Would a Balanced Budget Amendment Help or Hurt?

One component of the deal to raise the debt-ceiling is a requirement that Congress vote later this year on a “Balanced Budget Amendment” to the Constitution.  Is such an amendment a good idea?  At first glance, the idea seems attractive to a lot of people for whom the debt and deficits are seen as the key problem facing the economy (I am not one of these people).  After all, if you believe debt is bad, and debt comes from having deficits, then why not just pass a law amendment to the constitution that prohibits deficits, right? Well there are several problems with the idea.  Some are strategic – it’s really not a good idea to force a balanced budget every year.  But other problems are practical – the amendment, particularly as proposed now, simply wouldn’t work and would set up perverse incentives. Let’s look at these problems.

First off, there’s a bit of false advertising on the part of advocates of the “balanced budget amendment”.  The reality of what has been proposed goes beyond requiring a balanced budget.  A balanced budget would simply require government revenues to equal government expenditures each year.  The currently proposed amendment is really a “balanced budget with a strict cap on spending amendment”.  It has two parts. Not only would the budget have to be balanced each year, but the government spending would limited to 18% of GDP unless overridden by a 2/3 majority of Congress. The spending cap would limit government expenditures even if the budget were balanced.  The advocates of the balanced budget amendment, most of whom are Tea Party Republicans, are really proposing to re-write the Constitution to make it impossible for a majority of the duly elected Congress to expand the government beyond the limits they want.  It’s a rewrite of democracy.

The amendment and the spending cap in particular are totally unworkable in a practical sense.  First, the amendment and spending cap assumes that GDP and government spending are independent variables.  They aren’t.  In fact, government spending (G) helps determine GDP both directly since it  is a component of GDP and indirectly since the other components, consumption spending (C) and investment spending (I) and net exports (X-M) are themselves partially functions of government spending.  GDP = C + I + G + (X-M) by definition.  If you cut G, you cut GDP.  Suppose GDP = 100 and G = 20.  That’s government spending is 20% of GDP.  That would be too high under the amendment and would require a cut of government spending – revenue increase would not be allowed.  So suppose government cuts it’s spending to 18.  Keep in mind such a cut would be monumental. That would be a 10% (2/20) cut in government spending and we just had a paralyzing debate in Washington over how to cut spending by only 2-5%.  Imagine trying to cut 10%!   But even if the government did it, it wouldn’t work.  Because cutting government spending from 20 to 18 would take GDP down also.  The cuts would reduce both numerator and denominator.  If spending were cut to 18, then GDP would be no higher than 98, still leaving government spending as 18.37% of GDP. It would still be above the limit and require even deeper cuts which would then also cut GDP.  The reality would be even grimmer because C, I, and net exports all are partially influenced by government spending.  If you cut government spending for example, the people who got paid that government money, be they defense contractors, Social Security beneficiaries, teachers, or Medicare doctors, experience lower incomes.  They then cut their consumption spending and investment spending.  This is called the multiplier effect.

The practical problems are even greater when revenue is considered.  Government revenue, or taxes, are effectively a % of GDP.  That’s because virtually all the money collected by the government comes from GDP-related activity. Virtually all government revenue is either income taxes, payroll taxes, corporate profits taxes, or excise taxes on things that are used in production like gas.  If GDP goes up, then taxes collected goes up. If GDP goes down, then taxes go down also. Government spending goes in the opposite direction. When GDP goes up, many spending categories decline like unemployment compensation, welfare, Medicaid, etc. When GDP goes down, those spending items go up automatically.  These are called automatic stabilizers and they’re a major reason why recessions after World War II had been so mild compared to the depressions experienced routinely before WWII.  A balanced budget amendment means getting rid of automatic stabilizers and making mild recessions into worse recessions or even depressions. As  Simon Johnson at Baseline Conspiracy  put it:

 It makes no sense to target, as a matter of constitutional process, two numbers that are both outcomes of deeper economic processes.

A second very serious practical problem is with measurement.  GDP, while it’s commonly used and accepted, is only an economic concept, not a legal one.  The definition and calculation of GDP is subject to interpretation and depends on the prevailing views of statisticians and economists during any such era.  Simon Johnson at Baseline Conspiracy explains:

But GDP is not a legal concept – rather it is an economic measure, the details of which change all the time, subject to the prevailing view of best practice among statisticians.  Just to take one example, the flow value of housing services for people who own their houses is “imputed” to create a number that is roughly equivalent to what renters pay.  The goal is to more accurately measure a key component of consumption, which comprises the largest category of spending within GDP.  But the emphasis here is on “roughly” – the models used are sometimes called into question and must be revised from time to time.  And imputed spending on housing is a big number – probably around $1 trillion in today’s economy (with total GDP at about $15 trillion).

If an enterprising future administration wanted to lower spending relative to measured GDP, they could convene a panel of experts that could duly find that our current practice of not valuing household services – like cooking and taking care of children – is a statistical aberration as well as an affront to people who work very hard.  That should add at least $5 trillion to our annual GDP.  Alternatively, a statistical adjustment in the other direction would force real and painful spending cuts.  The constitution is the wrong place to pursue such details.

GDP is too fuzzy and imprecise of a measure, with too much estimation involved, to be enshrined in the constitution.  As an analogy, suppose we decided that we wanted to avoid the recent acrimonious debate over raising the debt-ceiling.  Suppose we thought too many Congresspeople acted too childishly.  Imagine if there were a proposal for a constitution amendment that required only “mature and intelligent ” adults “with an IQ above average” be allowed to run for Congress.  How would mature be defined?  How would it be measured?  We would make Congress dependent on a test, an IQ test, that itself is subject to revision and interpretation.  Later administrations would pressure psychologists to change the IQ test to satisfy the needs of their party.  The same happens if we enshrine GDP as a requirement in the Constitution.

In policy terms, the balanced budget amendment is a very bad idea. A balanced budget requirement forces the government to act pro-cyclically instead of counter-cyclically.  This means instead of fighting a recession, the government’s actions would make the recession worse.  Granted there are provisions in the amendment to waive the balanced budget requirement if GDP drops 10%, but keep in mind how severe that is.  The Great Recession/Financial Crisis of 2007-09 was only a 6% drop in GDP.  Government wouldn’t have been able to counter it.  The stimulus program, which was too small to trigger recovery but did successfully stop the free-fall, wouldn’t have happened until the crisis had indeed become as bad as the Great Depression.  A balanced budget amendment means a return to the old days before World War II when the U.S. routinely experienced severe depressions and financial crises. Again Simon Johnson:

.. sometimes it makes a great of sense to apply an economic stimulus to an economy in freefall.  One such moment was 1930 (and 1931 and 1932), when no stimulus was applied.  Other moments were 2008 and 2009; both President Bush and President Obama initiated stimulus packages.  When credit for and confidence in the private sector evaporates, do you really want the government sector to be forced to make quick cuts – or raise taxes?..

The second policy objection to this balanced budget amendment is that it is really a back-door attempt to circumvent democratic debate and decision-making.  The amendment proposes to limit government as part of the economy to 18%.  But why 18%?  Supporters claim that is what the U.S. has spent on average in recent decades.  But why is that the right number?  The size of government is a political, democratic choice that is up to the population at the time.  If today’s population wants a smaller government, they can elect politicians to do that.  And if some future generation should decide that 18% is not the right number, that maybe they want a different set of priorities and to devote a larger share of the nation’s resources to public goods, why shouldn’t they be able to do that?  Many nations devote a much higher % of GDP to public goods instead of private consumption goods.  Their economies are successful and their people are satisfied with it.  Having the current crop of legislators set a limit on what future generations may choose or do is not consistent with the concept of responsive democratic government.  It makes no more sense to enshrine an 18% limit on government spending in the constitution than it does to constitutionally enshrine a fixed limit on the number of soldiers the government may have.  It should be up to the representatives of each generation.

I’m not the only one who’s opposed to a balanced budget amendment.  And, the opposition isn’t all “Keynesian Democrats” (I don’t qualify as one of those either).  Simon Johnson, the author I’ve quoted above, is a former Chief Economist for the IMF.  The IMF has historically advocated and pushed for balanced budgets, yet it opposes this kind of handcuffs of economic policy.  Further, a Republican economist, Bruce Bartlett, has articulated many of these same problems with the amendment.

Debt-Ceiling: An Absurd, Unnecessary Law

The debt-ceiling circus in Washington continues as I write this.  The Republicans seem bound and determined to ruin the “full faith and credit” of the United States, while President Obama is frustrated that the Republicans won’t accept his deals to cut Social Security and Medicare.  None of this is necessary.  We don’t need a debt ceiling.  It’s absurd. It’s counterproductive.  It’s self-destructive.

James Surowiecki of The New Yorker writes (emphasis is mine):

The truth is that the United States doesn’t need, and shouldn’t have, a debt ceiling. Every other democratic country, with the exception of Denmark, does fine without one. There’s no debt limit in the Constitution. And, if Congress really wants to hold down government debt, it already has a way to do so that doesn’t risk economic chaos—namely, the annual budgeting process. The only reason we need to lift the debt ceiling, after all, is to pay for spending that Congress has already authorized. If the debt ceiling isn’t raised, we’ll face an absurd scenario in which Congress will have ordered the President to execute two laws that are flatly at odds with each other. If he obeys the debt ceiling, he cannot spend the money that Congress has told him to spend, which is why most government functions will be shut down. Yet if he spends the money as Congress has authorized him to he’ll end up violating the debt ceiling.

As it happens, the debt ceiling, which was adopted in 1917, did have a purpose once—it was a way for Congress to keep the President accountable. Congress used to exercise only loose control over the government budget, and the President was able to borrow money and spend money with little legislative oversight. But this hasn’t been the case since 1974; Congress now passes comprehensive budget resolutions that detail exactly how the government will tax and spend, and the Treasury Department borrows only the money that Congress allows it to. (It’s why TARP, for instance, required Congress to pass a law authorizing the Treasury to act.) This makes the debt ceiling an anachronism. These days, the debt limit actually makes the President less accountable to Congress, not more: if the ceiling isn’t raised, it’s President Obama who will be deciding which bills get paid and which don’t, with no say from Congress.

What happens if they don’t vote to raise the debt ceiling? Nobody knows.  There’s lots of scenarios.  It all depends on how crowds of people react and how those same crowds think the others in the crowd will react.  It’s unpredictable.  Interest rates might go up, they might go down, they might stay put.  Two things are for sure, though.  There will be lots of trading and uncertainty in financial markets with increased volatility.  And more important, if a default translates into the government actually spending significantly less money next month than now, then GDP is for sure going down.  Any government spending cut of greater than 10% immediately puts us back into recession – maybe even less.

So what’s really going on?  Well both the Republicans in Congress and President Obama are trying to accomplish non-budget goals that they can’t do by normal means.  Both are trying to radically scale back aspects of government that are too popular to do head-on.  They’re trying to cut Social Security, cut Medicare, raise the age on Medicare, change Obama’s healthcare plan, and other things that polls show are very popular.  So they’re trying to do it under cover of “having to for the debt”.  Except that they don’t have to do it.  The debt-ceiling law is totally unnecessary and contrived.

Arithmetic, Reality, and Dreams of A Balanced Budget

Apparently, the Republicans and Tea Partiers are insisting that the federal government budget be balanced immediately (the demand for no increase in the debt ceiling) and that it be done entirely from spending cuts (the “no tax increases” pledge) to discretionary spending.

This is enough to demonstrate that they simply are not dealing in reality and cannot do simple 2nd grade arithmetic.  I’ve commented before and in classes about how politicians simply cannot deal with large numbers – they confuse millions, billions, and trillions.  McCain on the campaign trail once insisted that approximately 100 different cuts of 1-50 million dollars each would be enough to close a trillion dollar deficit.  Only off by a factor of, oh, 2000 times!

The budget deficit is running approximately 40% of the total budget.  In other words, to bring spending down to the level of current tax collections, we would have to cut 40% of government spending.  Yet, a simple perusal of the government’s budget (the one they passed just 3 months ago), shows that non-defense discretionary spending is only 15% of the budget.  Even if we add in defense and completely shut down the entire armed forces and fire lay-off all soldiers, we only have 38% of the budget.  It still wouldn’t balance.

I don’t know what’s worse.  The fact that these politicians keep saying these things even though a child can tell you it won’t work, or the fact that the news media keeping repeating it without the slightest challenge, or the fact that apparently millions of Americans believe them.

How to Tell If the Politician or Reporter Is Ignorant, Foolish, or Has a Hidden Agenda – Part 1

One of the reasons my posts have been scarce* lately is because, frankly, I’m frustrated and nearly speechless at the foolish talk and nonsense that currently passes for news about the economy lately.  In particular, this year the politicians and reporters in Washington have been focused on the federal government deficits and debt.  We are being bombarded by total nonsense from politicians from both parties.  But the news reporting of the debates are even worse.  Unfortunately much of this nonsense is couched in serious tones amidst appeals to emotional triggers with people.  Result: folks are being misled.

So in a public spirited effort to help you sort out just when you’re listening to somebody who isn’t worth listening to, I’m starting a guide to How to tell if the politician or reporter is ignorant, foolish, or has a hidden agenda. This is part 1.

If the politician or reporter says anything about “reducing the government’s debt”, it’s time to stop listening.  They don’t know anything, including basic words in English.  They don’t know the difference between “debt” and “deficit” and the difference is huge.

Debt, in the context of the federal government, refers to the accumulated total of money that has been borrowed in the past by issuing bonds and T-bills.  Sovereign national debt, unlike private debts, do not have to be “paid off” now or ever.  When the bonds come due, the government issues new bonds to replace them.

Deficit, in the context of the federal government, refers to this year’s budget and whether taxes collected are less than the cash expenditures made.  If taxes collected this year are less than expenditures, the government (any sovereign government) can either borrow the difference by issuing new bonds (additional debt) or by creating new money (coins, paper currency, or bank reserves).  In the case of the U.S., the government has totally delegated the money-creation process to The Federal Reserve and promised that it would always borrow to make up the difference between taxes and expenditures.

There’s a relationship between Debt and Deficits.  The Deficit each year (assuming money creation is not used) will lead to more borrowing which will increase the total Debt outstanding.

So back to our politicians and reporters.  As official Washington tries to figure out how to politically raise the debt ceiling law (a foolish piece of legislation, but that’s for another post), reporters and politicians both have been reporting that talks are under way to “reduce the debt“.  NO!  AAAARGGGHHHH!  The debt isn’t going to be reduced, but the deficit might be.  To reduce the the debt, we would have to have a budget surplus, and that ain’t going to happen**.  What they are talking about is how to reduce the annual deficit (a foolish goal that’s doomed to failure, but right now I’m focused on the words).

At times it’s worse.  I’ve actually heard politicians (mostly Republicans) and reporters say on TV that they want to “eliminate the debt”.  Come on folks!  If you hear anybody say that, change the channel immediately.  Shield your children’s ears. A person who talks about “eliminating the debt” can’t even do first grade arithmetic.  The federal government debt is approximately $14 trillion.  The entire GDP of the U.S. is only a little more.  To eliminate the debt, the entire country, all of us, would have to produce and sell everything we’re doing now but then tax 100% of it and not consume a single thing – not even a single bottle of Coke.  

Suppose you went to your medical doctor because you thought you had an eating disorder and wanted to reduce your appetite. If the doctor said her goal was to totally eliminate your entire weight, you’d think her crazy, leave, and find an knowledgeable doctor instead of a quack.  But when politicians and reporters make equally absurd comments, we pay them and give them campaign contributions.

*neo-classical theory says they should be going up in price, but I’m still giving it for free.

** last time we were close to surplus was the last year of the Clinton administration (only time since mid-1950’s).  To have a surplus we would have to have full employment.  Even then, Republicans have shown (2001 and 2002) that they would continue to cut tax rates and tax collections faster and eliminate the surplus, putting us back in a massive deficit.

What Budget Crisis? Let’s Do Nothing Now

My Mother was a big advocate of patience. She was the anti-crisis.  In response to any panicked concerns I had about the some “crisis” that was coming, we always counseled “we’ll cross that bridge when we get to it”.  And sure enough, there was usually either no problem eventuallly crossing the bridge or there was no river to cross.  I wish Congress and the President could heed the same counsel.

The last couple weeks have built on the hysterical “budget crisis” talk of the last few months.  Politicians of both parties have trotted out grand “plans” for how to “fix the budget” crisis. Of course, by “budget crisis” they claim to mean the deficits that the government is currently running. Make no mistake, the plans being proposed are radical changes to America’s social structure, safety net, and political economy. The Republicans in the House yesterday voted a budget to phase out Medicare. The cuts both parties are proposing will be drastic.  Education spending will be slashed. Let’s consider another approach though.  Let’s think of it as my Mother’s cross-that-bridge-when-we-get-to-it approach.  The essence of this approach is that if we do nothing at all right now or for the rest  of this decade, the problem will solve itself.  In other words, the current laws on the books will eliminate the problem.

I will explain, but first I want to make a disclaimer.  First, as an economist, I do not buy into the “budget crisis” rhetoric to begin with.  As I’ve tried to explain in other posts about MMT, fiscal policy, and the government budget, I’m not worried about the government’s current deficit at all.  In fact, if anything, I’m concerned that the deficit is too small right now.  The signs are clear that we need more government spending, not less right now.  I likewise do not think eliminating the deficit completely is a worthwhile goal. Such a goal is likely to be harmful.  

But, for the sake of argument and understanding, let’s assume for the moment that we should eliminate the deficit eventually.  What do we need  to do? Cut Medicare and let seniors eat up their entire limited incomes in healthcare costs? Hand Social Security over to Wall Street?  Close all the schools? None of this kind of radical nonsense is necessary. I will let Annie Lowery of Slate Magazine do the explaining with emphasis added by me:

 The overarching principle of the Do-Nothing Plan is this: Leave everything as is. Current law stands, and spending and revenue levels continue according to the Congressional Budget Office’s baseline projections. Everyone walks away. Paul Ryan goes fishing. Sen. Harry Reid kicks back with a ginger ale. The rest of Congress gets back to bickering about mammograms. Miraculously, the budget just balances itself, in about a decade.

I know. Your eyebrows are running for your hairline; your jaw is headed to the floor. You’ve had the bejesus scared out of you by deficit hawks murmuring about bankruptcy and defaults and Chinese bondholders. But don’t take it from me. Take it from the number crunchers at the CBO. Look at the first chart here, and check the “primary deficit” in 2019. The number is positive. The deficit does not exist. There’s a technicality, granted: The primary deficit is the difference between spending and revenue. The total deficit, the number more commonly cited as “the deficit,” includes mandatory interest payments on the country’s debt. Even so, the total fiscal gap is a whisper, not a shout—about 3 percent of GDP, which is what economists say is healthy for an advanced economy.

So how does doing nothing actually return the budget to health? The answer is that doing nothing allows all kinds of fiscal changes that politicians generally abhor to take effect automatically. First, doing nothing means the Bush tax cuts would expire, as scheduled, at the end of next year. That would cause a moderately progressive tax hike, and one that hits most families, including the middle class. The top marginal rate would rise from 35 percent to 39.6 percent, and some tax benefits for investment income would disappear. Additionally, a patch to keep the alternative minimum tax from hitting 20 million or so families would end. Second, the Patient Protection and Affordable Care Act, Obama’s health care law, would proceed without getting repealed or defunded. The CBO believes that the plan would bend health care’s cost curve downward, wrestling the rate of health care inflation back toward the general rate of inflation. Third, doing nothing would mean that Medicare starts paying doctors low, low rates. Congress would not pass anymore of the regular “doc fixes” that keep reimbursements high. Nothing else happens. Almost magically, everything evens out.

These are the CBO’s baseline projections. But, of course, Congress is not likely to let the Bush tax cuts fully expire, or slash doctors’ payments. So the CBO also prepares an “alternative fiscal scenario” that looks more like the path we expect Congress to take. It’s the alternative scenario that has the horror-show deficits. But Congress doesn’t have to act. It just has to do nothing. Or when it does do something, it has to pay for it.

That last bit is important: We want the numbers of the do-nothing path but not necessarily the policies. The fiscal future written in current law is hardly the best of all fiscal futures. For one, health care spending would comprise an enormous portion of overall spending. Right now, the United States spends about $1 in every $6 on health care. In a decade or two, based on the do-nothing plan, it would spend $1 in every $5, then $1 in every $4, and not get better health outcomes, either. Those dollars would be better spent in other industries or on other priorities. Moreover, under the do-nothing plan, the government would tax a much bigger share of GDP than it currently does, and the tax burden on the middle-class would be uncomfortably high.

But the do-nothing plan proves the point that the budget revolution does not need to be particularly revolutionary. Yes, the dollar figures are enormous, so big that it would appear to require “bold” plans that include massive new taxes or cruel new cuts. But, in fact, we don’t really need to end Social Security, sell Alaska, or ship the poor to Canada to get back in the black. We just need to stick to current law—particularly the tax and health care provisions—and then we can tinker our way toward a better, healthier economy.

That is because, by and large, the hard work of fixing the fat part of the the budget has already happened—through health care reform. The Social Security crisis you sometimes hear about is essentially a myth. The trust fund will run out in 2037, “at which point tax income would be sufficient to pay about 75 percent of scheduled benefits through 2084.” Full Social Security solvency would require only about 0.7 percent of GDP, which you can get to by exposing income above $107,000 to the payroll tax. There is no debt crisis, either, as long as the U.S.’s lenders remain confident in the country. The crisis lies in spiraling health care costs. The Obama health care reform bill might not work, but it does contain programs that could turn the tide over time. The big wheels of deficit reduction are already turning—and it might be better for Congress to step back, stick to pay-as-you-go, and let them turn.

Yes. Annie is right. And Mother was right.  If we do nothing, then the deficit disappears because of laws already on the books and what Annie doesn’t mention: regaining full employment.  The sooner we regain full employment, the sooner the deficit disappears, assuming we leave the tax code and Medicare and healthcare and Social Security laws as they are right now.

So why is everyone in D.C. all agitated about the “budget crisis”? Two reasons. First, what they really want to do is to continue to lower tax rates for the very rich and the wealthy. The rich, after all, pay for lavish parties through lobbyists and pay for campaigns.  You and I don’t.  Lowering tax rates for the rich will create larger budget deficits. The Republican/Ryan plan to end Medicare is not a plan to “save” Medicare or to “fix the budget”.  It’s  a plan to cut medical care for seniors so that taxes can be cut on the highest income bracket payers, the rich.  Second, some people, particularly the Republican/Tea Party/Libertarian side of the aisle are actually trying to accomplish an ideological agenda.  They don’t like the welfare state. They are ideologically opposed to government services for anyone other than elites and wealthy. They have no chance of getting political support if they actually tell the truth about their agenda.  So, we have a fake crisis to solve.

U.S. Budget Proposal Analysis Tool (spending)

I missed this when it came out Feb 1, but an alert student pointed me to it.  The NYTimes has an excellent interactive visual breakdown of the U.S. Federal Budget spending.  It very graphically shows where the money goes and how much.

Link: http://www.nytimes.com/interactive/2010/02/01/us/budget.html

A couple of notes.  First, the graphic shows only spending and transfer payments (outlays).  It doesn’t show offsetting receipts. For example, Social Security payments are one of the biggest categories shown. But Social Security doesn’t contribute to the deficit.  Social Security taxes, which aren’t shown, more than exceed payments made.  Similarly, but on much smaller scale, postage sales which help offset cost of the postal system aren’t shown.

Second, it’s tempting to think that programs eliminated would result in a equal deficit reduction. For example, it’s tempting to think that if $400 billion in programs were eliminated then the deficit would drop by $400 billion.  Not so. You have to consider the macro impact on overall GDP and employment of cutting the program.  Cutting $400 billion in programs might (or might not) actually worsen the deficit if the cuts result in net an overall reduction in aggregate demand and employment.  That’s because the resulting drop in tax collections would offset the supposed savings from cutting the spending program.