Neil H. Buchanan

If We Must Obsess About Budget Deficits, Can We At Least Measure Them Correctly?

Thursday, January 28, 2010

Washington is once again in a tizzy about budget deficits. Republicans and anti-government activists have been screaming about growing deficits ever since President Obama took office. In so doing, they capitalize on people's misunderstanding of how budget deficits really work. They also exploit a false analogy between government budgets and family budgets, claiming that any responsible government must not go into debt -- while ignoring the very good reasons that motivate even the most responsible families to take out loans. The better analogy between governments and families here is simply that neither should go into debt without good reasons for doing so.

Having repeatedly heard such utterly false and opportunistic political arguments against budget deficits, the public is unsurprisingly willing to believe that the deficit must now be reduced. With recent changes in the polls showing trouble for Democrats, the President has apparently panicked and will soon propose spending cuts in order to prove that he can be tough on deficits. This is a shockingly dangerous policy error.

As many economists have pointed out, expedient political action to reduce deficits today recalls the mistakes of 1937, when President Roosevelt and a heavily Democratic Congress tried to balance the budget, even though the unemployment rate was over 16% at the time. Unsurprisingly, growth stalled and unemployment rose soon thereafter. The economy did not fully recover until deficit spending for World War II forced politicians to abandon fiscal orthodoxy.

As I argued in a FindLaw column last July, budget deficits are a valuable -- indeed, an essential -- policy tool. They are especially important during an economic downturn, and the arguments in favor of running deficits become even stronger during an economic crisis of historic proportions of the sort that we face today. The unemployment rate hovers near ten percent, yet President Obama is willing to make matters worse in the foolish (and surely futile) pursuit of short-term political advantage.

My purpose in this column, however, is not once again to defend budget deficits. Instead, I accept for the sake of argument that politicians will continue to be obsessed with budget deficits, and will continue to posture as "responsible stewards of the public purse," arguing for reduced deficits even when -- as now -- doing so would do serious harm to American families and the economy.

My purpose, instead, is to urge the following path: If politicians are going to focus on deficits, then we should at least insist that the deficit be measured correctly. It turns out that there is a surprisingly large number of different ways that the deficit can be measured, and using the wrong measuring rod can lead to irrational and damaging policies.

The deficit measure that we currently use is, unfortunately, a terrible way to measure deficits. Relying on it to guide policy is wholly irresponsible. Fortunately, there are better alternatives available.

How Is the Budget Deficit Currently Measured, and Why Is That Misleading?

Economists refer to the deficit that is reported in the newspapers as the "cash-flow" deficit, because it simply measures the annual difference between federal revenues and federal spending. For example, in 2008, the cash-flow deficit for the federal government was about $460 billion, or 3.2% of national income, which was the excess of $2,980 billion in spending over $2,520 billion in revenues.

That might seem like a very sensible way to define a deficit; and in a way, it is. The cash-flow measure tells us how much money the government borrowed each year on financial markets. Despite the intuitive appeal of such a simple definition, however, using the cash-flow deficit as a guide to policy causes politicians to see problems where none exist and to respond inappropriately when problems arise.

For example, suppose that the cash-flow deficit were equal to zero in a given year -- so that we would have the Holy Grail, a balanced budget. If the economy then started to weaken for any reason -- such as, say, a plunge in exports due to a recession abroad -- then our tax revenues would fall as U.S. workers were laid off. Similarly, government spending would rise, because those laid-off workers (who did nothing wrong) would begin to collect benefits from the government while they looked (possibly fruitlessly) for other jobs.

In other words, the previously-balanced budget would begin to show a deficit. Politicians who had sworn to "slay the deficit dragon" would then leap into action, cutting spending and raising taxes to close the gap. This, of course, would further harm the economy. We would have needlessly put more people out of work, because we failed to understand why the cash-flow deficit had increased in the first place.

This is hardly a hypothetical example. State governments, most of which (we are constantly reminded) must operate under balanced-budget constraints, prove over and over again what happens when a government cuts spending and raises taxes in a weak economy. The states find themselves making round after round of budget cuts, feeding a vicious cycle that not only leads to needless economic pain, but also feeds the public's distrust of government. After all, if politicians continually announce that they have balanced the budget, only to announce weeks or months later that still further cuts are necessary, then the public can certainly be forgiven for thinking that the budget has been handled poorly.

Fortunately, the Congressional Budget Office has for years been calculating a deficit measure that corrects for changes in the business cycle. The "cyclically-adjusted" deficit separates the cash-flow deficit into two parts: first, the borrowing that is the result of economic fluctuations, and, second, the borrowing that would be necessary even if the economy were operating at full strength. For example, when the budget deficit increased from 2007 to 2008 by almost $300 billion, about $50 billion of that change was due to the weakening economy. When the cash-flow deficit went up by another $955 billion in 2009, $310 billion of that was because of the ravages of the recession. The rest of the increases in the cash-flow deficit were due to tax cuts and spending increases that were designed to fight the Great Recession.

The important point lies not in the size of the cyclical adjustment in any given year, but rather in the signal that the cyclically-adjusted deficit sends. If it remains unchanged while the cash-flow deficit rises, then it is incorrect to think that policy has become more expansive. In fact, the deficit is responding not to policy changes but rather to changes in the economy that we should be trying to reverse, rather than exacerbate.

What about the States?

As noted above, states governments tend to respond to a weakening economy in a decidedly perverse way, cutting spending when it should be increased and raising taxes at the worst possible time. This perversity is reinforced by our failure, when trying to determine whether the budget deficit is expanding or contracting, to integrate the budgets of the states with the federal budget.

With the states' economies contracting furiously during a recession, the apparent strength of any federal response is often a mirage. For example, when the federal government was adding $234 billion in 2008 to the cyclically-adjusted deficit in order to fight the worsening recession, states were cutting $193 billion to meet their internal balanced-budget requirements. The moderate stimulus that we thought we saw coming from the federal government was thus almost entirely outweighed by the states' cutbacks. Indeed, one of the major purposes of the 2009 stimulus bill was not actually to stimulate the economy but simply to give states enough money to prevent massive layoffs of teachers, firefighters, and police officers.

The failure to include the states' fiscal situations in our measure of "the government's budget deficit" not only causes us to misread the fiscal situation, but also creates perverse incentives for cost-shifting. If Congress is only concerned about the federal budget situation, after all, it is awfully tempting to dump expenses onto the states as a way to take those costs off the federal books. (Of course, even if the states were able to cover those costs, the net result would still be no change in government spending. The federal deficit would be smaller, but overall spending would be unchanged.)

Given that the states are under such extreme fiscal pressure, of course, any area of responsibility that Congress shifts onto the states is almost sure to be the target of severe cuts. The net result is that ignoring state budgets ignores the realities of what we are doing -- or failing to do -- to fight the recession. Mismeasuring the budget deficit harms states and their citizens, all in the pursuit of a false form of fiscal responsibility.

A Genuine, Bipartisan Solution is Desperately Needed

The two problems I have discussed here -- the failure to adjust for the business cycle, and the failure to include state governments in the measurement of the overall deficit -- are hardly the end of the story. This column is not the place to discuss the other problems with the cash-flow measure of the budget deficit, problems that include such technical matters as inflation adjustments, time horizons, and so on. Rather, what matters here is the overarching point: There are many different ways to measure the deficit.

For example, in my doctoral dissertation, I identified thirteen different ways to measure budget deficits -- and believe me, I did not exhaust all of the possibilities. Each possible adjustment will change the measured deficit. More importantly, as the examples above demonstrate, each different adjustment can have a profound effect on the way that politicians act. Getting the measurement of the deficit right is thus an essential first step toward true fiscal responsibility.

Recently, there has been some talk of creating a bipartisan commission that would be empowered to dictate changes to our taxing and spending policies, in the hope of bringing the deficit under control. This is a problematic idea on many levels. Most importantly, a massive abrogation of responsibility by Congress would be involved in empowering such a commission with what would be essentially legislative powers.

If we must have a commission, then I would suggest that its mission be limited to recommending how best to measure the budget deficit in the first place. That recommendation could at least bring needed clarity to a policy debate that is too often based on little more than superstitious aversions to borrowing.

The current hysteria over the budget deficit is the result of years of misinformation and political cowardice, with politicians who know better refusing to stand up and tell Americans the truth about deficit spending. Given that we are now stuck with a political culture that focuses obsessively on budget deficits, however, the very least we should do is to make sure that we are measuring them accurately.

We would not measure the speed of a car without making sure that we had an accurate speedometer. We should be at least that careful when measuring the government's effect on the economy.

Neil H. Buchanan, J.D. Ph. D. (economics), is a Visiting Scholar at Cornell Law School, an Associate Professor at The George Washington University Law School, and a former economics professor.

Ads by FindLaw