Q: From a macroeconomics perspective, what's the best way to view the federal deficit?
A: I think it's probably best to look at the change in the ratio between national debt and gross domestic product.
The government is now running deficits that allow the debt-to-GDP ratio to stabilize. That's probably sustainable from a macro perspective. GDP at almost $7 trillion and annual deficits at about $200 billion give you a stable or slightly declining debt-to-GDP ratio.
There's some specific arithmetic that enables you to determine its behavior. On average the ratio can stabilize if the real growth rate is about equal to the real interest rate on the debt. We didn't achieve that in the 1980s. But we're back on a sustainable path in the 1990s.
Economist look out beyond the year 2000 and say the deficit will start rising again. I don't anticipate it rising very rapidly unless the government enacts a big new program.
Q: Is there much of a relationship between government debt and interest rates?
A: That's one of the most discussed questions in economics. It's the subject of a lot of casual empiricism. As an academic, I spent a lot of my time looking for a relationship. I was only able to find that there is upward pressure on interest rates when the deficit is rising fast enough to push up the debt-to-GDP ratio at an accelerating rate.
Of course, that situation can't last very long. Eventually the discipline of the market kicks in and people won't accept the government's debt. The bond market is a restraining force.
It is not surprising that real interest rates remained positive in the 1980s. Investors were not going to make the same mistake twice. Real rates were persistently negative in the 1970s because bondholders were fooled into thinking inflation was going to calm back down like it did in the 1950s and 1960s. Given the experience of the 1970s, bondholders imposed a higher risk premium in the 1980s. After two years of declining inflation, we've seen some of that fear disappear in the 1990s.
Q: Can the government exert downward pressure on long-term interest rates by reducing the annual deficit?
A: No. It's too small of a variable to detect. But I think most governments are convinced that they can do that. A lot of governments have endured a lot of pain as a result and have been disappointed. Other factors are much more important, such as demand for credit, what the central bank is doing, and inflationary expectations. For example, you may find yourself with high interest rates because there's an investment boom. There's nothing wrong with that and nothing you should do about it.
Q: Do you oppose a balanced budget amendment?
A: That question gets into an area that economists don't understand very well. It's really a political question. You can write a law saying you have to balance he budget. You can also call spending on capital equipment an investment and amortize that over several years. That gives you a lot of flexibility, a lot more tricks at your disposal. And surely there will be a politician who says if we can call a weapons system an investment there's no reason why we can't do the same thing with education or health care.
You avoid the fact that cutting the deficit means cutting spending or raising taxes. In general, I much prefer cutting spending because raising taxes cuts the revenue base by slowing growth and giving people more incentive to avoid paying taxes.
Q: Are there any political reforms that you'd like to see pertaining to the budget and the deficit, such as the line-item veto?
A: My own feeling is that the government should decide to spend only about as much as it takes in and adjust the scope of what it does accordingly. But it's not essential that you balance the budget. It's okay to have a deficit that maintains a stable debt-to-GDP ratio.
One of the things we do in the book is compare the balance sheet and income statement of the federal government with those of a typical large corporation. We found the government doesn't look so bad. It looks like a typical large corporation, in that it's relatively conservative given it's unlimited taxing power.
Q: The administration says the best way to tame the deficit is to control health care costs because it is essentially impossible to lower interest payments. What do you think of that logic?
A: Well in fact, you can lower interest payments by reducing the debt-to-GDP ratio. So in fact, reducing the current deficit amid continued growth does help some.
I don't see how an extensive federal health care program is going to help solve the deficit problem. To me it looks like a repeat of Medicare/Medicaid, where coverage keeps expanding. The administration wants to expand coverage to everyone. The only way that costs could be controlled is through implicit rationing, which is what Canada and Europe do. Under that system, you can get your sore thumb taken care of but you better take a book to read because you'll have to wait a day or so. And if you have a serious malady it could take even longer.
Q: What does the deficit picture look like through this decade?
A: I need to know what's going to happen with health care before I can make a specific forecast. My guess is that we'll see some moderate expansion of health care spending. Assuming that and barring the need no pump the defense budget back up, we'll probably see the debt-to-GDP ratio stabilize or decline slightly for the balance of the decade.
Two or three years ago, it became the vogue to be overly pessimistic about the deficit. For example, estimates for 1993 started at $330 billion and analyst were saying we'd have $300-plus billion deficits for as far as the eye can see. In fact, we actually got about a $250 billion deficit last year. Analysis did not anticipate the Resolution Trust Corp. problem going away so fast. The Federal Reserve was essentially able to repair bank and thrift balance sheets with a steep yield curve. And the 1990 budget agreement did slow growth in spending.
Actually, I think the deficit won't be a very interesting issue the best of this decade.
Q: Is the deficit a problem? And what should the government's goals be regarding the deficit?
A: At current levels, I guess I don't think the deficit is much of a problem from a macroeconomics standpoint. I do think the government ought to be thinking very conservatively about the things it wants to do.
The government always seems to be looking for more money. This brings up some interesting questions. Are payroll taxes, which are used to finance retirement programs, at a level where they penalize the hiring of labor? I think they are. One reason why people elect to buy new capital rather than hire another person is that the marginal cost of hiring is too high. We have payroll taxes close to 16% and plus. So people hire machines rather than people. That's been a defining characteristic of this recovery. So the government ought to think very hard about relying on payroll taxes, especially in the context of health care reform. I find it truly amazing to look at European economies, saddled with payroll taxes from 25% to 30%.
Q: Is the federal deficit by definition expansionary fiscal policy, regardless of whether it's rising or falling?
A: That's a tricky question. The deficit is expansionary in the sense that if you eliminated it growth would slow. But I'm not sure some the deficit causes the economy to grow faster because the deficit requires the central bank to be quite conservative. There is some modest bias toward higher rates. If you're selling $200 billion of government paper each year, you've got to keep the market in good shape. And that's one of the big drawbacks: It puts you in a defensive position so that the central bank has to be very careful to stay ahead of the inflation curve.
Q: In a recent speech, you said Congress cannot be trusted to remain vigilant about reducing the deficit.
A: That's true. I think this may be the last year there will be any political mileage to be gained from cutting the deficit. Also, health care reform is likely to cause the deficit to rise. And everyone is assuming a peaceful , stable world that will allow us to enjoy declining defense spending. History being what it is, that may not be a prudent assumption.
Q: What is the main point you want people to get from your new book?
A: The main message is that there is this law of unintended consequences. Things that are intended to reduce the deficit, sometimes don't. For example, social security benefits were indexed for inflation to control their growth just as we entered a period of rapid inflation. So the opposite occurred.
Q: and A:
with John Makin
Director of Fiscal Policy Studies
American Enterprise Institute
Fear and loathing of the federal budget deficit has played a major role in shaping policy discussions in the nation's capital for at least the last 15 years.
The deficit fell last year from a record high of $290 billion set in fiscal 1992 and is expected to fall again this year, which would be the first time in 20 years the deficit has fallen for two straight years.
Is the deficit problem going away?
Probably not, says John Makin, director of fiscal studies at the American Enterprises Institute in Washington. Are deficits going to matter much to the economy during the rest of the 1990s? Again, Makin says, probably not.
Other financial economists consider Makin, who is also chief economist of Caxton Corp., to be an expert on the deficit and its effects on both interest rates and the economy as a whole.
Makin's latest book, "Debt and Taxes: How America Got into Its Budget Mess and What Do About It" (Random House, 304 pages), co-written with Norman Ornstein, a political scholar at the institute, was published recently.
Here, Makin discusses his perspective on the federal deficit in the 1990s and his new book with staff reporter Dean Patterson.
