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TIMES BOARD OF ECONOMISTS

What the Country Needs Is More Discipline, Less Talk About a Tax Hike

February 07, 1988|Allan H. Meltzer | ALLAN H. MELTZER is J. M. Olin Professor of Political Economy and Public Policy at Carnegie Mellon University

Have budget deficits put our country on the road to ruin? Much public discussion makes it seem that the country is either on the brink of a calamity or headed toward one. Whether the complaint was high interest rates and a strong dollar in 1983 and 1984 or a falling dollar in 1986 and 1987, the budget deficit gets blamed. After the dramatic fall in stock prices in October, "everyone" seemed to agree that the most important thing to do was to reduce the budget deficit.

Everyone except the experts, that is. When academic experts talk about the deficit these days, there is often lively discussion about recent theoretical work showing that the deficit has no effect on output, employment, spending or interest rates.

A deficit, according to this theory, is just a decision to tax sometime in the future instead of now. What matters is the government's spending, not the decision to pay with today's taxes instead of tomorrow's.

Many economists, trained to believe that deficits are important, find the argument wildly implausible.

They point out that there are many possible reasons why the abstract and general argument may be formally correct but inapplicable to an economy like our own.

A great many efforts to show how wrong the argument is have turned up much less than the investigators expected, however. If deficits and debt have had important effects on interest rates or investment, researchers have not found them. The effects that have been found in the most careful studies seem tenuous, not calamitous.

Further, the experts agree that the size of recent budget deficits is overstated by as much as $65 billion. A main reason for the overstatement lies with the recording of interest payments on the national debt. These payments include a return to the lenders of the losses they expect from future inflation. The losses to the lenders are gains to the government. The government counts the interest it pays but it fails to count the gains, or receipts, from inflation.

Nevertheless, the proponents of gloom maintain, we have allowed the national debt to double in this decade. Two and one-half trillion dollars of government debt seems large. The U.S. economy produces $4.5 trillion of output, however, so the gross government debt is currently about 50% of a year's output. This is less than many other countries, including countries such as Japan and Italy (90%) or Austria, Britain, Sweden and Holland with debt between 55% and 70% of total output. None of these countries is on the verge of high inflation. The risk of inflation cannot be put aside entirely. A large debt and continuing large deficits raise the risk of inflation. Recently, we have seen this experience repeated in Brazil, Argentina, Bolivia, Israel and elsewhere.

The German hyper-inflation of the 1920s reminds everyone that money can become worthless and savings in bonds, savings accounts and insurance can be wiped out.

In each of these experiences with high inflation, deficits were financed by printing money.

If our government decided to finance continuing deficits with substantially higher money growth, the risk of inflation would rise. The Federal Reserve would run the printing press and use the money to buy up the debt, just as the central banks did in Bolivia, Brazil and other high-inflation countries. Once started, the temptation to continue inflating would be hard to resist.

To reduce the risk of inflation and other possible consequences of the budget deficit, we should bring the budget toward balance. By now, everyone has seen that Congress is unwilling to reduce spending and the President is properly hesitant to raise taxes. Is there a way out that doesn't require cuts in spending or increases in tax rates that the political process cannot, or does not, deliver?

The surprising answer is yes. If we are patient and ignore those who, in this election year, would make the deficit into a crisis waiting to happen, we can reduce the deficit without raising tax rates or reducing the real level of spending. By the end of the next presidential term, we can be close to balance, possibly even have a small surplus.

This is not just "pie in the sky." The economy has been growing at about 7% a year: 2% to 3% is real growth and about 4% is inflation. If taxes remain at the average rates of the fall of 1987 and spending rises at the 4% inflation rate, the budget will have a surplus at the end of 1992. (Tax reform lowers individual taxes but raises corporate tax rates, so the net effect leaves the average tax rate about the same.) There is even room for a slight increase in spending to raise Social Security payments faster than inflation.

This modest program brings us close to a balanced budget by the end of the next presidential term without raising taxes. And, if we correct the government's accounting for interest payments, the budget is in surplus by 1990, just two years from now.

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