Is Our Deficit Too Big?

By Jyoti Thottam

By next year, the difference between what the government spends and what it collects in taxes will exceed $450 billion, thanks to two years of tax cuts, hikes in defense spending and a falloff in tax revenue. The ballooning deficit has sparked a fierce debate among economists. Deficit hawks argue that, like credit-card balances, deficits may not hurt much in the short run but will eventually wreak havoc. In the worst-case scenario, the government keeps borrowing to finance itself, and interest rates rise. That retards growth by making mortgages, car loans and corporate investment more expensive. The Bush Administration argues that by returning tax revenue to families and businesses, the deficit is fueling the economic engine, which as it revs up will start to create jobs. Which scenario is more likely?

TIME'S JYOTI THOTTAM asked our Board of Economists to sort it out. The panel includes Lakshman Achuthan, managing director of the Economic Cycle Research Institute; Gary Burtless, senior fellow at the Brookings Institution; Veronique de Rugy, fiscal-policy analyst at Cato Institute; Edward McKelvey, senior economist at Goldman Sachs; and David Wyss, chief economist at Standard & Poor's.

TIME: Are we more likely to see the deficit's effects in the short term or the long run?

EDWARD MCKELVEY: We'll see different effects. Right now we're seeing the effects of the tax cuts in the strength of consumer spending and maybe even some of the business spending. But as time progresses, if we continue to have the sort of deficit that we anticipate, hovering in the neighborhood of 4% of GDP over the next decade, then the effects will turn negative. They will come through in interest rates that are higher than they otherwise would be, and therefore growth will probably be less than it would otherwise be.

VERONIQUE DE RUGY: This deficit does matter because it shows that the government is spending too much. I think interest rates are very likely to go up, but it's going to be minor.

LAKSHMAN ACHUTHAN: It's very much a question of timing. Essentially, a weak economy trumps a deficit. Now, if we have an economy growing, it could put some wind at the back of interest rates and pose some hurdles for economic growth.

GARY BURTLESS: The short-term stimulus has undoubtedly helped reduce the severity of the recession, and it has helped buoy consumer spending. I would have to agree with Ed, though, that after three or four years, we're going to see a slowdown in the rate of growth.

DAVID WYSS: In the short term, we're at a 45-year low in interest rates--that's no reason to worry. Second, you have the lowest inflation rate we've seen since the Beatles were on the Ed Sullivan Show, which only a few of us here remember.

MCKELVEY: I remember.

WYSS: That's 1964, for the rest of you. But in the long run, we're going to have an issue. After 2010, when us baby boomers start to retire, that number is going to soar.

ACHUTHAN: So it's not that deficits don't matter--it's that sometimes they're at the front of the line and sometimes behind other concerns. Right now it's jobs.

TIME: I'm a little bit surprised that there is consensus about the tax cuts. Do you all agree that they were a good policy?

WYSS: Generally, I think the policy was correct. Deficits do work. The best advice that was ever given to a politician was what Joseph told the Pharaoh--you store up the grain in the good years, and you use it in the bad years. But they are taking only half that advice this time.

ACHUTHAN: There has obviously been some impact from the stimulus. But I don't know that it's had the desired effect. We have this jobless recovery, and this is not normal. You're losing jobs as the overall output is growing, in a way you've never seen before. So let's say you give tax cuts for capital investment. What is the result? You have a little bit of capital investment that increases productivity. That means that you don't have to hire someone.

MCKELVEY: The question is, How much can you use the budget, through spending or tax cuts, to stimulate the economy now? Then how do you peel back that stimulus when the economy's got momentum?

DE RUGY: You're saying we're spending a lot of money today, but in fact the cost of the tax cut is 25% of the deficit.

TIME: So there's room for more tax cuts?

DE RUGY: No, there's just no more room for spending.

ACHUTHAN: It's not that you're not getting something for your money. You're getting growth. It's going to go to 4% and 5% in the next couple of quarters. The problem is, it's not translating into the job growth you typically see. If you're a business, you take the tax incentive to invest in productivity-enhancing equipment, and you take the opportunity to move some labor costs abroad.

BURTLESS: Whether the tax cuts were well structured depends crucially on your view of the sunset provisions. The way the tax law is written, many of the cuts come to an end, but suppose they were made permanent. If you look ahead 40 years, taking into account the growth in Medicare, Social Security, Medicaid, we have the deficit at 4% of GDP. About 60% of that is due to the tax reductions of the first three years of this Administration.

MCKELVEY: Tax cuts are like the British Empire--the sun will never set on them.

WYSS: All of us baby boomers are reaching retirement age, and we're not going to give up any of those entitlements.

DE RUGY: That's why I think it's totally fiscally irresponsible to push through this $400 billion prescription-drug bill that the President is supporting. I have yet to hear anyone in the Administration saying where they're going to cut.

TIME: Why is the deficit more of a problem today than it was in the early '90s?

MCKELVEY: First of all, a lot of that improvement in the budget came not just from a strong economy but from a strong stock market and capital-gains tax revenues that flowed from that. And I don't think too many people expect a repeat of the buoyant stock market we had.

WYSS: I think there is a big difference in that we're 10 years closer to 2010. After that, when the baby boomers start retiring, expenditures really start spiraling up.

ACHUTHAN: The difference is, this time around it's a different recovery. You're not going to follow a pattern of jobs snapping back to the rise in growth.

TIME: Does that mean the kind of job loss we're seeing will not necessarily respond to fiscal stimulus?

ACHUTHAN: I wonder, because even if you have something happen with exchange rates, it's not going to remove the difference in cost production in Asia.

DE RUGY: The nature of jobs moving is changing drastically. Didn't GM say it was moving 300 legal jobs to India? Politicians are going to have to react, but they don't give any sign that they will.

ACHUTHAN: I'm not sure what they could do.

DE RUGY: Stop spending so irresponsibly. Or at least tell us where they want to cut.

MCKELVEY: Or that it might cost us more in higher taxes.

ACHUTHAN: You end up with a politician spending more to get the economy going, but because of these structural changes, those jobs we're losing are unlikely to come back. You're going to have to create new, different types of jobs.

TIME: Another industry, basically.

WYSS: It's a change in the structure of the job market. First, the payroll numbers miss new-corporation formation. In an economic upturn, that's a big deal. Second, companies are not hiring; they are putting people on contract. Those don't show up in the payroll numbers.

ACHUTHAN: The magic bullet that some are holding their breath for is a strong rebound in the economy that overwhelms all this. And that is probably less likely because of the structural changes.

TIME: Could you make some suggestions as to how to avoid these issues? Sunsetting tax provisions--is that one?

DE RUGY: I would disagree with that.

WYSS: In the long run, we have to raise taxes and cut spending. Politically, you can't do it all on the spending side.

MCKELVEY: Let's give President Bush Sr. the credit that he deserves for the famous reneging of the no-new-taxes pledge. We got a fairly good system that worked through most of the '90s in the pay-as-you-go discretionary caps. My first suggestion would be that maybe his son could borrow that page out of his book. Occasionally we need political judgments that might require an increase in taxes.

TIME: Is it inevitable taxes go back up?

WYSS: I'll give you 10 to 1, there will be a tax increase by the end of the decade.

MCKELVEY: Problem is, you will have this huge increase in taxes that's nothing more than peeling back what was done in 2001.

TIME: Were the cuts a mistake to begin with?

WYSS: No, but it does suggest there was fraud in passing them with the sunsets.

BURTLESS: Yes, it was a mistake. The policy stance of the 1990s, of budget stringency and monetary ease, was better for the growth of potential GDP.

TIME: The picture you paint is not a pretty one. We're going to have rising interest rates but not particularly strong growth. The manufacturing sector is going through a secular decline. And the people who are able to shift into new jobs, they'll be lucky if they get real jobs with full benefits. Is this where the economy is heading?

BURTLESS: I question the statement that we are not going to have particularly strong growth. Something goes on that affects total factor productivity growth, and we don't fully understand it. Fiscal and monetary policy in the '90s made it cheaper for businesses to finance investments in productivity. But it was way beyond any economic model to predict.

WYSS: We will get back to full employment. There will be more contract freelance jobs, and whether that's good or bad depends on you. Some people's skills are going to become obsolete. It becomes a Red Queen world, where you have to run faster and faster to stay in the same place.

MCKELVEY: If you're asking what does it mean to the average person, it means interest rates are higher than you might have otherwise had. It eventually means a threat to the growth rate, and it also means people will have this uncertainty whether Medicare and Social Security payments are going to come as promised. Right now the deficit is helping the economy grow, so it's very much an American story--more now at the risk of having to pay later.