A Financial Crisis, Not A Deficit Crisis

What caused the deficits and rising public debt? The answer comes in two parts: present deficits and projected future deficits.

Overwhelmingly, the present deficits are caused by the financial crisis. The financial crisis – the fall in asset (especially housing) values, and withdrawal of bank lending to business and households – has meant a sharp decline in economic activity, and therefore a sharp decrease in tax revenues and an increase in automatic payments for unemployment insurance and the like.

According to a new International Monetary Fund staff analysis, fully half of the large increase in budget deficits in major economies around the world is due to collapsing tax revenues, and a further large share to low (often negative) growth in relation to interest payments on existing debt. Less than 10 percent is due to increased discretionary public expenditure, as in stimulus packages.

This point is important because it shows that the claim that deficits have resulted from “overspending” is false, both in the United States and abroad.

Unlike the present deficits, expected future deficits are not usually considered to be due to continued recession and high unemployment. To understand how the discussion of future deficits is being framed, it is necessary to grasp the work of the principal forecasting authority, the Congressional Budget Office. CBO’s projections proceed in two steps. First, they wipe out the current deficits, over a very short time horizon, by assuming a full economic recovery. Second, they create an entirely new source of future deficits, essentially out of whole cloth.

CBO claims to expect a relatively rapid return, over five years, to high levels of employment, and the baseline incorporates a correspondingly high rate of real growth in the early recovery from the great crisis. But under present financial conditions this scenario of a rapid return to high employment is highly unrealistic. It can only happen if the credit system finances economic growth, which implies a rising level of private (household and company) debt relative to gross domestic product. And that clearly is not going to happen. On the contrary, deleveraging in the private sector is sure to remain the rule for a long time, as mortgages and other debts default or are paid down, and as many households remain effectively insolvent due to their mortgage debt.

With high unemployment, high public deficits are inevitable. The only choice is between an active deficit, incurred by putting people to work or otherwise serving national needs – such as providing a decent retirement and health care to the aged – and a passive deficit, incurred because at high unemployment tax revenues necessarily fail to cover public spending. Cutting public spending or raising taxes, now or in the future, by any amount, cannot reduce a deficit due to high unemployment. The only fiscal effect is to convert an active deficit into a passive one – with disastrous economic and social effects.

The only way to reduce a deficit caused by unemployment is to reduce unemployment. And this must be done with a substantial component of private financing, which is to say by bank credit, if the public deficit is going to be reduced. This is a fact of accounting. It is not a matter of theory or ideology; it is merely a fact. The only way to grow out of our deficit is to cure the financial crisis.

To cure the financial crisis would require two comprehensive measures. The first is debt restructuring for the entire household sector, to restore private borrowing power. The second is a reconstruction of the banking system, effectively purging the toxic assets from bank balance sheets and also reforming the bank personnel and compensation and other practices that produced the financial crisis in the first place. To repeat: this is the only way to generate deficit-reducing, privately-funded growth and employment.

As a former top adviser in the Clinton White House, co-chairman Erskine Bowles no doubt knows that privately-funded economic growth produced the boom years of the late 1990s and the associated surplus in the federal budget. He must also know that the practices of banks and investment banks with which they were closely associated worked to destroy the financial system a decade later. But I would wager that the Commission has spent no time, so far, on a discussion of the relationship between deficit reduction and financial reform.

To be clear: unemployment can be cured without private-sector financing, if public deficits are large enough – as was done during World War II. But if the objective is to reduce public deficits, for whatever reason, then a large contribution from private credit is essential.

One more time: without private credit, deficit reduction plans through fiscal austerity, now or in the future, will fail. They cannot succeed. If at the time the cuts take effect the economy is still relying on public expenditure to fund economic activity, then reducing expenditure (or increasing taxes) will simply reduce GDP and the deficits will not go away.

Further, if the finances of the private sector could be fixed, then an austerity program would be entirely unnecessary to reduce public debt. The entire national experience from 1946 to 1980, when public debt fell from 121 to about 33 percent of GDP and again from 1994 to 2000, proves this. In those years the debt-to-GDP ratio fell mainly because of credit-driven economic growth – certainly not because of public-sector austerity programs. And this is why the deficits returned, in 1980-2 and in 2000, once the credit markets froze up and the private economy entered recession.

Thus until the private financial sector is fully reformed – or supplemented by parallel financing institutions as was done in the New Deal – high deficits and a high public-debt-to-GDP ratio are inevitable. In the limit, if there is no private financial recovery, debt-to-GDP will converge to some steady-state value, probably near 100 percent – a normal number in some countries – and at that point the public deficit will be the sole engine of new economic growth going forward. Only when the private sector steps up will the debt-to-GDP ratio begin to decline.

For this reason, a commission report focused on “entitlement reform” rather than “financial reform” would be entirely beside the point. Entitlement cuts, no matter how severe, cannot and will not achieve deficit reduction. They cannot “meaningfully improve the long-term fiscal outlook,” as required by your charter. All they will accomplish is to impoverish vulnerable Americans, impairing the functioning of the private economy and the taxing capacity of the government.