The Dangers of Debt Reduction By Paul Davidson and James K. Galbraith
03/03/99 The Wall Street Journal Page A18 (Copyright (c) 1999, Dow Jones & Company, Inc.)
Are drastic reductions in the federal debt a good idea? President Clinton thinks so. He plans to allow budget surpluses to accumulate over 15 years, cutting the federal debt held by the public to a percentage of total output not seen since 1917. But there are grave dangers in his proposal.
This plan assumes that full employment will be maintained independent of federal spending, which will be strictly restricted in order to create surpluses. This assumption is foolhardy, for tight budgets depress economic growth and raise unemployment. Japan's recent experience illustrates the point: Strong economic growth plus a tight budget strategy produced a budget surplus by 1990 that then led to a decade of stagnation and recession. Europe, tied to tight budgets by treaty, similarly faces stagnation and may be heading toward recession now.
Today, many believe that the Federal Reserve has a magical power to maintain full employment, whatever the budget. But even assuming that the Fed remains committed to full employment, its powers are limited, particularly when interest rates are already low. Monetary policy can easily spur growth by cutting, say, a 10% interest rate, but that's much harder when rates are in the 5% range. This is another old lesson the Japanese are relearning, as they push interest rates toward zero with little effect.
The promised buy-down of the government's own debts, should it occur, poses another set of dangers. U.S. government bonds are a safe asset, completely free of default risk. Their vast abundance and the liquidity of the Treasury market are stabilizing elements in world finance. Take them away, and individual investors seeking safety and income will be obliged to invest elsewhere. Private investors will be forced to seek safety in hedging, which tends to destabilize financial markets. Worse, when system crises occur, as happened in late 1998, the "flight to quality" may no longer be toward U.S. government bonds and Treasury bills. Instead, it could be toward another region's assets -- such as the euro.
The depressing effect of tight budgets means that the promised surpluses will probably never materialize. But even if they did, it is incorrect to assume that the ensuing debt reduction would produce a new pool of "savings" for any private purpose. The expected debt reduction comes from an excess of taxes over spending; the effect is to reduce private financial wealth. Private savings are created when private incomes after taxes exceed planned consumption. This cannot happen when taxes grossly exceed government spending, as the president proposes.
But don't we need the surplus to save Social Security? No. The policy of "saving the surplus" contributes nothing to the future of Social Security. It is impossible for "savings" today to "pay" for pensions 20 years from now. Proposals to "fund" Social Security misunderstand the basic fact that putting "funds" into the "trust fund" is redundant. Congress, not the trust fund, controls benefit levels paid under Social Security. The promises to pay are already written into law. The special government bonds that the trust fund holds and that Mr. Clinton would have the projected surpluses add to are mere symbols of that legal commitment. So long as Congress leaves the law intact, benefits will be paid whether or not a bond is held in the trust fund to be redeemed when future benefit payments are met.
How will the benefit obligations be met? Exactly as if no trust fund existed: first from payroll taxes; if those are insufficient, then from other revenues; and finally from new outside borrowing. In the case of pay-as-you-go from payroll taxes, the trust fund is obviously unaffected. In the second case, a bond issued by the government to the trust fund would first be repurchased and extinguished with general revenues destined for pensions. This is a bookkeeping activity, with no economic meaning. In the third event, a bond redeemed by the trust fund would be, in effect, repackaged for sale to the public, with exactly the same economic effect as if the government issued a new bond.
Worst-case official projections show a depleted trust fund by 2032. But if the economy grows more rapidly than those projections assume, future payroll taxes will cover future retirement outlays for much longer. In that case, the redundancy of "saving the surplus" becomes even more transparent: The surpluses may never be drawn. Indeed, the entire perception that there is a Social Security "crisis" rests on implausibly pessimistic assumptions about economic growth. Weak growth forecasts generate the shortfalls that the reform proposals are supposed to meet. The projections have already been revised upward repeatedly; as they are, the supposed crisis recedes into the future.
What will it take to keep the economy growing? Continued low interest rates, sure. But also we will need new government spending, and tax relief for working families is a good idea. A balanced and growing public and private economy is far more likely to enjoy stable and sustained economic growth than one that relies wholly on either the public or the private sector. And if the world economy needs deficit spending in Japan, as even high U.S. Treasury officials now repeatedly argue, why would anyone think huge surpluses in the U.S., which would vastly offset any Japanese efforts, are a sound and sensible idea?
If the economy performs badly, the president's idea becomes even more dangerous. In a slump, it is appropriate and necessary to run deficits -- large deficits -- and to borrow to meet Social Security as well as other public obligations.
On the supply side, the underlying economic goal of the president's plan is to stimulate private spending at the expense of public priorities. But our nation desperately needs improved public services in many fields: public schools, universities, environment, transportation, housing, health care, libraries, parks and amenities of all kinds. We need better support and services for poor children, the disabled and other needy citizens. These important goals are precluded by Mr. Clinton's proposal to reduce the debt.
In sum, the policy to accumulate budget surpluses and buy down the publicly held portion of the national debt is unlikely to succeed. If attempted seriously, it will probably depress the economy and increase unemployment. It is also unnecessary to preserve Social Security, and actively inimical to other pressing public goals. Policy makers, the press and professional economists should reject this simplistic idea. As the late Robert Eisner titled his last essay, published a few weeks ago, we must "Save Social Security From Its Saviors".
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Mr. Davidson is a professor of political economy at the University of Tennessee. Mr. Galbraith is author of "Created Unequal: The Crisis in American Pay" (Free Press, 1998). He is a professor at the University of Texas's LBJ School of Public Affairs and a senior scholar at the Levy Economics Institute.
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