The problem with deficits

The consequences of the United States’ growing federal budget deficit were brought into better focus recently. In his testimony on Capitol Hill on April 29, Alan Greenspan discussed recent economic research that very convincingly shows that higher budget deficits lead to higher interest rates. The implication? We do in fact need to worry about the budget deficit, which is growing worse by the week, and is now likely to reach $400 billion for this year alone.

Of course, the idea that budget deficits lead to higher interest rates is not new to anyone who has taken a course in economics. Even those who haven’t formally studied economics can easily see the logic: if the U.S. government borrows more money, then there will be less money left over for businesses and individuals, which will make it more expensive for everyone in the country to borrow – and presto, we have higher interest rates.

In the past, President Bush agreed with this logic. In April 2002 he remarked, “I’m mindful of what overspending can mean to interest rates.” This concern is shared by the vast majority of economists.

Recently, however, members of the Bush administration have made several attempts to downplay this effect on interest rates, and thus the danger of large budget deficits. In a speech on Jan. 10, Dick Cheney said that he doesn’t believe budget deficits cause interest rates to rise. Similarly, White House Budget Director Mitch Daniels and Bush’s first chief economist, Glenn Hubbard, called the standard, common sense idea that deficits raise interest rates “nonsense.” Hubbard and others even coined a term to describe the linkage between budget deficits and interest rates, calling it “Rubinomics,” after Clinton Treasury Secretary Robert Rubin.

Using a clever and sarcastic name for this economic phenomenon doesn’t make it less true, however. The most recent and rigorous economic research, which Greenspan called “exceptionally good” in his testimony last week, now shows that budget deficits do indeed lead to significantly higher interest rates.

What does this mean for you and me? Two things. In the short run – say, over the next year or two – deficits are probably a good thing to help stimulate the economy. But over the longer run, persistently large deficits will increase interest rates. So over the next several years we can expect to pay more on our credit card debts, car loans and home mortgages than we would otherwise. Similarly, higher interest rates will cause private businesses to take fewer risks and expand more slowly, thus slowing the real engine for long-run growth.

Second, running persistently large budget deficits mean that our kids and grandkids will face higher taxes as it comes time to repay that debt. For the rest of their lives they will have to pay for the spending we are doing right now. In his first budget President Bush wanted to ensure that “future generations are not shackled with the responsibility of paying for the current generation’s overspending.” Unfortunately, making future generations pay for our current spending is exactly what our government is now doing. Doesn’t seem fair, does it?

It’s natural to wonder why the deficit has grown so dramatically recently. Part of the answer is the sluggish economy, of course. The long-run deficit was also significantly worsened by the huge tax cut of 2001, and will be worsened still further by any subsequent long-term tax cuts, such as those the president has recently proposed.

But you may be surprised to learn that the budget deficit is also significantly due to skyrocketing government spending over the past two years. Consider this: from 1992 to 2000, federal spending grew by a total of just 9.6 percent, adjusted for inflation. But since 2000, expenditures have leapt by more than $300 billion a year, which translates to a nearly 20 percent rise in real spending in the last 21/2 years, compared to less than a 10 percent increase over the previous eight. We are currently experiencing the fastest growth in government spending since the “Great Society” push of the 1960s.

Some of this increased spending certainly may be reasonable, given our security threats – indeed, much of this is simply for the military. But keep in mind that the incredibly successful wars in Afghanistan and Iraq were fought primarily using a military that was built during the 1990s. Increased defense spending today will take some years before it yields a much larger military. As for whether we will need a military much larger than the one that just won so easily in Iraq, your guess is as good as mine.

Exactly what we’re spending all of this extra money on is a different subject, however. What we have learned quite convincingly in the past weeks is that massive budget deficits will have real, harmful long-term consequences for us and for our children. One member of Maine’s congressional delegation, Sen. Olympia Snowe, deserves credit for recognizing this and taking a stand to limit the long-run revenue effects of a new tax cut. Hopefully other representatives in Washington will also remember the problem with deficits as they work on the budget over the coming months.

Kashif S. Mansori is assistant professor of economics at Colby College.