Thurow, Lester C.

English

Research Papers in Economics

LONG-TERM  IMPACTS  OF THE  FEDERAL DEFICIT
Lester C. Thurow
Massachusetts  Institute of Technology
While the $200 billion deficit in the federal budget is the center of
public attention,  the $130  billion deficit  in the balance  of trade is in
many ways more important.  While the national debt is owed by us to
us,  the international  borrowing  necessary  to  finance  a  $130  billion
trade  deficit  is real  - owed  by  us  to the rest  of the  world.  And  at
present rates  of borrowing  the United  States  will shift,  for the first
time since World  War I, from being a net creditor country to being a
net debtor country  in mid-1985.
At that point interest  payments will  shift from being  a net inflow
into the United  States to being a net outflow  from the United States
and the  current  account  will  deteriorate  rapidly  since  interest  pay-
ments rapidly  compound.  Next year in addition to whatever must be
borrowed  to  finance  next  year's  deficit  in  the balance  of trade,  an
additional  $13  billion (assuming a 10 percent interest rate) will have
to be borrowed to finance this year's borrowings.
In the summer of 1982 no one knew the maximum amount of money
that Mexico  could borrow.  By fall everyone  knew the  Mexican  limit.
When the world discovered  that it had lent $85  billion to Mexico  the
rest of the world refused to lend more.
In a similar manner  no one now knows the maximum  amount that
America  can  borrow.  Since  the  United  States is  a  much larger  and
wealthier country,  the American limit is much bigger, but it remains
true  that the number  is finite.  At  some  point the world  will  decide
that it has invested enough of its assets in the United States and future
lending will halt. At this point the dollar will plunge.
The Great Dollar Bubble
While no one knows or can know the precise moment when the dollar
will fall, two other facts are known. First, it will happen. No country
can  forever  run  a  deficit  in  its balance  of payments.  The  fact that
something  occurs  (an over-valued  dollar)  for longer than anyone  be-
lieved  possible  does  not  repeal  fundamental  principles  of economic
gravity.
13Second,  when the fall comes  it is apt to be very rapid. This can  be
seen  by looking  at the  situation  from the point  of view  of a  foreign
money manager.  A German  money manager wants to keep his liquid
funds  in the United States  since he receives  an  interest rate  almost
twice what he can get in Germany. But he also knows that if he moves
300 million marks into the United  States when  it is  3  marks to the
dollar and has to  move  his money  back to the  United States when it
is 2  marks to the dollar, he  loses  100  million marks.  As  a result he
wants to  be the  first person  out the  door  when  the  fall  comes.  And
since the last person out the door loses the maximum amount of money
everyone will rush for the door at the same time.
Why  has the dollar been  so high  so  long?  Part of the answer  is to
be found in higher interest rates, a more rapid economic recovery, and
political  stability,  but  only part of the  answer.  To  really understand
what is  going on,  let me take  you back  in history to Amsterdam  in
1633.  Leave  the world  of the rational  and enter the  world  of the ir-
rational.
For some unknown reason the price of tulips starts to rise. Everyone
understands that in the long run tulips cannot sell for more than the
cost of growing tulips.  Yet prices  rise above  this level.  Initially, ana-
lysts predict that the price of tulips will quickly  fall.  But they don't.
They continue to rise in  1634 and  1635.  Having been proven  wrong,
analysts start to  look  for  semi-logical  reasons  as  to  why tulip  prices
could stay high forever.  (Business Week just had an article  saying that
the dollar could stay high for  10 years.) Tulip  prices continue  to rise
in  1636.  And  in early  1637  they are  selling  for hundreds  of dollars.
But of course such a price is crazy and tulip prices crash in 1637 wiping
out all of those who have been speculating  in tulip bulbs.
Such bubbles have  happened over  and over  in human history.  The
South Sea Bubble burst in 1720.  The great Florida  land booms of the
1920s  or  the stock  market  crash  of 1929  are  reminders  of the same
facts of life. Greed plus hubris leads to disaster. Everyone understands
that tulips or the dollar are overpriced but everyone also understands
that  they  can  make  money  by  speculating  on  even  higher  prices.
Everyone also believes that they are the smart ones that will jump off
the roller coaster before it heads down. But they cannot.
At  the moment  we  are  in  the midst of what  might be  called the
"Great Dollar Bubble".  It will burst.
Problems Associated  With Large Deficits
But  back  to  the federal  budget  deficit.  Large  deficits  lead  to two
problems.  First they  represent  Keynesian  stimulus.  When  breaking
out of a recession they are appropriate,  but they should  be eliminated
as the economy approaches  full  employment.  If they aren't the  econ-
omy will be over-stimulated  and inflation  will break out.
14But let me remind you of some history.  General excess demand  in-
flation does  not lead to a sudden outburst of inflation  in the manner
of a food  or  energy  supply shock.  In the  Viet  Nam war  it took  four
years of over-stimulation  to raise the inflation rate from 1  /2  percent
to 5 percent. Given today's levels of capacity utilization, general excess
demand inflation won't really become apparent  until 1986 or  1987 at
the earliest.
Federal deficits are also negative savings. They represent funds bor-
rowed from the pool of savings and used to finance public consumption.
They make a low savings society into an even lower savings  society.
With  large  deficits  Americans  invest  less and  our growth  rate  falls
below that of our international  competitors.  But such an adverse com-
petitive effect isn't visible  to the average person  for five to ten years.
Here  again  there is  no Monday morning  crisis that will  demand  at-
tention.
Dealing  With the Deficit
The  lack of a crisis is important  since  without it our democracy  is
unlikely to address the deficit problem. To understand this fact of life
it is only necessary to review some elementary budgetary arithmetic.
Suppose that the $200 billion  budget deficit were  to be eliminated
with budget  cuts. National  defense  absorbs  $300 billion.  To balance
the budget  using  defense  would  require  a defense  cut  back  of two-
thirds.  Defense is in fact growing more than  10 percent  per year and
the President  won't cut defense.  Social  Security and Medicare absorb
$250 billion. To balance the budget using Social Security and Medicare
would require a three-quarters cut in every pension check in America.
Tens  of millions  of elderly  people  vote  and  the  Democrats  say that
Social Security cannot be cut.  Interest on the national debt is a legal
obligation  and cannot be cut.
If these three functions are left aside, the rest of the federal govern-
ment only spends slightly more than $200 billion. The cuts necessary
to  do the job would essentially  mean the end  of public roads,  no na-
tional parks, no FBI, no  Congress, no weather bureau.
If the deficit were to be eliminated with tax increases the arithmetic
is equally unappealing.  The personal income tax only raises $300 bil-
lion. To raise what must be raised would require not a 5 or 10 percent
surtax  but a 67  percent  surtax.  To mention the surtax  number is to
understand its impossibility without an obvious crisis.
In addition  economists  have  been repeatedly  wrong  on  their fore-
casts.  Why should anyone now believe them when they say that it is
necessary to eliminate  the deficit to prevent  future  problems? Presi-
dent Reagan  has just spent the last two  years rejecting  such  advice
from the Chairman of his Council  of Economic  Advisers.  Such advice
15is not apt to be given by the next Chairman,  and if it is it will be just
as quickly  rejected.
Suppose that the Congress were to substantially cut the budget def-
icit. In the short run this might lead to lower interest rates. But what
would those lower interest rates trigger? - in all likelihood a falling
dollar.  But what is the classic government  response  to a falling cur-
rency? Central banks force up interest rates to slow  down or prevent
their currency  from  falling.  As a  result, in  the medium  run,  higher
taxes  or  lower  spending  might  well  lead  to higher,  and  not lower,
interest rates.  One  shouldn't  too confidently  sell deficit reduction  on
the grounds that it will certainly lead to lower interest rates. It might
lead to precisely the opposite.
What is likely to happen  on the deficit  front given a  Reagan  or  a
Mondale  election?  If Reagan  is reelected little is  apt to happen. Why
should it? The economy  is doing well and there is no crisis. In addition
the Republican platform  essentially  promises no tax increases  under
any circumstances.  If this platform plank were  written  by unknown
delegates it could be ignored, but it was, in fact, written by Jack Kemp
and other Republican  congressmen.  If President Reagan  were to  pro-
pose  a  tax  increase  without  an  obvious  crisis  he  could  not carry  a
majority of his own party with him and without a large majority among
Republican  congressmen,  it would  be  impossible  to  get  Democratic
congressmen  to vote for the President's tax increase. Why should Dem-
ocrats vote for tax increases and then find themselves fighting reelec-
tion campaigns against  Republicans who did not vote for them?
Mondale  has promised  to cut the deficit by two-thirds  over a  four
year period  of time,  but if elected  I  bet that he would do  something
quite different.  We don't know what a President does when he inherits
a large deficit from his predecessor.  It has never happened  before. But
we  do  know  what happens  when  a governor  inherits  a  large  deficit
from his predecessor  - regardless  of whether he is a Republican or a
Democrat. He immediately asks for a large tax increase to essentially
eliminate the deficit at the beginning of his term and blames the action
on his predecessor. For if he does not, he basically doesn't get a chance
to be governor or President.  Instead he is a custodian  of his predeces-
sor's deficit and after taking care  of it for four years it will become his
deficit.  Political factors call for getting rid of the deficit now.
There is a case to be made for reduced  spending in the federal budget,
but  it is  a case that involves  structural  changes that will  lead to big
spending reductions in the long run but only very small reductions  in
the short run.  To treat the Federal  deficit as  a short-run  crisis is es-
sentially to guarantee that nothing will be done  to reduce the deficit.
Consider Social  Security.  The  Social Security  system was set up to
prevent middle class  people from falling out of the middle class when
they became  elderly.  As late as  the mid-1960s the  elderly  had a per
capita  income that  was far below  that of the  non-elderly.  But some-
16thing happened in the past two decades.  The per capita income of the
elderly  now  exceeds  that  of the  non-elderly  and the  elderly  have  a
lower incidence  of poverty than the non-elderly.  Yet I know of no one
who has it as a  social goal to make the elderly  richer than the  non-
elderly.  Yet that is exactly  what the system is now doing.
To cure the problem the Social Security  system needs to be put on
a different basis. Suppose that the current system of periodic increases
plus cost of living adjustments were replaced with a system where the
average Social Security benefit was indexed to the per capita GNP. In
such  a  system  the  elderly  would float with  the general  economy.  If
America  were economically  successful,  the elderly  would get benefit
increases, but if America were not successful the elderly would not get
benefit increases.  Such a system  can be sold to the elderly since it is
a win-lose  rather than  lose-lose  situation.  If America  succeeds,  they
get a  bigger pension than they would  under today's  system.  In  con-
trast, straight  forward  attempts to simply  cut benefits to reduce  the
budget deficit is lose-lose.  Why should the elderly vote  for that? And
while little is saved  in the short run by such a change  in the  system,
billions and billions are saved by the turn of the century  if the Amer-
ican economy continues to behave as it has.
Consider  Medicare.  Here  we  Americans  are  refusing  to  deal  with
the  issue underlying  rapidly  rising  health  care  costs.  Technology  is
forcing  a fundamental  change  in traditional  medical  practices.  Tra-
ditionally  doctors stop  any treatment when that treatment  ceases to
have positive benefits or when the adverse side effects overwhelm the
primary benefits.  But we  are now  developing  technologies  that have
positive  benefits  but are  so  expensive  that we  cannot  afford  to  use
them.  Consider the Barney  Clark artificial heart.  Such a heart kept
Barney  Clark alive for four  months. Suppose that just half of the el-
derly could be kept alive for another four months with a similar heart.
This single procedure  would absorb one-third  of the entire American
GNP.  As it is,  between  25  and  30  percent  of your current Medicare
spending  goes to people in the last six months  of their lives.
The problem is not health care spending - that is but a symptom.
The real problem is learning where and how to say "no" to things that
can be done technologically  but cannot be afforded  for everyone.
In many ways we in the United States have  the worst of all worlds.
Socialists  know how  to say  "no". They appropriate  a sum for  health
care  spending  and that is all there  is. Capitalists  know  how  to  say
"no".  The  rich  get the treatment  and the poor  don't.  But we  in  the
United States  are willing  to practice  neither  approach.  The rich  get
to buy what they can  afford and then everyone else expects  the state
to provide what the rich have purchased.
But you  don't break out of such a dilemma  by simply  shifting to a
system  of hospital  cost  containment. The  Reagan administration  has
just shifted to a  system where  each  patient  will be assigned  to  a di-
17agnostic  class  and  the hospital  is  essentially  given  a fixed  sum  re-
gardless of the actual costs of treating that particular patient.  Such a
system  won't work for  a simple  reason.  Who  is going to take care  of
the high cost  patient within each  diagnostic class? Private hospitals
will dump  such patients on the public hospitals,  as is now beginning
to happen, and funds will either be found to treat such patients or they
will be forced to  go without treatment.  But the  chances that we  as a
society  will  deliberately  let  people  die  because  they  are  poor  while
others live because they are rich is very slight. The cost problem  will
remain.
Health costs can only be contained when we as a society  are willing
to  confront  the real problem - technologically  we  can do  things we
cannot  afford  to  do economically  - and have  developed  a technique
for saying "no" to both rich and poor that both rich and poor are willing
to  live with.  Economically  treatments  should be  stopped  when mar-
ginal costs  equal marginal  benefits  - but who  is to make this judg-
ment when human life is concerned?
Defense budget problems are similar in nature. Budget deficits don't
tell us very much about  how much  we should or should  not spend on
defense.  That can  only  be determined  by assessing the nature  of the
threat and the technical parameters of our own defense system.  From
an economic standpoint there is little that can be said about the nature
of the threat.  But there are economic  conclusions that flow from the
technological  parameters.
If you believe the nuclear winter hypothesis, there is no justification
for buying  any more  missiles  or  delivery  systems  after  a nation has
achieved  the  ability to  create  such  a  nuclear  winter.  And what the
other side  does  in terms of its  defense  spending is  completely  irrele-
vant!  No nuclear  ability  above  the  nuclear winter  threshold buys  a
country anything in terms of deterrence or power. And if nuclear sub-
marines are the cheapest way to deliver such weapons, then all spend-
ing on alternative  delivery  systems is a waste  of money.
Yet missile counting or budget comparison is how we now determine
our defense budget. If the Russians are buying more missiles or spend-
ing more than we, then we must spend more.  Such a response is easy
to understand but it isn't intelligent.
The  real  problem  is  to replace what we  now  do with a realization
that, after a certain point,  extra defense -spending has  zero marginal
value  regardless  of what the opposition  is doing.  If reductions  are to
be made in the defense  budget it is just such a realization that must
be  sold  to  the  American  voters.  For  no  one  will  or  should  cut  the
defense budget  simply because  the United  States has a large budget
deficit.
The  same  approach  must exist  on  the  tax side if we  are  to  make
progress. There  are taxes that should  be raised,  not because they re-
18duce the budget  deficit,  although they certainly  do, but because  they
make it possible to achieve  other national goals.
Consider  the  gasoline  tax.  Europe  and Japan  now  have  taxes  in
excess of $1.50 per gallon.  Why do  they have  such  taxes? Energy  is
imported and they cannot afford economically  or politically to pay for
it. Therefore  they seek to limit  energy  imports with high taxes that
discourage usage. But when it comes to such motives, we in the United
States are no different.  We also cannot afford to buy the current amounts
of imported oil either economically  or politically. No rapid deployment
force in the Mideast is a good substitute for simply not needing Middle
Eastern oil. The nation has better ways to spend 4 percent of its GNP.
It cannot afford $130  billion trade deficits.
Each  one  penny  of gasoline  tax raises  $1  billion  dollars.  A  $1  per
gallon tax  would raise $100 billion dollars. That would go a long way
toward eliminating  our federal budget deficit.  Yet politically  we can-
not now  do  it.  Somehow  we  have  to find  a way  to make  politically
possible what is now politically  impossible.
Or think  about  our savings  and investment  problems.  The United
States  invests  one-half  as  much  as the Japanese  and two-thirds  as
much as  the  Europeans  in  plant and equipment.  It does  not take  a
genius  to know that we need  to invest more.  But to invest more  we
must save more. In 1983 the United State's personal savings rate was
5  percent.  This was the lowest  in the industrial  world  by a factor of
almost three. The Canadians  saved 13  percent.
But to save more we must consume less. What way better to do this
than  a  value  added  tax  - one  of the techniques  used by  all  of our
industrial competitors?  A 10 percent value added tax raises more than
$300 billion. The average  European  value  added tax rate is about  15
percent. If a value  added tax were  made progressive  with a $250 per
capita income tax credit a 10 percent value  added tax would still net
$250 billion.
Here again in the conventional  wisdom a value  added tax is politi-
cally  impossible.  But  it also must be recognized  that  there  is no  so-
lution to the budget deficit problem that does not violate the conventional
wisdom as to what is politically  possible.
19PROVIDING PUBLIC SERVICES
IN AN ERA OF
DECLINING TAXPAYER  SUPPORT

LONG-TERM IMPACTS OF THE FEDERAL DEFICIT

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