Secretary Rubin's Theory of Budget Deficits, Economic Confidence, and Financial Crises By Jeff Lemieux
January 10, 2004
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Former Treasury Secretary Robert Rubin and economists Peter Orszag and Allen Sinai have written a new paper decrying budget deficits, not just because deficits would gradually crowd out private investment and slow U.S. growth rates, but instead because they could erode public confidence -- in the U.S. and overseas -- and spark a sudden economic and financial crisis.
There are many reasons to worry about the federal deficit. Economists have always told us that unless private savers react to expanded deficits by increasing their savings (and reducing their consumption), interest rates will rise and private investment -- the main source of economic growth in the long run -- will be crowded out.
Likewise, if we borrow from overseas to finance our deficits, we effectively shift a share of our economy's future profits and economic returns abroad.
Former Secretary of the Treasury Robert Rubin and his colleagues argue that persistent budget deficits, especially as the retirement of the baby boom generation approaches, are holding back confidence in the U.S. economy.
The Rubin argument has three steps:
1. The federal deficit will remain high and the national debt will continue to increase, especially after the baby boomers retire, starting in 2010.
2. As standard economics predicts, high deficits and rising debt levels will either crowd out domestic investment or shift claims on U.S. assets to foreign owners. This causes a gradual reduction in economic returns.
3. However, out-of-control deficits and debt levels could also cause a sudden crisis of confidence, which could then precipitate a much more abrupt economic downturn. This possibility is real, but infrequently discussed.
The Bush Administration has generally discounted the deficit problem. First, the Administration has said that deficits are not out-of-control, and will be reduced substantially in coming years. Second, the President's economists have said that because interest rates remain low, and borrowing costs therefore are not constraining private investment, deficits don't matter very much.
Neither of those counter-arguments is very persuasive. First, Congress does not seem to be in the mood to make spending cuts or quit cutting taxes, and the Administration's forecasts of an improving budget picture do not seem realistic. The Bush White House continues to push Congress for spending increases and tax cuts, not fiscal restraint.
Second, interest rates are indeed low, but they will probably start rising soon. Besides, if foreign investors or central banks are financing our deficits, that will reduce U.S. returns in the long run.
One argument for high U.S. deficits -- which the Administration cannot really mention -- is that the risk of global deflation remains high, and that a policy of vigorous re-inflation in the U.S. may be necessary to prevent a deflationary crisis.
(In an extreme deflationary scenario, consumers believe prices will keep going down, and therefore delay purchases in the hope of getting even better bargains later. Of course, delayed purchases slow economic growth, which leads in turn to greater discounting, further delays in purchases, and an unfavorable cycle of deflation and recession.)
Moreover, even if the risk of U.S. deflation is low, U.S. re-inflation could help East and South Asian countries absorb the huge inflow of new workers just beginning to enter global production markets without deflation.
However, even this "altruistic deficits" argument does not hold up for the long run. If our real goals were to prevent global deflation and boost economic prospects in newly opened economies like China and India, there is no reason for the Bush Administration to encourage Congress to cut taxes and raise spending in the distant future. Instead, we have been promising tax cuts and increases in entitlement spending into the next decades, not just to ease the world economy through a rough period.
The U.S economy is probably too large to fall into an Argentina-style debt crisis, even if the deficits continue to mount and investors remain uncertain about medium- and long-term U.S. prospects.
But the warnings of Secretary Rubin and his colleagues should be taken seriously. No economy is too big to fall, confidence does matter, and U.S. budgetary irresponsibility is increasingly alarming.
Links:
Robert Rubin, Peter Orszag and Allen Sinai Sustained Budget Deficits: Longer-Run U.S. Economic Performance and the Risk of Financial and Fiscal Disarray (January 5, 2004)
Centrist Policy Network When Treasury Secretaries Attack! (January 11, 2004)
Centrists.Org A Closer Look at the Latest Jobs Figures -- Plenty of Stimulus, a Scarcity of Confidence (January 11, 2004)
Centrists.Org Preparing for CBO's Updated Baseline Projections and the President's New Budget (January 10, 2004)
Centrist Policy Network It's the Confidence, Stupid. (September 5, 2003)
Centrists.Org Issue Summary Budget and Tax Policy (Basics)
