Why the tax-cut deal won't solve America's fiscal or economic crises.

Commentaries on economics and technology.
Dec. 16 2010 5:10 PM

Federal Deficit Disorder

Why the tax-cut deal won't solve America's fiscal or economic crises.

George H. W. Bush. Click image to expand.
Will we ever escape what George H.W. Bush called "voodoo economics"?

Democratic and Republican leaders in Washington are suddenly falling over themselves to agree on the need for major tax cuts—affecting not just middle-class Americans but also very rich people (both living and dead). Does this sudden outbreak of the long-desired bipartisan consensus indicate that a new, stronger America is just around the corner? Unfortunately, the opposite is true. What we are seeing is agreement on a very dangerous approach to public finance: a continuation and extension of what President George H.W. Bush memorably called "voodoo economics." Its consequences are about to catch up with America and the world.

Bush used the phrase when he was competing with Ronald Reagan for the Republican presidential nomination in 1980. Reagan suggested that tax cuts would pay for themselves, i.e., actually raise revenue—a notion that became known as "supply side" economics. There's nothing wrong with worrying about the disincentive effect of higher taxes, but the extreme version put forward by Reagan did not really apply to the United States. When you cut taxes, you get lower revenue, which means a bigger budget deficit.

To be sure, no serious people are claiming the full Reagan effect today—partly because the Congressional Budget Office has kept everyone honest by showing in detail that the tax cuts will increase the deficit by close to $900 billion. But there is a broader Reagan-type reasoning at work here: Unemployment is high, the economy is not growing fast enough, and we "need a fiscal stimulus." For those who generally like lower taxes, of course, this, too, is wishful thinking.

Experience with fiscal policy over the past few decades is clear. It is worth stimulating the economy with discretionary fiscal policy only occasionally—specifically, when not doing so would be calamitous. Thus, it made sense to pursue a fiscal stimulus of some kind in early 2009. More generally, fiscal stimulus is unlikely to have much lasting effect, as is the case now. There may be some temporary positive impact on demand, or higher interest rates could offset the entire fiscal push—rates on the benchmark 10-year Treasury bond are up significantly from a month ago (from 3.21 percent to 4.16 percent), when the discussion of tax cuts began in earnest.

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The market is nervous—mostly about the prospect of large fiscal deficits as far as the eye can see. Some commentators dismiss this as irrational, but, again, that is wishful thinking. The path-breaking work over many years by Carmen Reinhart, my colleague at the Peterson Institute in Washington, makes this very clear: No country, including the United States, escapes the deleterious consequences of persistent large fiscal deficits. (Her book with Ken Rogoff, This Time Is Different, should be required reading for U.S. policymakers.)

In this environment, a further fiscal stimulus may prove counterproductive, with the extra spending counterbalanced by the negative effect on the housing market of higher interest rates. The Federal Reserve promised to hold down longer-term rates, but its commitments in that direction now seem ineffective. But that is not the real danger here. Most American politicians like to think and talk only about the United States. But longer-term U.S. interest rates are very much affected by what happens in the rest of the world—and how private-sector investors view U.S. government debt relative to other countries' sovereign debt.

The Eurozone's problems certainly help the United States sell more debt at lower prices—for now. But the chances are high that the Eurozone will sort out its difficulties in a year or so (most likely after another round or two of crisis), in part through the judicious use of fiscal austerity. It would make complete sense if a German-led core emerged stronger and more politically integrated than before within a Eurozone that has a different composition, a different structure, and very different rules. This presumably more-fiscally-unified political entity would be highly attractive to investors.

A year from now, what kind of economy will the United States have? Any short-term "fiscal stimulus" effect will have worn off, unemployment will still be high, and there will no doubt be politicians clamoring for more tax cuts. The budget deficit will likely be in the range of 8 percent to 10 percent of GDP, even if growth comes back to some extent. And the bond markets will be much more nervous, meaning higher interest payments, which will widen the deficit further. We might also be looking at a potential ratings downgrade for U.S. government debt—implying the prospect of even higher interest rates.

Some people expected Rep. Paul Ryan—a rising star in the Republican Party and the chairman of the House Budget Committee in the next Congress—to provide a fiscally responsible anchor to the next round of the deficit debate in the United States. Writing in the Financial Times in early November, Ryan suggested, "America is eager for an adult conversation on the threat of debt." But all indications are that he is just as childishly reckless on fiscal policy as most of his Republican colleagues since Ronald Reagan.

Unfortunately, there is no sign yet that the Democratic leadership is ready for a mature conversation about fiscal consolidation, either. Both parties' leaders will get there—but only when dragged, kicking and screaming, by the financial markets.

This article comes from Project Syndicate.

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Simon Johnson is a professor at MIT’s Sloan School of Management and the co-author of White House Burning: The Founding Fathers, Our National Debt, And Why It Matters To You.

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