Ever since enormous federal budget deficits became a reality, the public has been bombarded with false theories about the consequences.
We were initially told that by causing high interest rates the deficits would prevent a recovery from the 1981-82 recession. That was false. Then we were told that they would intensify inflation. That was false. Now we are told that they have caused our large trade deficits. This theory, if not entirely false, is so misleading that it is almost worthless.
The economists who concoct these stories exaggerate what they know, thinking that they have embarked on a vital crusade: deficit reduction. Congress is supposed to be scared into action. But the result is just the opposite. As the budget deficits' adverse effects are discredited, political pressure to deal with them evaporates. Congress doesn't want to cut spending or raise taxes for no apparent gain.
The budget deficits need to be treated candidly--neither sensationalized nor ignored. In many respects the politics of big budget deficits resembles the politics of inflation in the 1960s and '70s. Controlling both involves making difficult short-term choices to avoid larger but ill-defined future problems. We tolerated creeping inflation for nearly two decades, ignoring warnings that it one day might get out of hand. It did, and only the wrenching austerity of the early 1980s stopped the inflationary spiral.
So, too, large budget deficits can be temporarily tolerated. But the longer they last, the greater the danger that they will snowball into a bigger crisis. No one can say precisely what or when. It's this ambiguity that tempts economists and others to advance more dramatic theories tying the deficits to some concrete economic problem. The connection between the budget deficits and the trade deficits is simply the latest example.
The argument is oversimplified, and has perverse side effects. It's being used by Japan and West Germany to resist U.S. pleas to stimulate their economies. The Reagan Administration correctly contends that these countries are draining demand from the world economy with their huge trade surpluses. Faster economic growth and higher imports would help sustain the global recovery. West Germany and Japan wrongly dismiss this view, attributing their trade surpluses mainly to our huge trade and budget deficits.
The U.S. trade deficits mean that as a nation we are spending more than we are producing, and are relying on imports to fill the gap. Blaming this excess national spending on the budget deficits is superficially plausible because, as the following table shows, the two deficits have roughly grown together. (The budget figures reflect the government's fiscal year, from October to September; the trade figures are for the calendar year.)
Budget Deficit Trade Deficit in billions in billions 1981 $78.9 $39.7 1982 $127.9 $42.6 1983 $208.9 $69.3 1984 $185.3 $123.3 1985 $212.3 $148.5 1986 $220.7 $170.0*
*estimate But this argument's flaw is simple: We could produce much more here. Between 1981 and 1983, our trade deficit rose 75%; meanwhile, civilian unemployment averaged 8.8% and factories operated at 75.6% of capacity. Even now there is room for more production. In 1986 unemployment was 7% and factory utilization was 79.5%.
A more sophisticated theory connects the trade and budget deficits via the dollar's high exchange rate, which has made U.S. exports less competitive and imports cheaper. By this logic the big budget deficits--and the expectation that they would continue--pushed up U.S. interest rates in the early 1980s, attracting international investors into dollar securities. As investors sold other currencies and bought dollars, the dollar's exchange rate rose more than 60% between 1980 and 1985.
The trouble with this theory is that the budget deficits were not the main cause of high U.S. interest rates. Most of the rise had occurred by 1982, before big budget deficits, and reflected the Federal Reserve's policy of crushing inflation with tighter credit. The budget deficits may have kept rates up after 1982 and contributed to the trade deficits. But budget deficits are only one of many causes. Others include the Third World debt crisis and slow growth abroad. Both cut demand for U.S. exports.
Being more precise about the budget deficits' effects usually is intellectual arrogance. Economists often pretend to know more than they do. The truth is that as the U.S. economy has become more integrated into the world economy it has become harder to understand. There are new uncertainties and complications. Although economists may grasp general tendencies, detailed predictions are difficult.
In the future the connection between the two deficits may become more important. As the dollar's exchange rate falls, U.S. goods become more competitive and our trade deficit also should fall. Satisfying the spending demands of consumers, businesses and government will be tougher. More of our production will be exported, and imports will slow. Higher production can help, but, if unemployment drops and factory utilization rises, spending pressures could increase inflation or interest rates. Cutting the budget deficit is one obvious way to ease those spending pressures.
That is only one reason for reducing big budget deficits. A government that spends far more than it collects is courting trouble. Potential problems abound: Government may inflate away its debt by printing money, government borrowing may crowd out private investment and big deficits may frustrate spending on vital new needs. The case for cutting the budget deficits does not require sophisticated economic analysis. It's common genre.