Budget Freeze Attractive as Deficit Solution but Difficult to Implement

There is widespread agreement that the major economic problems facing the United States stem from our large federal government budget deficit. For several years, we had budget deficits on the order of $200 billion, or 5% of gross national product; last year’s deficit was about three-fourths that size.

Such deficits are unusual during prosperous peacetime, although common during the depths of recessions and wartime. As late as 1985, it appeared that the budget deficit might skyrocket to the $300-billion level. Two years of no growth in defense and a decline in interest rates and oil prices has the deficit on a flat, or slightly declining, course.

Freeze Has Appeal

When the federal government borrows 4% to 5% of GNP, it drains away most of the available private saving in the economy. The result would be a collapse in our already low investment rate unless we borrow from abroad. In recent years, we have done just that: borrowed about $150 billion annually, shifting the United States from being the world’s largest lender to being the largest debtor.

By the end of last year, the United States had an external debt of about $425 billion. Borrowing $150 billion a year from the rest of the world for four more years would increase our external debt to more than $1 trillion. Just the cost of servicing that debt--paying net interest, dividends and rent on the foreign-owned assets--would amount to 2% of GNP. This means that Americans would be able to use only 98% of what they produce, just as we have used 103% of what we have produced in recent years.

Of course, if private saving in the United States were much higher, these large federal deficits would not require us to borrow from abroad. Raising private saving is a national concern, but it is unlikely that we can do so by 4% to 5% of GNP on a sustained basis any time soon. Thus, the task of restoring balance between national saving (private saving less government borrowing) and very modest investment must fall on sustained reductions in the budget deficit.

The recent budget summit produced a modest two-year bipartisan compromise as a first step toward that goal. Much, much more will need to be done in the next four years. That is why so much attention is being focused on the various presidential candidates’ proposals to reduce the budget deficit. One potentially attractive idea is a budget freeze of some sort.

Before discussing a budget freeze, let me reiterate that, if the economy suffers a downturn, we ought not to raise taxes and reduce spending until the economy recovers. The additional deficit that automatically accompanies a downturn--as revenues fall and unemployment benefit payments rise--should be allowed to occur; a tax increase or spending cut would worsen the recession.

Further, the sustained push toward a balanced budget that I believe ought to take place primarily on the spending side must be accompanied by coordinated action by the Federal Reserve to prevent a recession. Thus, a $30-billion to $40-billion deficit reduction per year for several years would get the budget in balance and is a plausible goal. It may have to be postponed for a few quarters if there is a downturn in the economy; the important thing is that the deficit, adjusted for the state of the business cycle, be headed rapidly downward.

Handling Entitlements

What role could a budget freeze play in this? Is it a practical solution, easy to implement, spreading the pain fairly among Americans?

Partial or selective freezes on specific programs have been enacted in previous budgets, and attempts to freeze cost-of-living adjustments (COLAs) for Social Security and other programs fizzled at the last moment in 1985 and again in 1987. The idea of a budget freeze seems simple and fair. That is undoubtedly its greatest appeal. Everyone can understand having to live on the same budget next year as this year.

Actually, however, implementing a spending freeze would be quite complex and not necessarily fair. For example, even if a budget freeze exempted currently poor persons, it would still drive hundreds of thousands of persons now above the poverty line below it.

It is not clear whether the federal government even has the instruments at its disposal to freeze the budget. A spending freeze can be defined in various ways. The typical interpretation is spending the same number of dollars next year as this year; with inflation of about 4%, that means real cuts of 4%. It could also mean holding spending growth purely to inflation, which would mean that nominal dollar spending would be higher by the amount of the inflation. Most discussions of a freeze are vague but state or imply that it would cover the entire budget, which is not possible. Interest on the national debt must be paid; contract commitments previously made must be honored.

Even more important, but somewhat less obvious, is the fact that most entitlement programs are difficult to freeze. Take Social Security, an item much discussed in the debates. Spending rises automatically because 1 million to 2 million people retire annually. Even if we provide full COLAs for current recipients of Social Security benefits, real spending would rise to make payments to the new retirees.

Thus, a budget freeze for these types of programs usually must be based on the COLAs. These could be skipped for a period, delayed or reduced in size. None of these would accomplish a complete freeze within the programs, but would reduce outlays.

For so-called discretionary programs, a freeze generally applies to budget authority, not to outlays. Congress determines budget authority in the annual appropriations bills. When new budget authority is provided, agencies can enter into obligations, but the time pattern of actual outlays based on these obligations can be very uncertain. For example, obligations entered into may not result in cash outlays for several years. The administrative mechanisms are designed to make certain that the obligations do not exceed the new budget authority; they do not place direct control on the timing of the actual amount of the outlay.

In summary, even if the President and Congress wanted to implement a freeze, it would require so many changes in statutes and operating procedures in government agencies and Congress as to be virtually impossible, program by program. It would require substantial cuts in many programs to offset the outlays generated automatically by honoring previous contract commitments, interest payments, the eligibility of new recipients, etc.

A final point deserves emphasis: Our budget deficit is a problem because it creates an imbalance between our national saving and investment. If additional revenues are required as part of the deficit-reduction package (and I hope any revenue increases will be kept to a minimum), they should come from fees and taxes on consumption, not saving.

A tax increase on saving would reduce the budget deficit but would result in a purely cosmetic transfer of our national saving and investment imbalance from too much government borrowing to still less private saving. This fundamental point must supersede the demagogy surrounding tax-increase proposals--or we will balance the budget without balancing our national saving and investment, leaving the economy on the same external debt path, headed for trouble.