Seeing Red: The Budget Deficit - Past, Present and Future

In Fiscal Year (FY) 2009, the United States government incurred its largest ever peacetime budget deficit of $1.4 trillion, equal to 10 percent of GDP.  The way out of this fiscal hole must surely involve the slaughter of some of the sacred cows of both the right and left.  A review of earlier cycles of deficit growth and contraction – the 1930s, World War II, and the 1980s – reveals the full magnitude of the current imbalance and the harsh choices necessary to restore fiscal sustainability.

The United States operated deficits averaging 4.8 percent of GDP during the worst Depression years of FY1932-1936, but the imbalance only averaged 2.2 percent in FDR’s second term.  What the experience of the 1930s teaches above all, however, is not how to bring recession deficits under control but the need to ensure that deficits are sufficiently large to stimulate economic recovery during a serious downturn.  Roosevelt’s reluctance to run up bigger imbalances contributed to the longevity of the Depression and his effort to balance the FY1938 budget in the belief that recovery was at hand only generated a new recession.  The lesson for today is not to turn off the stimulus spigot too soon in the interest of short-term budget repair because strong economic recovery is essential for long-term growth of federal tax revenues. 

Averaging 22.2 percent of GDP, the World War II deficits of FY1942-1945 dwarfed those of today, but fiscal recovery was also more rapid than is possible in current circumstances.  The war dragged the economy out of the 1930s Depression and laid the basis for sustainable economic expansion in the post-war era. The combination of economic growth and the massive expansion of income tax eligibility that was a legacy of World War II generated bumper revenues for government coffers.  Federal receipts mushroomed from 6.8 percent of GDP in FY1940 to 14.4 percent of GDP ten years later and 17.9 percent of GDP in FY1960.  This development underwrote a quarter-century of relative fiscal equilibrium that lasted until the economically troubled 1970s and allowed for a spectacular reduction of the public debt from its record level of 108.6 percent of GDP in FY1946 to 28 percent in FY1970.   

The deficit mushroomed once more in the 1980s thanks in large part to Ronald Reagan’s promotion of the largest tax cuts in American history and the largest defense expansion since the Korean War, without corollary cuts in domestic spending.  Having borrowed from the future in this era, the United States faced up to the necessity of payback to put its fiscal house in order in the next decade.  Taking an option not open to current policymakers, post-cold war retrenchment reduced annual defense spending from some 6 percent of GDP to 3 percent.  Moreover, despite the fervent partisanship of the era, two of the main three deficit reduction initiatives of the 1990s – those of 1990 and 1997 (Clinton’s 1993 program was the sole exception) – entailed bipartisan cooperation.  Finally, progress on deficit reduction eased investor fears of inflation, thereby allowing the Federal Reserve to relax monetary policy, which had the consequence of creating a massive boom that in turn produced huge budget surpluses in FY1998-2001.

History, therefore, does not offer much of a guide for current policymakers who face fiscal problems of an entirely different order.  There is little prospect that spectacular economic recovery can resolve America’s fiscal problems as happened after World War II and in the 1990s because the budgetary future would have been bleak even without the worst recession since the 1930s.  America’s fiscal difficulties are fundamentally structural, in other words the result of policy decisions, rather than the cyclical.  Without doubt, recovery from the recession is a precondition to addressing these structural problems, so the movement from fiscal stimulus to restraint must not be too abrupt, but it must start before too long.

The currently deep partisan divisions on fiscal issues do not augur well for budgetary repair, but bi-partisan cooperation and compromise are essential to reach agreement on key issues.  It is difficult to see how fiscal recovery is to be achieved without revenue enhancement that will require Republican acceptance of higher taxes.  Had all the Bush tax cuts been allowed to expire on schedule at the end of 2010, the resultant increase of 2 percent of GDP in revenues would have generated immediate improvement in the budgetary outlook.  Even forty years of additional receipts, however, would not prevent the public debt reaching 171 percent of GDP by 2050.

To prevent this development, the Democrats have to accept reform of the Social Security, Medicare and Medicaid entitlements in a manner that does not penalize the less well-off. A Social Security fix could be achieved through COLA reductions, raising the retirement age, and substitution of price indexing for wage indexing to determine initial benefits.  Reform of medical entitlements is both more pressing and more difficult since beneficiary costs have been increasing on annual average by 2.5 percent more than per capita GDP since 1970.  If there is general agreement about the scope of the problem, there is corresponding dissensus on its resolution as the current debate over the healthcare bill vividly illustrates.

Without entitlement reform and revenue enhancement, however, the United States is looking into the fiscal abyss.  The Center for Budget Policy and Priorities estimates that the steady expansion of the deficit from 2020 will push it up to 21 percent in 2050, by when – thanks to compound interest – the public debt will equate to 279 percent of GDP.  Skeptics may scoff that no-one can predict the future with accuracy, but ignoring the risk is a huge gamble.  Adding to America’s problems, it has become increasingly dependent on foreign central banks, notably China’s, to finance government debt.  Abraham Lincoln remarked of the mushrooming Civil War debt, “Men readily perceive that they can not be much oppressed by a debt which they owe to themselves.”  Matters are entirely different in the twenty-first century.  The dangers of a foreign retreat from Treasury securities are slight in the short-term but increase over time as the public debt continues to grow.  Americans would do well to realize that things which cannot go on forever tend not to.