Campaign Issues Deficits: Lunchtime Is Over

By Michael Kinsley

Take pity on Fiscal Chicken Little. This little chickie is getting a little hoarse. Shrieking "The sky is falling" quarter after sunny, seasonally adjusted quarter for the better part of a decade is weary work. In the sixth year of steady economic growth -- with unemployment at 5.6%, near its 14-year low, and inflation at 5.2%, modest by the standards of the early 1980s -- it is not easy to maintain the courage of your pessimism.

At least she's in good company. The shopworn notion that America has been living on credit cards, that the party has to end, that there's no free lunch, and so on and so forth, is not the sole possession of Democratic politicians (who, like Republicans, don't propose to do anything serious about it anyway). Variations on this theme are played in two new books by past heads of President Reagan's own Council of Economic Advisers. Murray Weidenbaum says in Rendezvous with Reality, "We are consuming more than we are producing, borrowing more than we are saving, and spending more than we are earning. We are rapidly approaching the time when we have to pay the piper." William Niskanen says in Reaganomics, "The federal budget reflects a fundamentally schizophrenic preference -- for federal spending of about 23% of GNP and for federal taxes of about 19% of GNP. Something must give."

Of course, no one says it better than the master himself. From his 1981 Inaugural Address (in the days when $80 billion was a record federal deficit and the rest of the world still owed America money): "You and I as individuals can, by borrowing, live beyond our means, but for only a limited period of time. Why, then, should we think that collectively, as a nation, we're not bound by that same limitation?"

If it's any comfort to the Cassandras, nobody -- Cassandra nor Pollyanna -- predicted the 1980s economy correctly. The decade began with the deepest recession since the Great Depression, engineered by the Federal Reserve Board to purge inflation. The early Reagan deficits helped stimulate the economy back into expansion -- a classic exercise in Keynesianism of the sort the President has spent his political career deploring (and still deplores, given half a chance).

The supply-side Pollyannas predicted that lower tax rates would induce huge increases in saving and investment, which would produce enormous growth, which would wipe out the deficits. They were wrong. Net private saving, which averaged 8.1% of GNP in the 1960s and 1970s, dropped to 5.8% in the 1980s. (It was 4.1% last year.) Investment in new plant and equipment averaged 3.3% of GNP in 1950-80 and 2.3% during the 1980s. Economic growth averaged 4.8% in the 1960s, 2.8% in the 1970s and 2.2% in the 1980s. And we know what happened to the deficit.

The Cassandras predicted that huge deficits during an economic recovery would inevitably lead to renewed inflation (if the Fed went along by increasing the money supply) or an interest-rate squeeze and a U-turn back into recession (if the Fed held fast). They also were wrong. They overlooked the new globalization of credit markets and the willingness of foreigners to step in and supply the dough. The Cassandras have been updating their scenarios throughout the 1980s: the overvalued dollar will destroy American industry; or, the undervalued dollar will hand American industry to foreigners; or, when the foreigners get tired of spotting us, interest rates will shoot up, and we'll have a recession; or, as the trade deficit narrows, domestic and export demand will combine to create inflation; or, the burning of Brazilian rain forests will deprive the world of oxygen, and we'll all choke to death; etc. But the sky hasn't fallen. And trying to persuade people it's going to fall any minute is probably not the best way to build a consensus on the next step.

Maybe the next President can muddle through four years without either a crisis or a dramatic effort to avert one. But Reagan was right in 1981: a society, like an individual family, cannot live beyond its means indefinitely. In fact, if it wants to prosper and grow, it cannot even live at its means. It must save and invest for the future. We have not been doing that, and unless this changes we will suffer for it, even if the suffering takes the form of slow stagnation rather than some bloodcurdling cataclysm.

The budget deficit and the trade deficit are really aspects of the problem of too much consumption and not enough saving. As Harvard professor Benjamin Friedman points out in his forthcoming book Day of Reckoning, the share of national income raised in federal taxes is exactly what it was in 1979, but the share returning to individuals in the form of transfer payments (Social Security and so on) has gone up. The Government borrows the difference, thus replacing national savings with consumption. The 1980s' consumption boom, Friedman notes, has been financed in three ways: by this shift in the Government budget; by a larger share of the population in the work force (owing to the maturing of the baby boomers and women going to work, two social trends that have just about reached their limit); and by lower investment for future growth. Meanwhile, when foreigners lend us the difference between our anemic investment rate and our even more anemic savings rate, this means that a large chunk of our future prosperity will go to them, not to us.

The next President's simple economic challenge, therefore, is to arrange for America to consume less and save more. And the best way to do that is -- yes, tedious but true -- to reduce the federal deficit by reducing spending and/or raising taxes.

This still leaves plenty to argue about. To what extent is Government spending -- on highways, on science research, on education, on health -- a form of investment rather than present consumption? (Answer: a lot, but less than in the past and not enough to excuse the present deficit.) Apart from deficit reduction, do we need new policies to encourage savings and investment in the private sector? (Answer: perhaps, but be suspicious of both conservative schemes that amount to new tax breaks for rich folks and liberal schemes that amount to Government officials trying to play business better than businessmen.) Are trade restrictions a sensible way to reduce consumption of imported goods? (Answer: no.)

Above all, how do we get there from here? That is, How do we engineer a reduction in consumption that will lead to productive investment rather than a self-feeding economic contraction and recession? Actually, there isn't much dispute about this one. If the deficit were to come down, the Fed would gladly accommodate this "tight" fiscal policy with a "loose" monetary policy. Low interest rates would spur private investment to take up the slack in demand, and everyone would live happily ever after.

Two of the most dangerous economic illusions of the Reagan years are that we have somehow abolished the business cycle and the Phillips curve. The first is that occasional economic slowdowns are unavoidable; the second is the principle that there is a trade-off between policies to prevent recession and policies to prevent inflation. Antirecession medicines are pleasant, even addictive, while anti-inflation medicines are not, and Presidents always prefer the former. The moral challenge for our society is not to squander the Fed's tremendously costly victory over the inflation of the early 1980s. Any program of reviving investment and savings depends on having a stable currency.

Anyone not running for office can come up with a shopping list of budget cuts and new revenue sources (yes, yes, taxes) to close the deficit gap. The leadership challenge is getting at least 51% of Americans to agree to any particular list. A recent Gallup Poll for the Times Mirror Co. offered 20 possible deficit-reduction measures. Only three got majority support. Interestingly, all three were tax hikes: on people earning over $80,000, on alcohol and on tobacco.

More important than the particulars are the principles that should guide the revenue hunt. First is that the deficit gap cannot be closed painlessly by George Bush's proposed "flexible freeze" or by Michael Dukakis' proposed war on tax cheats. In either case, the numbers just don't add up.

The second principle is that spending cuts should come from subsidies to the middle class, not genuine Government investment or programs that aid the poor. Obvious targets are farm programs, Social Security and our disproportionate share of the defense of Europe and Japan, which is a subsidy to middle-class foreigners. But merely to list these is to build a monument to hopelessness. That's why, for all the candidates' bluster, salvation will probably come, if at all, on the revenue side.

The principles guiding the search for new tax revenues should be: no increases in marginal tax rates, and no gimmicks (such as Bush's proposed capital-gains tax cut) that supposedly would increase revenues by lowering rates. Lunchtime is over. There are genuine revenue raisers that would have a minimal effect on saving and investment. Some obvious ones: increasing the gasoline tax (worth about a billion dollars a penny) and taxing accrued capital gains at death (currently a $5 billion-a-year loophole).

Current projections by the Congressional Budget Office (CBO) show the deficit shrinking to $121 billion by 1994, or only 1.7% of GNP (this year's $155 billion is 3.2% of GNP), even without dramatic changes (though also without a recession for another six years). But the projected 1994 deficit would be $234 billion if not for a $113 billion surplus in the Social Security trust funds. Although he doesn't advertise the fact, President Reagan signed the biggest tax increase in history in the form of the 1983 Social Security reform, which will be generating gargantuan sums for the next several decades. And although Social Security has been ostentatiously taken "off-budget," its surpluses (which are lent back to the Government) are subtracted in computing the total federal deficit.

There are two problems with this increasingly convenient arrangement. One is that the Social Security tax is tremendously unfair. While the regular income tax exempts low incomes, Social Security exempts high incomes (over $45,000). It also exempts all investment income: interest, dividends, capital gains. Using such a tax to fund a workers' retirement program is one thing; using it to fund the general workings of Government is another. The second problem is double counting: you can't pretend this money is reducing the deficit today while also pretending that it is available, with interest, to fund baby boomers' retirements in the next century. Huge tax increases or benefit reductions will be needed when it's time to take the money out of this alleged trust fund. At best, the Social Security surplus offers the next President a chance to keep practicing credit-card economics on a Reaganite scale.

True leadership means leading people where they don't want to go. It takes a Moses to lead his people into the desert; anyone can lead them into the promised land. By this exalted standard, how much economic leadership will the next President need to have? Not much, really. Professor Friedman, whose whole point in Day of Reckoning is to induce panic, notes that closing the trade gap and servicing the accumulated foreign debt will require reducing the share of national income going to consumption by 5%.

That sounds formidable. But personal-consumption spending has increased more than 26% in real terms during 1981-87. (GNP has increased only 19.8%: that's the problem. Even if all growth stopped tomorrow, putting our international accounts in order would require moving us back to the standard of living of mid-1986, hardly a heroic sacrifice. Now let's keep going. If, in addition, we wanted to increase our national savings rate, currently 2.8% of GNP, back to the post-Worl War II levels of about 7.5%, we need to reduce consumption by another 5% or so. That puts us back to the impoverished life-style of mid- 1985.

And growth has not stopped. If the CBO's estimate of 2.3% a year is right, we'd be home free if the next President could persuade us simply to hold consumption at its present levels for his first term, using the dividends of economic growth to pay off our debts and invest for an even more prosperous future.

Maybe the sky won't fall if we don't do something like this. But don't blame Chicken Little if it does. Cluck, cluck.