The economy this autumn is still growing, inflation is low, unemployment is down. Whether this proves the success of supply-side economics or is just another deficit-driven Keynesian recovery will be argued for years to come. It seems to me clear that the enormous federal budget deficit was largely responsible for the recovery and that it could become extremely dangerous if it is not controlled. The important question now is how the recovery can be sustained in view of all the urgent financial problems facing the economy. These include the record domestic budget deficit and the record deficit in the balance of trade; they also include a national debt that will soon amount to $2 trillion and a third world debt that will soon amount to $1 trillion. In effect, we are now borrowing heavily from our children to finance a great many expenditures we really cannot afford. This is neither moral nor prudent.
Will the current growth of the economy eliminate these deficits? Those who believe that it will might recall that the most important rule in business is never to bet the entire company. By betting so heavily on growth, we are running the risk of having our national debt over-whelm the federal budget. Financing that debt threatens to absorb far too much capital needed for investment in the domestic economy if it is to sustain growth, improve its comparatively low rate of productivity, and compete successfully abroad.
The Congressional Budget Office has estimated that by 1989—even assuming an average real growth rate of 4 percent between 1983 and 1989—the national debt will amount to almost 50 percent of GNP, up from 35 percent in 1983. Interest on the national debt will be 16 percent of the budget and it will be growing swiftly. To pay that interest, a government would have to make a grim choice: either to cut social programs and the military budget beyond anything now contemplated or to increase taxes constantly.
It has been argued that the level of the debt need not cause concern because, in 1960, the national debt stood at close to 50 percent of GNP. Important differences, however, exist between 1960 and today. First, more and more of our debt is now financed from abroad (last year about $80 billion), a situation unlike that of 1960. We are therefore at the mercy of foreign investors who, should they lose confidence in the US economy, could create a dollar crisis and higher interest rates in short order. Without the additional capital available from abroad, our low rate of national savings would not be sufficient to accommodate the foreseeable needs of both government and private business.
Two other differences from the economic situation in 1960 are instructive now. The 1960 debt was the result of borrowing during World War II and the Korean War; and the budget deficits between 1960 and 1965 hovered between zero and 1.3 percent of GNP. A rapidly growing economy in the 1960s kept the deficit below 3 percent of GNP even at the height of the Vietnam War. The debt as a percentage of GNP dropped rapidly, and lower interest rates kept the impact on the budget within bounds.
Now we have a completely different situation. Despite a growing economy the continuing deficit requires the government to borrow between $180 and $240 billion each year. The debt is growing much more rapidly than GNP. Interest on a steadily growing debt feeds on itself, like a form of financial cancer. The situation of the US too closely resembles that of New York City between 1970 and 1975 and that of Argentina, Brazil, and Mexico between 1975 and 1982.
There is much talk of the need for greater fairness in any future economic policy, and much of it is justifiable. Between 1980 and 1984, the share of disposable family income of the poorest fifth of the population actually declined from 6.8 percent to 6.1 percent. The share of the most prosperous fifth of the population increased from 37 percent to 38.9 percent. Clearly that is not an acceptable trend in any society committed to the idea that all parts of the population should benefit from growth and prosperity.
In dealing with our budget problems, however, we cannot create the illusion that fairness means that the government will simply do more for the poor, the unemployed, the retired, the minorities. All these groups stand to suffer from a fiscal breakdown that could cripple economic growth, or cause a great surge of inflation, or both. If sacrifices have to be made to avoid those consequences, fairness means that the largest sacrifices must be made by those who can best afford them; but, unfortunately, some sacrifices will also have to be made by all groups above the poverty level.
This was the general principle we tried to follow in resolving New York City’s fiscal crisis. It should be the basis for the new policies for taxes and entitlements that will be needed to deal with the problems of the budget and the national debt. In my view much is at stake. In one way or another, the most urgent problems facing the US in the world economy—the rise of the dollar, the safety of our banking system, the dangers of protectionism—are all related to our federal budget deficit.
The Budget and the National Debt
The budget deficit is causing the national debt to grow at a rate almost twice the growth in GNP. That is a prescription for national bankruptcy. If that rate continues, interest on the national debt will grow to more than $200 billion a year by the end of the decade, preventing more and more vital government programs from being carried out as government revenues are consumed in debt payments. In addition to the obvious costs being incurred domestically, the international effects are increasingly dangerous. As a result of escalating indebtedness, the level of the dollar is constantly pushed upward, putting many American industries in difficulty, unable to compete with cheaper foreign imports at home or to sell in markets abroad. The government’s borrowing requirements, a major factor in maintaining interest rates at very high levels, increase the risk to our banking system of large-scale failure by third world countries to pay their debts. We are fostering speculation instead of investment. We are purchasing short-term prosperity by starving the rest of the world of badly needed capital and destabilizing the international monetary system. Since we live in a world market whether we like it or not, we cannot continue much longer
Some, including President Reagan, have argued that rising interest rates are largely a matter of psychology—that they move up in response to the premature and self-protective fears of bankers that deficits will lead to inflation. Although high interest rates are not solely caused by deficits, this is a superficial view. Several factors are at work in the rise of interest rates, among them the deregulation of financial institutions. But the most important factor of all, in my view, has been the vast increase in the use of debt by all the sectors of the economy. The US government debt grew from $290 billion in 1960 to $1.4 trillion in 1984. Corporate debt grew from $40 billion in 1960 to $400 billion in 1983. Mortgage debt grew from $470 billion in 1973 to $1.7 trillion in 1983. Third world debt grew from $80 billion in 1970 to $800 billion in 1984.
Neither the savings rate nor the capital of financial institutions or corporations has kept up with this explosive growth of debt, much of which has to be constantly rolled over and refinanced. Monetary policy is not the answer to this problem; we must reduce the demand for credit. While there is no magic number for the appropriate proportion of debt to GNP, it makes obvious sense to stabilize an apparently runaway situation and to limit the growth of the debt as closely as possible to the growth of GNP.
Eventually we will be forced to do something about the deficit. But what should we do and when? The answer to “when” is easy; as soon as possible and preferably before the next economic downturn. If we have to close the budget gap during a period of recession we would run risks that seem to me very dangerous indeed. We could then be faced with a growing deficit as a result of recession, increasing interest rates and a collapsing dollar as a result of capital outflows, and a banking crisis as a result of both. This is not a risk worth running. A deficit reduction program should begin as soon as possible after the election and no later than early 1985. The question of “how” and at what velocity is more difficult.
Vice-President Mondale has proposed to reduce the deficit by two-thirds—or about $160 billion—by 1989. He proposes about $85 billion in new taxes (about $25 billion in corporate taxes, and the rest from income taxes); about $24 billion in expenditure reductions and $51 billion as a result of interest cost reductions. President Reagan, for his part, has asserted that no new taxes are required and that continued growth and savings in government efficiency will eliminate the deficit—a position he restated in the first debate with Mondale. That hardly seems likely.
I have several reservations about the Mondale plan. It relies too heavily on tax increases—especially personal income taxes—and is vague on how expenditures would be controlled. As a result, the financial markets and the Federal Reserve will likely be skeptical about its effectiveness and the reduction in interest rates Mr. Mondale hopes for would not take place. But the plan is, at least, a serious one, worth serious discussion. It does not, as the administration has done so far, wave away the deficit and debt problems with assurances that growth and tighter control of executive spending will somehow make them go away.
With the economy as strong as it is now, I would suggest a program to close the gap more rapidly and more rigorously by about $150 billion over three years—half through taxes, half through budget cuts. The Congressional Budget Office projects a deficit of about $216 billion for fiscal 1987. Such a reduction would leave about $60 billion of deficits—about 2 percent of GNP. The lower interest rates that would result from a lower deficit should eliminate much of that balance as the cost of government borrowing falls.
Higher taxes will not create economic growth. Simply taxing the rich will not abolish poverty, or create jobs, or lead to investment in improved technology. If taxes are increased, this should be done in the way least likely to slow down the economy. Any tax increase, moreover, should also be combined with a simplification of the tax system that would result in lower personal rates and fewer deductions and loopholes.