Friday, August 6, 2010

A history of deficits

This piece was published by the staff of Vote iQ, the first major social networking site expressly designed for politics.

Rick Shenkman, HNN editor-in-chief, is Vice President, Media & Partnerships at Vote iQ.

In President Clinton's last full year in office (2000), the federal budget was roughly $1.8 trillion dollars. When President Bush was inaugurated in January 2001, his administration received the previous year's $236 billion dollar budgetary surplus. By fiscal year (FY) 2010, a mere decade later, the United States' budget had doubled to nearly $3.6 trillion, and incurred a $1.6 trillion budget deficit. A budget deficit is the difference between outlays (expenditures) and income for a single fiscal year.

So how exactly did we get to this point, where our federal deficit is almost as large as our entire federal budget was just 10 short years ago? To answer that question we must explore the concept of deficits and our nation's financial history.

When economists refer to "the deficit" they are talking about the annual fiscal difference between what the government spends (outlays) and receives (taxes). More formerly, this difference is referred to as the budget-deficit, as distinguished from the trade-deficit, or the net difference between imports and exports. While we will focus here primarily on the budget-deficit, it's important to note that historically the United States has covered its budget deficit with a trade surplus, or vice versa. More recently however (since the early 70's), we have developed an unhealthy pattern of simultaneously spending more than we receive from tax revenues, and importing more than we export.

One way we compensate for going over budget is by selling United States government securities or bonds. Private investors, including foreign governments such as China's, can purchase these securities from the Department of the Treasury. We leverage the income from the sales of these securities against the annual deficit. The aggregation of outstanding bonds and securities-the aggregation of the deficits over a period of years-is referred to as the national debt. Our government, regardless of which political party is in office, tends to operate on the assumption that regardless of the size of our deficit, investors and foreign countries will always cover the difference by buying these securities.

We offset a portion of the amount of bonds we need to sell by minting new currency. This raises the danger of inflation, according to many economists, though the extent of the danger is a matter of opinion.

Why do we have deficits?

But why do we have deficits in the first place? Many economists believe that deficits are the result of naturally recurring lifecycles of the economy. During periods of economic expansion, employment tends to be near capacity. As a result, taxable income peaks. The government's receipts come close to meeting (and in some years actually exceeding) expenditures. Conversely, however, during times of recession when unemployment is relatively high, taxable income decreases. At the same time, social welfare programs are stressed when more people are unemployed, so the government paradoxically ends up spending more at the same time that it's receiving less-a double edged sword. What's important to realize is that often deficits are the result of endogenous factors, the natural ebb of economic cycles. While economists such as Milton Friedman might argue that the term "cycle" is a misnomer-economic history tends to be asymmetric and sporadic-there is no denying the presence of a cyclical-nature at the very least.

Sometimes, however, deficits are caused by systemic irritants or exogenous factors. Unforeseeable events such as wars, natural catastrophes, political unrest or poor financial planning (the selling of subprime mortgages, for example) means the government has to spend more than it has planned for, or more than the current economy can support. These deficits can be compounded by cyclical deficits-for example, we went to war with Iraq during a trough in the business cycle.

When Deficits Occur

Having established a perfunctory explanation of "why" deficits occur, it is now necessary to establish "when" they occur. Is economic history really asymmetric and sporadic or are there certain observable trends? Do certain economic variables have a high predictive validity regarding the future condition of the budget? In short, are we able to empirically-divine when periods of large deficit spending will occur?

Historian Bernard Weisberger thinks so. In thisessay on the website of the History News Network, he argues that large budgetary surpluses are also the harbingers of massive future deficits.

President Jefferson inherited an $80 million national debt (largely from the Revolutionary War) when he was inaugurated in 1801. However, tumult on the European continent allowed America's fledgling system of mercantilism to prosper from manufacturing and trade. During his tenure Jefferson was able to cut taxes, reduce the debt by half, and buy the Louisiana territory all while accumulating budgetary surpluses each year from 1801 to 1807.

To accomplish this, Jefferson-always the proponent of a small federal government-cut military expenditures significantly. When James Madison succeeded Jefferson as President, America's foreign rivals took notice of our paltry defenses; Britain, in 1812, resolved to test the strength of our still pubescent nation. Responding to the threat of British usurpation, Madison borrowed heavily to rebuild the military-pushing the debt back toward the pre-Jeffersonian levels of $80 million.

The debt wasn't repaid entirely until 1835 (the first and last time this has happened) under President Andrew Jackson. Public land sales in the western territories provided substantial revenue for the federal government. Free of debt, and with ostensibly limitless surpluses in the future, Jackson sought to "return" $37 million in surpluses to the states. The plan backfired and caused "widespread speculation in land," and a recession, resulting in $20 million in deficits over the next 2 years.

Similarly, in the 1880's as the United States emerged from the Civil War with roughly $2 billion of debt, the economy rebounded. High tax rates and a rapidly expanding industrial economy led to a string of huge surpluses. As Weisberger notes, the question facing Grover Cleveland's administration was much like the one that had faced Jefferson and Jackson: How do we return surplus tax revenue to the people? Cleveland decided to subsidize the private sector, grant entitlements to veterans, and expand the military. In 1893 the stock market plummeted and the country again ran substantial deficits.

The 19th century trend Weisberger notes is this: large surpluses tend to precede large deficits. But the trend didn't die with the century. The surpluses of the 1920's led to tax cuts, and subsequently, the Great Depresssion. The surpluses in the late 1990's led to President Bush's tax cuts, and subsequently, our most recent recession.

Do surpluses cause deficits? It's likely not that simple, but the correlation is clear. It seems that large surpluses tend to trigger a sort of fiscal emetic reflex-politicians instinctively want to throw excess money back to the electorate. Often, they over compensate and tamper with the system that led to the surpluses in the first instance. While saving the money might be more prudent, it's not popular. .

A History of Deficit Spending: The Great Depression and World War II

Following a huge post-World War I expansion in the 1920's, the economy was destined for a cyclical downturn-much as the dotcom bubble was destined to "burst" circa the new millennium. The deficits in the early to mid 1930's naturally paralleled the record high unemployment rates that came to define the same era. As we noted above, high unemployment means less taxable income. This, coupled with FDR's New Deal legislation, meant government spending increased as government income decreased.

Some economists argue that when the economy is under-producing, as happened during the Depression, excess deficit spending actually may prove beneficial in the long run as it serves as a catalyst to "speed-up" the economy, providing the foundation for long term future growth and resultantly, more taxable income. John Maynard Keynes, the famous British economist, was a proponent of this idea.

Factually, we know this much: the deficit spending in the 30's coupled with high unemployment resulted in deficits equal to roughly 5% of GDP from 1932-1935.

Compared with the deficits of the 30's, those of the 40's were enormous, equaling more than 22% of the Gross Domestic Product (GDP). As a generation of young men dropped out of the workforce to fight overseas, the American economy was forced to reinvent itself. Many women entered the workforce, and big-industry geared up to buttress the war effort. Military spending ballooned-and the economy boomed.

After the war soldiers returned home and became civilian auto-manufacturers, steel producers, and owners of businesses. Deficit spending, which had been feared, had helped build the platform for a larger economy in the future, indicating that deficit spending is not always the evil villain it is often caricaturized as. Still, the spending contributed to a massive public debt that, while it has been periodically reduced, has never been completely paid off and is currently in a period of growth. In fact, the last time the national debt was paid off in full was 1835, when Andrew Jackson was president.

Our Current Streak of Deficits - Bush and Obama

Every Fiscal Year (FY) since 2002 we have posted a budget deficit. During a brief stretch of four years which included President Clinton's second term and President Bush's first year (FY's 1998-2001) expenditures were less than outlays. But before that, we had twenty-nine consecutive years in the red. However, the deficits in the last few years in particular are unique because of their size-almost $500 billion in FY 2008, $1.4 trillion in FY 2009, and $1.6 trillion in 2010. (See CBO's Budget Report archives). The most recent deficit represents 10% of national GDP and as noted earlier, is roughly the same size as our entire federal budget was just 10 years earlier.

Many factors, endogenous and exogenous, have contributed to our tumultuous finances. During the late 1990's, we experienced the expansion of the World Wide Web. The Internet fundamentally changed how companies did business, streamlining communication, sales and distribution in addition to revolutionizing advertising. The result was a huge expansion of investment capital in a very short amount of time. As in the past, speculative fever led to overly optimistic claims about the new dotcom economy's resiliency, leading to grossly overvalued stocks. The economy grew so much so quickly that it surpassed an invisible level of GDP that economists like to call "potential GDP," or the optimal size for an economy at any given point in time given the size of the work force, amount of liquid capital, and other economic variables. In simple terms, the economy was artificially inflated beyond its maximum sustainable level, which led inevitably to a period of shrinkage-the dotcom bubble "burst."

The terror attacks on September 11, 2001 and our subsequent military involvement in the Middle East compounded these problems. The perception of global instability caused investors to lose confidence in the financial markets-at one point in late September the Dow Jones had dropped 3,000 points below its summer peak. And though the market recovered, growth was stifled. Capital gains were thereby low and failed to generate tax revenue. Coupled with the mobilization effort of the military, we saw the budget increase and income decrease.

Some think that China's low currency rate - believed by many economists to be artificially low -compounds this problem. The Chinese government has adopted policies which allow it to control the value of the yuan (also known as the renminbi) in relationship to foreign currencies, such as the dollar. By synthetically deflating the value of its own currency, relative to the world, it keeps Chinese exports inexpensive for American consumers-so we buy more of their products-and simultaneously makes imports for their own consumers more expensive-so they buy less of our products. If you picture this in terms of a simple supply-demand graph for U.S. dollars in Chinese yuan, China's policies decrease demand for our currency abroad by setting an exchange rate above the equilibrium. Economists estimate this may cost the U.S. economy $200 billion/year in growth and as many as 1 million domestic jobs.

Then came the Bush tax-cuts. Predicated on the assumption that government was suffocating investment-Bush inherited a $236 billion budgetary surplus from Clinton-the new administration sought to "return" these dollars to American investors. Strict free market proponents from argue that by reducing taxes, you stimulate entrepreneurship, which grows the economy, which in turn results in a larger GDP and more taxable income. The idea is that if you increase the size of the pie, you can feed the government a proportionally smaller piece, but in the end the government will still end up with more pie in absolute terms. The theory is that everybody wins; the government brings in more revenue, and investors earn more money.

Did the Bush tax cuts increase the deficit? It is unclear exactly what effect these cuts had on the deficit, as the economy in the first decade of this millennium has been complex and convoluted in many ways. Paul Krugman, a self-professed liberal economist, argues vehemently that the tax-cuts did in fact play a crucial role in the subsequent deficits. Conversely, the conservative Heritage Foundation's top budget analyst, Brian Reidl, argues that uncontrolled spending, not tax-cuts, are to be blamed. Regardless there is a correlation between the Bush tax-cuts and an increase in the size of the deficit, which seems to contradict the notion that lower taxes lead to a smaller deficit. The same trend was observed during the era of the Reagan tax cuts-the deficit grew. However, correlation is not causation, and the GDP did increase significantly during both periods. The "pie" did get bigger.

The coup de gras came in 2008 when the housing bubble "burst" much in the same way the dotcom bubble had. Home values plummeted and the banks which had financed the mortgages failed. Taxable income went down as unemployment went up. The auto-industry in Detroit faced its own problems and liquid capital was nearly non-existent. The economy basically stalled-out.

In order to limit the damage to the average American, both the Bush administration (in its final days) and the new Obama administration resolved to bailout the same financial institutions that had caused the problems. Here is a brief list of where the "bailout" money went since 2008:

$30 billion to Bear Stearns, 2008 $400 billion to Fannie Mae & Freddie Mac, 2008 $180 billion to A.I.G., 2008 $630 billion congressional spending bill, September 2008 $700 billion TARP (Troubled Asset Relief Program), October 2008 Includes $25 billion to Citigroup $45 billion to Bank of America $787 billion American Recovery and Reinvestment Act, 2009

The current budget deficits are the result of these massive spending efforts by the government. Some argue that the deficit spending saved the American economy from a second Great Depression. Opponents claim that we should have let the economic natural-selection prevail and allow failing institutions to fail.

Regardless, we now face the largest budget deficits in our nation's history.

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