the years after 2033. Inequality is a big part of this story. If so much income had not been redistributed upward over the past three decades, placing it above the cap on taxable payroll, the projected shortfall would be 30-40 percent smaller.

The other reason inequality is important to the solvency of Social Security is that workers willingness to pay taxes will depend in part on the growth of their wages. If workers were getting their share of productivity growth so that real wages were rising 1.0-1.5 percent annually, it is likely that they would be more receptive to taking back 0.1 percentage points of this increase in the form of higher payroll taxes. It is much better to get a 1.5 percent wage hike and a 0.1 percentage increase in the payroll tax than no increase in wages and no increase in taxes. In short, in a context where workers are getting their share of the economy's growth, it would be difficult to see the problems facing Social Security as anything other than trivial.

This gets us to Medicare and other government health care spending. The figure below adjusts CBO's long-term deficit projections assuming that per person costs in the United States were the same as in Germany or the U.K. In either example, we would be looking at huge long-term surpluses in the primary budget.

Progressives should be upset by the projections of exploding growth. Essentially, they imply that we will be devoting an ever-larger share of the economy to paying rents to providers in the health care industry. While progressives must be ardent defenders of quality health care, we should also be vigilant in attacking rent-seeking that redistributes an enormous amount of income upward and is often harmful to the public's health. If our per person health care costs were comparable to those of any other country's, we would be looking at huge budget surpluses, not deficits.

Just to take the most obvious, doctors in the United States earn roughly twice the pay as the average for other wealthy countries. There is no reason to believe that we get better quality care for these generous paychecks. The country could save close to $80 billion a year (0.5 percent of GDP) if our doctors were paid the same as doctors in Europe or Canada. We could get much of the way towards bringing doctors' pay in line with other countries by exposing them to international competition. It is incredible that we openly discuss bringing immigrant STEM workers, nurses, even farmworkers to bring down the pay in these sectors, but no one ever raises the issue of bringing in foreign doctors.

There is no reason that progressives should not make opening up the medical profession to market forces as a big item on our agenda. Doctors are the largest single occupation among the one percent, and virtually all of them are in the richest 5 percent of workers. We can make the economy more efficient, saving trillions of taxpayer dollars in the decades ahead, and promote equality by bringing the pay of our doctors in line with the rest of the world.

The same applies to drugs. We spend more than $300 billion a year on drugs that would probably not cost one tenth as much in a free market. The reason is government granted patent monopolies. The justification for patent monopolies is that they are needed to finance research. However there are much more efficient mechanisms to finance research.

Everyone who has had an intro economic class can identify all the bad things that happen when the government imposes a tariff or quota that raises the price of a product by 20 or 30 percent. All the same bad things happen and more when the government grants a patent monopoly that allows drug companies to charge prices that are thousands of percent above the free market price. The situation is made even worse by the problem of asymmetric information: drug companies know far more about their drugs than do patients or even doctors.

In this context we should expect to see drug companies mislead the public about the safety and efficacy of their drugs and to promote them for inappropriate uses. This is of course what we do see. The result is that people often get bad care and needlessly suffer injury or even death. That's what happens when the government intervenes in the market.

There is a much longer list of ways that we can get our health care costs in line with the rest of the world. All will look like political non-starters. That should not be relevant in the context of the question asked here.

We do have a problem of out of control health care costs for both the public and private sector. Progressives should have our to-do list to throw out in public wherever and whenever possible. Let the Peter Peterson types tell us that we can't do anything about doctors' salaries because they are too powerful.

The point is that we need a clear answer to the people who are scared by the projections of exploding health care costs. There are ways to deal with these costs, if the rich and powerful would just let us. We do not have worry about lack of ideas. Our problem is that lack of political power to implement them.