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Last week, the nonpartisan Congressional Budget Office (CBO) announced that the estimated 10-year federal budget surplus would be $4 trillion lower than last year's estimate for the same time frame. While a $4 trillion difference is staggering indeed, this reversal of fortune should be a reminder of the precariousness of economic activity and the futility of 10-year projections.
As the party out of the White House, the Democrats view the revised budget numbers as proof of the "fiscal irresponsibility" of the Bush administration and its tax cuts that became law last June. Several key Democrats, including Senate Majority Leader Tom Daschle (D-S.D.), have not only blamed the tax cuts for dissipating the surplus, but for worsening current economic conditions as well. In a recent speech, Senator Daschle argued that investment, consumption, and employment have all suffered because the Bush tax cut has increased long term interest rates.
The notion that budget deficits lead to higher interest rates is not something Senator Daschle invented. In fact, former Treasury Secretary Robert Rubin swears by the causal effect between deficits and long term interest rates. But to pretend as though this theory is endorsed by most economists, or that the empirical evidence offers much support for it is disingenuous.
The case that higher deficits lead to higher long term interest rates is based on an elementary notion of supply and demand. To finance deficits, the federal government must borrow money in the form of treasury bonds. The higher the deficits, the more bonds that the government must float, which increases the demand for loanable capital. By increasing this demand, while leaving supply of loanable capital constant, deficits will increase interest rates.
In a closed economy where the suppliers of loans are largely consumers, businesses, and average citizens, the budget deficit would indeed have a profound effect on interest rates as the government demand dislocates capital from more productive use. But thankfully, in a world economy where capital knows no political boundaries, investors in other nations are able to purchase the bonds of other nations. Because of the stability, and hence popularity, of securities denominated in United States dollars, the U.S. attracts bondholders from all over the world including banks, business, and individual investors.
Thus, the difficulty in determining the actual supply of loanable funds, or the other policy components that make one nation's debt more attractive than another's makes the entire issue far more complicated than Senator Daschle indicates. For example, Japan has one of the world's largest budget deficits (in relation to GDP), but the world's lowest interest rates at the same time. In fact, when taking a current sample of the world's largest economies, it is impossible to perceive a causal relationship between deficits and higher interest rates
And even if such a relationship did exist, there is no evidence that the Bush tax cuts from last year had anything to do with the deficits. As CBO Director Dan Crippen made clear in his testimony before the Senate Budget Committee, "Over 70 percent of that reduction (in the estimated 2002 surplus) results from the weak economy and related technical factors." Yet only 3 percent of the Bush tax cut took effect in 2002. With no interest rate hoax to fall back on, it is clear that the Democrats charges amount to nothing more than political partisanship and election year nonsense.
If our elected officials are truly concerned with the CBO budget forecast, they should take steps to reduce government spending. After all, no government has to issue a treasury bond to allow its citizens to keep more of their hard earned money. But even more importantly from an economic efficiency standpoint, reducing spending contributes to economic growth by limiting the amount of scarce resources pried from the market to be redistributed to favored constituencies. Redistribution sacrifices growth for political patronage and other concerns unrelated to efficiency and, in the process, harms output, employment, and investment.
President Bush was right to fight for real tax relief last year. Tax cuts are essential to stem the growth of government because with our progressive income tax system, government revenues rise far faster than national income as individuals pay an ever increasing share of their income to the government. But President Bush must not stop with the tax cuts. In the 2002 budget, he would be well served to pay closer attention to the other, less glamorous side of fiscal discipline: reducing government outlays.
Unfortunately, the President's 2002 budget calls for an 8 percent increase in spending. Some of this new money may be needed to defend the nation against future terrorist attack, but the existing budget could be reallocated to provide for these needs. In a time when American businesses have cut back staff, reduced benefits, and tried to do more with less, would it be so wrong for the American electorate to expect its government to do the same? The government -- with its disdain for measures of efficiency and inveterate desire for perpetually expanding budgets -- has been insulated from the real world for far too long.