The Federal Budget's Twin Deficits and the Balanced Budget Amendment John S. Atlee, 1/3/95

The proposed Balanced Budget Amendment (BBA) would prohibit "total outlays" from exceeding "total receipts" in any fiscal year, or any tax or debt increase, unless approved by a 60% vote of the whole membership in each house. It would take effect in 2002, or two years after ratification, whichever is later.

The BBA's Achilles' heel.  The BBA would cause a tangle of definitional, accounting, legislative, judicial and federal/state/local-relations nightmares. But the reason it is most unworkable is illustrated by the budget's twin structural components:

  Figure 1

The Policy Deficit is controlled by Congressional tax and spending policies -- the BBA's ostensible concern.

The HI-Unemployment (HI-UE) Deficit (the difference between the total deficit and the Policy Deficit), is determined by the economy's overall growth rate and unemployment rate, which are controlled mainly by the Federal Reserve -- over which Congress and the BBA have no effective control.

When the Fed slows the economy and increases unemployment "to combat inflation," federal outlays for welfare, unemployment benefits and other means-tested entitlements automatically increase. But a much bigger effect is the automatic plunge of receipts from income and employment taxes -- much like the effect on laid-off workers and recession-hit businesses. The BBA's requirement of a politically impractical 60% vote for a deficit or a tax increase implicitly forces Congress to try to respond to every Fed-induced revenue reduction by an even greater reduction of current Policy Budget outlays. This would tend to cause a downward economic spiral and disrupt the federal Policy Budget the way recessions now disrupt state/local government budgets.

The President and Congress now make deficit projections for five years ahead, based on unreliable and ever- changing economic forecasts. But the Fed "forecasts" its monetary policy and the economy for only one year ahead. This is absurd! -- and the BBA would make it worse.

Reducing the HI-UE Deficit is the best key to total deficit reduction.  Just one percent change in unemployment would automatically change the HI-UE Deficit by nearly $60 billion this year, $80 billion in 2000 -- more than most of Congress's controversial spending changes.

In the chart above, "high" unemployment is anything above the 4% rate which is legally mandated by the Humphrey/Hawkins (H/H) "Full Employment and Balanced Growth Act of 1978." That's a rate we have bettered several times since World War II with even less inflation than we have now, and is a clearly achievable policy goal.

But in 1973 and again in 1979 the OPEC cartel levied an extortionist "oil tax" on the world economy and the Fed used "tight money" and high unemployment to combat the resulting inflation. Since 1973 HI-UE Deficits have accounted for 2/3 of the total increase in our national debt. And if the HI-UE share of debt interest payments were included in the current HI-UE Deficit, the Policy Deficit would now have a surplus of over $80 billion.

Thus, contrary to the allegations of BBA and "smaller government" ideologues, most past deficits and resulting increases in federal debt have been caused more by Fed-induced revenue deficit than by "out of control" non-military deficit spending. As the chart above shows, the Policy Deficit didn't become a serious endemic problem until the Reagan ideologues adopted a calculated political strategy of cutting taxes and increasing military spending and then pushing for a BBA and cuts in non-military spending "to balance the budget" -- a strategy apparently being re-adopted by the new "Republican Revolution."

Why federal fiscal responsibility is fundamentally different from non-federal.  Households, businesses and state/local governments have little control over their own current income. But the federal government, through Fed control of the economy, has major control over not only its own income but also everybody else's. Thus, federal fiscal responsibility also requires federal economic responsibility -- with much more systematic coordination of fiscal, monetary and all other economic policy tools. The BBA, by ignoring the HI-UE Deficit and putting the Policy Deficit in a straight-jacket, would make such businesslike economic management impossible.

Needed: real full employment as key policy goal.  The Clinton Administration, Congressional Budget Office and Fed have all accepted the 6% "Non-Accelerating-Inflation Rate of Unemployment" (NAIRU) as an implicit policy target. But that rate is utterly unacceptable as a national policy goal if we want to rebuild America and revive the American Dream:

• It leaves 13 million wholly or partly unemployed -- including 1/3 of all black teenagers -- and scores of millions more with economic anxiety. With so much work that needs to be done, anybody who really wants to work should be able to find a job.
• Lack of job opportunities is a key cause of many of our worst social problems.
• In this era of global competition we simply can't afford the economic, social and fiscal costs of continuous high unemployment.

By contrast, a full-employment economic environment would:

• Facilitate solving most of our social problems.
• Ease the readjustment pain from NAFTA, GATT, military downsizing, etc.
• Make it politically easier to reduce "military pork" and other wasteful policy spending, and mitigate the false political dilemma between tax increases and spending cuts.
• Reduce our present horrendous fiscal waste.

Reducing unemployment to 4% during the next 5 years would save about $500 billion dollars of otherwise lost budget resources -- and make this available for tax cuts, deficit reduction or increased investment spending. Our own history shows that it would be entirely possible economically to reduce unemployment even to below 3%, without inflation, if there is the political vision and will to do that.

Don't just forecast -- manage!

To achieve real fiscal responsibility, recognize clearly that the twin deficits have different causes, and attack both simultaneously. This requires much more systematic coordination between all our economic policy tools.

1. Make the Fed an explicit and active partner in the deficit-reduction process.

   As long as the Fed aims for 6% unemployment and 2.5% growth the Republicans won't get any "economic stimulus" from their "dynamic scoring" of capital gains and other tax cuts. Congress can get more economic stimulus only by a more businesslike overall economic policy which makes the Fed comfortable in allowing faster growth and lower unemployment.

   A Monetary Policy Sunshine Act should require the Fed to:

   • ESTIMATE the fastest possible non-inflationary economic recovery track towards the legally-mandated goal of 4% unemployment for the full 5 years of the federal budget.
   • EXPLAIN what monetary and credit policies are needed to actually achieve that recovery track and how it plans to carry out those policies.
   • RECOMMEND what Policy Deficit (or surplus), and what non- monetary anti-inflation policies by the rest of the government, would best facilitate that process.
   • MAINTAIN well-designed selective standby credit controls to be invoked "automatically" whenever excessive consumer and business borrowing causes inflationary market conditions in credit-financed economic sectors such as cars, housing, office buildings and leveraged buyouts.

   The Fed is blamed for the 1994 run-up of interest rates, but this has probably been caused more by the increase in consumer and business borrowing on the demand side of the credit market than by the Fed's slower money growth on the supply side. Allowing this unsustainable credit boom to "run its natural course" imposes a high interest tax on the whole economy -- including hundreds of dollars a month on the millions of middle class people with adjustable-rate home mortgages. Reducing this interest tax by credit controls would do far more for them than the proposed tax breaks.

2. Recognize that the key economic responsibility of fiscal policy is to maintain stable low real interest rates -- by "counter-cyclical" adjustments of the federal budget's deficit or surplus to maintain a stable balance between the economy's total supply and demand for credit.

   How fast the present Policy Deficit can be reduced without adversely affecting the economy depends mainly on the national credit balance, as indicated by short-term real interest rates. These are now about 2% above historical norms. Thus, now would be an ideal time to further reduce the Policy Deficit and the interest tax by eliminating the inappropriate tax deduction on non-housing-related home equity interest or by an energy tax to reduce our dangerous dependence on foreign oil -- and our huge trade deficit. The 1993 deficit reduction legislation showed that when there is strong leadership in either the White House or Congress, and even a minimum of cooperation between them, the Policy Deficit can be reduced at an economically appropriate rate without the BBA.

   But any kind of tax cut now would increase the interest tax on the whole economy, including the middle class.

   The FASTA solution. In 1961 the prestigious Commission on Money and Credit recommended a special formula-based, flexible, temporary adjustment of withholding taxes as the best means of permanently strengthening the "automatic stabilizer" role of the federal budget. Such a Formula-Administered Stabilization Tax Adjustment (FASTA) could automatically (without current political involvement by Congress or the White House) coordinate fiscal policy with Fed monetary and credit- control policies to maintain the national credit balance with stable low interest rates. This policy tool deserves urgent study now by the Clinton Administration and the new Congress. Restoring and maintaining stable low interest rates would:

   • Facilitate longer-range planning and productivity-increasing investment by all sectors.
   • Minimize the "derivatives" problem, current jitters in the bond and stock markets, and the risk of future savings and loan or banking crises.
   • Reduce the future Policy Deficit by holding hold down the interest cost of past HI-UE and Policy Deficits.
   • Reduce the interest tax on middle class homeowners.

   The BBA would effectively preempt use of all these fiscal policies for managing the economy in a more businesslike manner.

3. Recognize that an effective package of non-monetary anti-inflation policies is an essential "third leg" (with monetary and fiscal policy) for a coordinated recovery policy.

   This would allow the Fed to focus more on maintaining stable economic recovery and less on preventing inflation. Maintaining slow economic growth and high unemployment is a clumsy, inefficient and cruel way to fight inflation. It causes the whole economy -- and the HI-UE Deficit -- to suffer even when the inflationary pressures are mainly limited to a few sectors.

   There are many better anti-inflation policy tools -- health care reform, a mandatory "tax-free" COLA price index to prevent cost- and price-boosting excise and employment taxes from starting an inflationary spiral, better worker education and training, labor/management cooperation to increase productivity and refocus worker dissatisfaction on non-wage issues, better employment services, anti-monopoly policies, consumer education, etc.

The challenge for presidential leadership

Getting Congress and the public to look at the budget and the BBA in the twin-deficit perspective would make a major contribution to more rational and productive debate on these issues. Viewed this way, deficit control becomes a nonpartisan issue of businesslike fiscal management, potentially negotiable with moderate Republicans. Once this twin-deficit perspective becomes widely understood, hard-pressed state governors and city mayors, Wall Streeters and grass-roots voters will undoubtedly want to tell Congress (particularly the new members) to vote against the BBA. And, who knows, the intellectual side of Newt Gingrich might convince him that the BBA would eventually become a political liability, so that he too would be open to some sort of "package deal" for dropping his support of it.

But in the two weeks before the scheduled BBA vote there is probably only one way to get the national media to publicize this new perspective widely enough to be effective: President Clinton must use his "bully pulpit" to invoke the H/H 4% unemployment mandate with an inspiring and imaginative American Dream VISION of a stable full-employment American economy as a primary national policy objective, and then present his annual budget message to Congress in the twin-deficit format with visually effective charts -- not only for the overall deficit but also for the most economy- sensitive individual revenue sources and spending items such as means-tested entitlements, Social Security and farm subsidies. For optimum educational effect this presentation should also be used in the Economic Report of the President, the State of the Union speech and his TV speeches.

Since the budget message is not scheduled to arrive in Congress until after the scheduled BBA vote, this strategy would require leaking to the media the twin-deficit charts and outline of the strategy far enough ahead of the BBA vote that many members now pledged to vote for it will start worrying about whether they will appear politically silly having done so. It would be far better to finally kill the BBA now rather than have to re-fight this battle again and again in individual states over the next five years.

If Clinton is seeking a way recapture his presidential leadership, re-inspire the populist soul of the Democratic Party and slow the conservative steamroller in Congress, it would be hard to find a better strategy than this twin-deficit budget model and the full-employment policy goal -- it is certainly far better than playing catch-up with tax and spending cuts.