The faith-based economics of deficit reduction

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Dean Baker

Dean Baker is co-director of the Center for Economic and Policy Research

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June 10th, 2011 12:25 PM

The faith-based economics of deficit reduction

Deficit cutting has become the common 'wisdom' of economic policy wonks in DC. But it can't muster one rational argument

By Dean Baker

Sometimes, it can be fun to get inside a crazy worldview to ask how it deals with contradictory evidence. For example, how do creationists reconcile their view that all plants and animals were created in their current form around 10,000 years ago, with fossil evidence of life forms dating back hundreds of millions of years?

In this vein, it's worth asking how the proponents of deficit reduction think that lower deficits will lead to increased growth and job creation in an economy mired in a severe slump? There is not an easy answer.

There is a standard "econ 101" story about how reducing deficits can boost the economy. The theory goes that if the government reduces its deficit, and therefore borrows less, it will reduce interest rates. Lower interest rates will, in turn, give firms incentive to invest more.

Lower interest rates should also cause the dollar to decline, since it will make US government bonds and other dollar assets less attractive to foreign investors. If the dollar falls in value, then our goods will be more competitive on world markets. This will cause us to import less and export more, thereby creating jobs.

However, is this what the deficit hawks believe will happen now? The interest rate on 10-year Treasury bonds is already down to 3.0%. Assuming a 2% inflation rate, this translates into a real rate of about 1%. How much lower do the deficit hawks think interest rates will fall if we were to sharply cut the deficit? Furthermore, how much more investment do they think we can induce even if we got a large reduction (for example, 0.5 percentage point) in real interest rates?

Do they think that this sort of decline in interest rates will send the dollar tumbling and thereby improve our trade balance? Against which currencies will a lower interest rate cause the dollar to fall sharply?

Neither of these stories really passes the laugh test. At best, we may hope to see modestly lower interest rates if cutting the budget deficit slows growth further. But there is no reason to expect any future decline to have any more impact than the recent decline in the 10-year Treasury rate from 3.6% in the winter to near 3.0% present this month.

There is another story that the deficit hawks occasionally push. This one says that if we lay off workers in the public sector, that will increase employment in the private sector. The story here is, presumably, that mass layoffs of public sector workers will depress the wages of workers further, thereby making it more profitable for employers to hire them. There's a simple problem in this picture. In order for wages to actually fall, the additional employment in the private sector must not be as large as the job loss in the public sector.

In other words, if we lay off 500,000 public sector workers, then the private sector must increase employment by less than 500,000 workers; otherwise, wages would rise, not fall, and businesses would then not have any incentive to hire more workers. This means that this route of economic stimulus through government cutbacks can, at best, get us close to where we were before the layoffs. It is not a way to add jobs to the economy. And even in a best case scenario, it would take a considerable period of time to get close to that situation, since wages do not fall quickly.

Neither of these channels sounds very promising, as almost any serious person would have to acknowledge. This leaves the mystery channel of bad feelings. This story goes that businesses feel bad about the deficit. They are worried that they might pay higher taxes in the future, there could be inflation, or the government could collapse. For these reasons, businesses that would otherwise be investing their hefty profits are, instead, sitting on them.

There are two problems with the bad feelings story. First, businesses actually are investing at a pretty healthy rate. There was huge overbuilding of structures in the real estate boom, but investment in equipment and software as a share of GDP is almost back to its pre-recession level. Given the excess capacity in this sector, we really should be asking why investment is so high, not why it is low.

The second problem with this story is that the fear of higher taxes in the future is a good reason for businesses to try to invest and earn profits now. When the congressional budget office used various models to examine the impact of Bush-type tax cuts, the ones that showed the most positive effects were ones that assumed the tax cuts would be temporary. This effectively pulled investment and work effort forward into the low tax period. The point is that if people really believed they would pay much higher taxes in the future, then they should be working hard and investing today – the opposite of the deficit hawk story.

So, finally, we don't have a coherent story as to how reducing the budget deficit will boost growth – just as the creationists don't have a coherent explanation for what we know about the plant and animal kingdoms. The big difference is that the deficit hawks are determining economic policy.