A Twin Deficit Perspective on the Federal Budget

The proposed Balanced Budget Amendment (BBA) would prohibit "total outlays" from exceeding "total receipts" in any fiscal year, and any tax or debt increase, unless approved by a 60% vote of the whole membership in each house of Congress. It would not take effect for at least 7 years.

• Part I of this paper explains why the inherent functional relationships between the federal budget balance, Federal Reserve policy and the economy would prevent the BBA from achieving its ostensible purpose and would greatly increase the difficulty of achieving it by more effective means.
  
• Part II outlines a more effective approach to deficit control and economic management.
  
• Part III notes the philosophical and political context of the controversy and the challenge for Presidential leadership.

I. The BBA's Achilles' heel

It is generally understood that the BBA would cause a tangle of definitional, accounting, legislative, judicial and federal/state/local-relations nightmares. But its real Achilles' heel can best be understood by looking at the federal budget's two functional components, as shown in Figure 1:

 
Figure 1

When the Fed slows the economy and increase's unemployment to combat inflation, federal outlays for welfare, unemployment benefits and other means-tested entitlements automatically increase. But the biggest effect is the automatic nosedive of receipts from income and employment taxes -- much like the effect on laid-off workers and recession-hit businesses. A one percent change in unemployment automatically changes the HI-UE Deficit by more than most of the spending changes that Congress votes on -- nearly $60 billion a year in 1995, $80 billion in 2000.

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 .

The BBA's requirement of a politically impractical 60% vote for a tax increase implicitly forces Congress to try to respond to every Fed-induced revenue reduction by an even greater reduction of current policy outlays. This would hardly facilitate stable businesslike management of the government.

Causes of past deficits.

Historically, the Policy Deficit has been caused mainly by Congress's political unwillingness to impose higher taxes to pay for higher military spending. The Policy Deficit was over 2% of GDP in the Korean War (1952-53), nearly 2% in the Vietnam War (1967-68), and varied between 2«% and 3«% during 1983-94 (when the military buildup over 1979 levels accounted for half of the total Policy Deficit). But the structurally endemic nature of the Policy Deficit since 1982 was also caused by the calculated "Reagan Revolution" political strategy of trying to "reduce the size of government" by cutting taxes and then pushing for cuts in non-military spending "to balance the budget." The renewed "Republican Revolution" now seems to be adopting this same strategy.

The HI-UE Deficit has been a serious problem mainly when governments have rejected an "activist" approach to managing the economy and abandoned full employment as a primary goal of national policy. The HI-UE Deficit reached temporary peaks of 3% of GDP in 1958 and 1960 (Eisenhower) and over 2% in 1970/71 (Nixon). But it became endemically high (over 1«%) only in 1974 when the OPEC cartel's first extortionist "oil tax" caused an economically- devastating worldwide inflation and ensuing recession -- and governments continued to rely primarily on "tight money" and high unemployment to combat the inflation. Since then HI-UE Deficits have accounted for 2/3 of the total increase in our national debt -- and the interest payments on it.

In fact, interest payments on the HI-UE debt are a key link between the HI-UE and Policy Deficits. If interest on the HI-UE share of the debt were included in the current HI-UE Deficit the Policy Deficit would now have a surplus of over $80 billion.

Why federal fiscal responsibility is fundamentally different from non-federal.

Households, businesses and state/local governments have little current control over their own income. But the federal government, through Fed monetary policy, has major control over not only its own income but also everybody else's. Governor Pete Wilson recently referred to his California as a "proud sovereign state." But states, counties and cities are not sovereign economically. In an integrated national economy, mismanaged policy in Washington can bring California to its knees along with everyone else.

Thus, federal fiscal responsibility also requires federal economic responsibility -- with much more systematic coordination of all our economic policy tools. By ignoring the HI-UE Deficit and putting the Policy Deficit in a straight-jacket the BBA would make businesslike economic management impossible.

Defining the Deficits: How much unemployment is politically acceptable?

One reason the deficit isn't usually separated into its two functional components in policy discussions is the "political" problem of choosing the "full-employment" unemployment rate from which to calculate the "excess" unemployment for the HI-UE Deficit. It's a "political," rather than an economic problem because it would be entirely possible economically to again reduce our unemployment to below 3% without inflation if there were the political will to do it . (From 1960 to 1973 Germany and Japan even kept their unemployment near 1%.) Thus, I have intentionally postponed explaining the definitional division between the two deficits until now because I wanted to first make clear the functional relationship between them.

The analysis in this paper defines "high" unemployment as anything above the 4% rate which is legally mandated by the Humphrey/Hawkins (H/H) "Full Employment and Balanced Growth Act of 1978" as the "interim target" of national economic policy -- and a rate we have bettered several times since World War II with even less inflation than we have now.

The values in Figure 1 are derived from the corresponding Congressional Budget Office (CBO) deficit components:

• The "standardized unemployment" (SE) policy deficit [1] -- the CBO estimate of what the deficit would be if the economy were operating at its "potential" ("full-employment") trend GDP.

• The "cyclical" deficit -- the difference between the combined (total) deficit and the SE deficit.

NAIRU -- the "Non-Accelerating-Inflation Rate of Unemployment."

The CBO's estimate of "potential" GDP is based on its estimate of the NAIRU. This varies from a low 5.4% in 1955 to a high 6.3% in 1978 and back down to a projected 5.7% in 1999 -- mainly because of the changing labor-force composition (women and teenagers tend to have higher unemployment rates). This rate is now apparently the implicit policy target of the Fed and the Clinton Administration. But it seems a travesty to consider this rate our "full-employment potential" GDP. Therefore, since NAIRU was 2.3 percentage points above 4% when the H/H act was adopted, I adjusted the CBO's SE deficit to the H/H 4% rate.  [2]

The NAIRU unemployment rate is fiscally, economically, politically, socially and morally unacceptable as an American national policy goal, for the following very basic reasons:

• It leaves 13 million people wholly or partly unemployed -- including 1/3 of all black teenagers (no wonder some use crime to earn money!) -- and leaves scores of millions more with an abiding sense of economic anxiety.
• The nation's mayors are now noting increasing hunger and homelessness -- while so much work needs to be done to achieve an American Dream where our cities are safe and livable, 200 mph railroads run on time and anybody who really wants to work can find a job.
• An overall full-employment economic environment can greatly ease the adjustment pain in those sectors of the economy adversely affected by NAFTA, GATT, military spending cuts and other structural readjustments.
• When people can more easily find other jobs it will be politically much easier to reduce wasteful federal spending in the Policy Deficit -- including "military pork" such as the admittedly unneeded Trident nuclear attack submarine and excess military bases.
• Lack of job opportunities is a key cause of many of our worst social problems, and a full-employment economic environment is an essential (though obviously not sufficient) requirement for curing them. To reduce crime and the present dangerous degree of public anger unemployment must be reduced to at least the rates we used to achieve before the OPEC oil tax and Reagan deficits.
• In this era of global competition we simply can't afford the economic and social costs of continuous high unemployment.
• And we can't afford this much fiscal waste. Reducing unemployment to the H/H policy target during the next 5 years would save about $500 billion dollars of otherwise lost budget resources -- and thus make this available for tax cuts, deficit reduction or increased investment spending. (Compare this to the projected benefits of proposed spending cuts.) Lower unemployment greatly mitigates the false political dilemma between tax increases and spending cuts.
• We can achieve full employment without inflation. But the CBO "rule of thumb" estimates that the inflation rate increases only «% for each 1% that the unemployment rate falls below NAIRU for a year. If we can reduce unemployment to 4% with a 1% inflation increase, that would seem to be well worth the cost while we work out the structural economic damage from past high unemployment which is such an important cause of inflationary imbalances.
• Our own history shows that the H/H 4% is not an unrealistic policy target - - if we have the political will to manage our economy responsibly, with systematic coordination of all appropriate policy tools.

II. There is a better way than the BBA to achieve real fiscal responsibility

Because Congress has no direct control over the HI-UE Deficit it can be significantly reduced only by much more systematic coordination between monetary and fiscal policy -- and the BBA does nothing to facilitate that. If Congress finally has the political courage to really balance the budget, there is a much sounder and more effective strategy than the BBA: recognize clearly that the two deficits have different causes, and attack both simultaneously.

1)  Make the Federal Reserve an explicit and active partner in the deficit-reduction process.

The President and Congress are now required to make deficit projections for five years ahead, based on unreliable and ever-changing economic projections. But the Fed, which basically controls the HI-UE Deficit, is now required only to "forecast" its monetary policy and the economy for only one year ahead. This is a fiscal absurdity! The key principle should be:

Don't forecast -- manage!

As long as the Fed targets 6% unemployment and tries to prevent economic growth from reducing it below that, Republican talk about "dynamic scoring" to take account of potential "economic stimulus" from capital gains and other tax cuts can be only wishful thinking. In the early 1980s when the Fed was permitting recovery from that devastating recession, "dynamic scoring" seemed plausible, but the promised results didn't happen even then. Under present conditions the only way Congress can produce more economic stimulus is by managing the economy in a more businesslike manner with more systematic and effective coordination of monetary and fiscal policy -- so that the Fed feels comfortable in allowing faster growth.

For its part, the Fed should be required 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 standby consumer and business credit controls to be invoked "automatically" whenever excessive borrowing increases real interest rates and causes inflationary market conditions in credit-financed economic sectors such as cars and housing. (These controls must be better designed and better applied than those used to slow inflation in 1980, the authority for which expired in 1982.)

  The Fed seems to have managed our overall economic growth pretty well during the past three years, although probably a little too slow in 1992-93, when the total demand for credit was too low for a full recovery rate of money growth, and maybe a little too fast in 1994 when total credit demand was excessive. The Fed is usually given most blame for the run-up of interest rates this year, but this has probably been caused much more by the excessive and unsustainable growth of consumer and business borrowing (on the demand side) -- on top of the now-excessive federal deficit -- than by the Fed's slower money growth (on the supply side).

Allowing this unsustainable temporary credit imbalance to "run its natural course" imposes a high interest tax on the whole economy -- including hundreds of dollars a month on the millions of people with adjustable-rate home mortgages. It also forces the Fed to further restrict money growth, which further increases interest rates, the Policy Deficit and inflation, and may ultimately lead to another general recession -- which will further increase the HI-UE Deficit. Reducing the interest tax would do far more for the middle class than the proposed federal tax breaks -- and the credit controls would not be means-tested.

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.

"Cyclical" fluctuations of borrowing, particularly consumer credit, home mortgage borrowing and business credit to finance the capital investment needed to meet these credit-financed fluctuations in consumer demand, are key factors in continuing the "business cycle."

• Excessive total borrowing, federal and non-federal combined, as in 1994, drives up interest rates and increases the Policy Deficit through interest on the federal debt. In addition, excessive consumer borrowing tends to cause inflationary market conditions in credit-financed sectors such as houses and cars, thus causing the Fed to slow the whole economy and increase the HI-UE Deficit.

• Insufficient total borrowing, as indicated by abnormally low real interest rates as, in 1980 and 1992-93, makes it difficult for the Fed and the banks to maintain a recovery rate of money growth, and thus increases the HI-UE Deficit. In this case a temporary increase in the Policy Deficit would tend to reduce the HI-UE Deficit.

But any kind of tax cut now would be economically inappropriate. Fed Vice Chairman Alan Blinder says that the Fed is likely restrict economic growth even further if the Republican "smaller government" ideologues repeat the Reagan era fiscal irresponsibility by combining tax cuts with another military buildup.

The FASTA solution.

The traditional "automatic stabilizer" effect of economic fluctuations on the HI-UE Deficit helps to stabilize the national credit balance, but by its very nature is always too little and too late.

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 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 policy to maintain the national credit balance and resulting stable low interest rates. This policy tool deserves urgent study now by the Clinton Administration and the new Congress.

Maintaining stable low interest rates would greatly facilitate longer-range planning by all sectors of the economy. It would minimize the "derivatives" problem and current jitters in the bond and stock markets. And there would probably have been no savings and loan or banking crises in the 1980s.

Stable low interest rates would also hold down the interest cost of past HI-UE and Policy Deficits, and thus reduce the current Policy Deficit. The current HI-UE Deficit would be eliminated by reducing unemployment to 4%. Together these would reduce the total deficit more and faster than the BBA or any other plan now being seriously proposed in Congress.

Under present credit conditions the FASTA formula would call for a small temporary increase in withholding taxes. Because the economy's excess total borrowing is still rather small, the actual amount of the needed FASTA withholding increase would probably still be so small that most people wouldn't even notice it. When the consumer credit boom is over, FASTA would reward people with a welcome tax rebate.

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.

"Inflation" means rising prices, wages and interest rates. Direct controls on non-credit prices and wages are inappropriate where markets are effectively competitive . But the OPEC "oil tax" is not the only "price-tax" extracted from consumers by monopolistic market-power, and businesslike management of the economy requires constant vigilance on this. It is not yet clear whether this problem will be mitigated or exacerbated by ever-larger multinational corporations.

But 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.

These non-monetary anti-inflation tools are especially important during the recovery transition period to counteract the inherently inflationary structural distortions and capacity shortages caused by the economic mismanagement which exacerbates the inherent "cyclical" tendencies of our free-market economy. (There is no inherent "business cycle" that couldn't be largely eliminated by systematic coordination of all our economic potentially available policy tools.)

III. The Philosophical and Political Context

The Preamble of the Constitution says that one of the purposes of the Constitution and the federal government is to "promote the general welfare." Thus the government has two choices:

• an "activist" philosophy to prevent problems and help people by long-run "framework" planning to create the kind of social-economic, full-employment environment in which businesses, workers, consumers and investors everywhere can have maximum confidence to plan further ahead in pursuit of the American Dream without having to call on government for the kind of assistance which tends to concentrate power in Washington;

• a "laissez-faire" philosophy which permits the traditional "business cycle" and free-enterprise profit motive to work without interference -- until things fall apart (like the savings and loan debacle), and then reluctantly and inefficiently yield to public demands for the government to "pick up the pieces."

Conservative opposition to the goal of full employment.

After WW II, Congress passed the "Em ployment Act of 1946." Although it is often referred to today as "the full -employment act" conservatives forced Congress to take the "full" out of the title because they recognized that if an "activist" government accepts effective responsibility for maintaining stable full employment growth it would require many "interventions" in the economy which are opposed by those who know how to profit from "the business cycle" and from the absence of effective legislation protecting the general welfare. The H/H Act kept "full " in its title and set specific economic goals, but conservatives made sure that it had so few real teeth that it has been largely ignored.

The "size of government" issue.

Undoubtedly, some supporters of the BBA either really believe it would help reduce the deficit or don't realize that there are more effective means of doing that. But for some conservative ideologues the most basic purpose of the BBA is to "reduce the size of government" by putting artificial pressure on Congress to reduce non-military federal spending, even when that clearly diminishes the national welfare. When they were pushing the BBA in 1936 they were really trying to prevent FDR, whom they hated ideologically, from mobilizing the full powers of the government to get us out of the Great Depression. In 1982 they pushed it in support of the Reagan Revolution. Now they are using the general public discontent with the results of past government mismanagement of the budget and the economy to gain public support for the BBA. But if the public fully realized the nature and implications of the BBA's basic ideological purpose, it is doubtful if many would support it.

Since 1929 the relative size of the federal government has been greatly increased by four factors: the Great Depression, World War II, the Cold War, and excessive unemployment most of the time. All of these might have been avoided by a more effective "activist" federal government with more vision to understand what was needed to prevent those catastrophes and better leadership to help the public understand what needed to be done.

If "size of government" is measured by the amount of current spending, and if the self-financing Social Security system, other pension programs and Medicare and Medicaid are excluded, then the great bulk of policy budget spending goes for current military spending and the interest cost of previous HI-UE Deficits and deficit-financed military spending. In this perspective, the best way to "reduce the size of government" is to eliminate the HI-UE Deficit by managing the economy for stable full employment, reforming and strengthening the United Nations so that it could take over a good share of America's national defense and foreign military responsibilities, and enacting a universal, effective, cost-conscious and largely self-financing (like Social Security) national health-care system . Everything else is marginal.

The challenge for presidential leadership

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.

The BBA, unless it is loaded down with so many definitions, special exemptions and provisos as to make it a meaningless mockery of the Constitution, would effectively preempt a more businesslike activist government policy. In particular, the BBA and the 60% vote requirement for any tax increase would preclude the use of FASTA or any other fiscal policy stabilization tools designed for systematic coordination with Fed monetary policy. The BBA is like the 18th Amendment banning "intoxicating liquors" -- it's so impractical that if it were passed it would soon have to be repealed -- and it's much better to kill it now and get on to solving our real problems.

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, and could finally kill the BBA proposal. Viewed this way, the deficit and the BBA become issues of businesslike fiscal management, potentially negotiable with moderate Republicans. And, who knows, the intellectual side of Newt Gingrich might even 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 few weeks before the scheduled BBA vote there is probably only one way to get the national media to publicize this new perspective widely enough: President Clinton could 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 these charts should also be used in the Economic Report of the President, the State of the Union address and TV speeches.

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. It would be far better to finally kill it now rather than have to re-fight this battle again and again in individual states for the next five years.

It would be politically irresponsible for Congress to vote for the BBA without facing the hard policy choices for implementing it, and the Republican leaders should spell out the details of their plan before calling for a BBA vote.

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.

NOTES
 
Note 1.  CBO's "Standardized Employment" (SE) Policy Deficit -- The CBO publishes two versions of the combined (SE and "cyclical") deficit:

• The "on budget" deficit (also called the "federal funds" deficit). This includes the amount "borrowed" annually from the Social Security Trust Fund (SSTF), which has amounted to about 1% of GDP since 1989.

• The "total" deficit (also called the "unified" budget). The CBO really should call this the "net" deficit because it nets the SSTF surplus against the "on budget" (total) deficit.

(back to ref 1)
 
Note 2.  For each year I calculated the excess of the actual unemployment rate over the NAIRU rate, and then I plotted the following scatter chart of this excess unemployment against the CBO's "cyclical" deficit as a ratio to GDP (to make them both "operating rate shortfalls").

Most values were well-concentrated along a well-defined slope, which was evaluated by the "black-thread method," shown below, to most appropriately eliminate the outlier values).

This disclosed that each 1% increase in unemployment increases the deficit by 0.693% of GDP -- a value referred to here as D_ue1.

(Note: During severe recessions the deficit was significantly above this trend line, partly because only annual data was available, while "person" unemployment -- as distinguished from person-hour employment -- typically lags about one quarter behind incomes, tax receipts and unemployment benefits. More precise estimates might be derived from quarterly data and by taking account of specific changes in tax rates and spending programs.)

Thus, the chart values were calculated by these formulas:

HI-UE Deficit = CBO "cyclical" deficit + 2.3 * D_ue1 + .0017 GDP (scatter chart intercept).

Policy Deficit = CBO SE deficit + SSTF surplus - 2.3 * D_ue1

(back to ref 2)