This week, the White House released its 2007 federal budget, which projected a shortfall of $423 billion for the current fiscal year. The good news: Budgeters predict diminishing deficits in years ahead, even while accounting for extending the Bush tax cuts. The bad news: For those forecasts to come true, Iraq will have to turn into Canada next year, Afghanistan into Sweden, and Congress into an order of mendicant monks.
Mostly the new deficit numbers—and the more realistic and depressing projections included in this Brookings paper—should shame the fiscally unbalanced Republicans who run the government. But there is also a shade of discomfort among those of us who love to hate deficits. We must acknowledge that the U.S. economy has performed pretty well in the Bush years, despite a stupendous reversal in the nation's fiscal position. Gross domestic product grew at a rate of 3.5 percent in 2005 on top of 4.2 percent in 2004. The January unemployment figure was 4.7 percent, which is within striking distance of its Clinton-era bottom. Despite massive Keynesian fiscal stimulation, long-term interest rates remain low and there's no sign of inflation. If deficits are so terrible, why is the economy so good?
One possibility is that Vice President Dick Cheney was right when he said that "Reagan proved deficits don't matter." The theory behind this view, to the extent there is one, is that in a global market for capital, government borrowing does not "crowd out" private investment the way it does in an insular economy. A Federal Reserve Board's model suggests that 1 percentage point of GDP in deficit spending raises long-term interest rates 50 to 70 basis points—.5 percent to .7 percent. We pretty clearly aren't seeing such a strong effect, at least in the short term. In 2003, when Washington decided to add another trillion dollars in deficit spending to pay for a Medicare prescription-drug program, rates barely budged. Perhaps bond traders are overdoing the serotonin reuptake inhibitors. Or perhaps the international appetite for Treasury bonds means that deficits no longer move interest rates the way they once did.
But even if that change is real, Cheney and others who wave aside the budget gap are still wildly, recklessly wrong. Deficits are as malignant as ever. The effects are just hard to make out at the moment. The basic problem is quite obvious: We are making ourselves poorer. Borrowing to consume, which is what the United States is doing, as opposed to borrowing to invest, is a lousy long-range strategy unless you plan to die young. Because of the deficit, our net national savings is now barely 1 percent of GDP. A society that saves and invests so little may be able to postpone a decline in living standards for a good while. But it cannot do so indefinitely.
The Bush binge could end with a bang or a whimper. If confidence in the U.S. economy erodes, foreigners may look askance at continuing to finance our deficits. The Treasury would have to offer higher returns to sell its bonds, raising long-term rates. The withdrawal of foreign capital could also prompt a decline in the value of the dollar, as traders sold instruments denominated in U.S. currency. Such trends can create a vicious cycle, in which misery is never at a loss for company. In a worst-case scenario, unchecked deficits could provoke a Mexican- or Asian-type financial crisis. The Fed might be able to forestall a meltdown—or it might not. As former Treasury Secretary Lawrence Summers once put it, the thing about a dysfunctional relationship with the rest of the world is that it can go on much longer than you expect, but it can also end much more suddenly than you expect.
Another hazard is losing what Robert E. Rubin, Summers' predecessor as treasury secretary and my guru on this subject, calls "resilience." A deficit of 3.2 percent of GDP, which is what Bush predicts for this year, curtails the ability of policy-makers to respond effectively to the unforeseen and unforeseeable. The U.S. economy was able to absorb the shock of Sept. 11 without falling into recession in part because of Washington's use of fiscal as well as monetary policy in response. But when the budget is already deeply in the red, the "break glass in case of fire" box comes pre-smashed. In the event of another major terrorist attack or natural disaster, such Keynesian tools as tax cuts and stimulus spending will be much harder to deploy than they were in 2001, when the budget was still in surplus.
Perhaps the gravest harm deficits do is undermining government's ability to take on the country's non-emergency problems and prepare for the future—the health-care mess, the education mess, the baby-boom generation's underfunded retirement, and so forth. Even into the 1990s, many Democrats tacitly approved of deficit spending, because it enabled them to do more without higher taxes. In those days, Republicans tended to oppose deficits, because they wanted government to do less. But during the Bush presidency, these roles have reversed. Republicans now see deficits as a way to disable the federal government by "starving the beast." Democrats, by contrast, have come to loathe deficits, because they prevent government from doing anything.
If we deficit hawks have failed to generate enough alarm to motivate action, it may be because our metaphors have gotten stale. Running a deficit isn't so much like shooting yourself in the foot, which hurts immediately. It's more like smoking, drinking to excess, and not exercising. It will in fact kill you—just not tomorrow.