Though Everyone Complains About the Deficit, Is the Sky Really Falling?

One wonders how a king new to his job would have reacted when Chicken Little, Foxy-Loxy and Goosey-Loosey presented him with their unanimous opinion that the sky was falling. President-elect George Bush is faced with a gaggle of advisers and experts even more hysterical than that famous barnyard trio clamoring that the federal budget deficit is about to cause an American recession, a worldwide economic catastrophe or worse.

The breadth of the alarmist consensus on the budget deficit is astonishing. Almost all economists, from liberals like Robert B. Reich to conservatives like Martin S. Feldstein, insist that taxes must be raised to stave off the deficit monster. In a recent survey of the world economy, a usually level-headed journal, the Economist, opined that a U.S. tax increase was the only way to save the world from a financial disaster. Sophisticated American media condemned with one voice both Bush’s and Michael S. Dukakis’ presidential campaigns for their failure to address the deficit issue. And after Bush’s election, the stock market dropped, allegedly out of fear that he would not deal decisively with the deficit.

During the presidential campaign, the budget deficit was one of those rare issues that damaged both parties. Bush was hurt, of course, because the deficit is such a blot on Republican economic stewardship. But Dukakis, arguably, suffered the most, because the specter of the deficit prevented him from embracing any real social spending programs, the traditional rallying point for the Democratic faithful.

Since the economic fraternity has been preaching the imminence of a deficit-driven recession for at least six years now, it is perhaps time to look more closely at the evidence for the horrors the deficit is allegedly wreaking.

The most common complaint is that the deficit is “choking off American investment,” as Dukakis put it during the campaign. The theory is that federal borrowing to finance the deficit dries up the available pool of investment capital.

Nothing could be further from the truth. Business capital investment will turn in a record-breaking year in 1988, with more than 11% real year-to-year growth. Indeed economic policy-makers have good reason to worry about excessive liquid pools of capital. Banks and investment funds have allocated about $250 billion to finance company leveraged buyouts (LBOs).

Whatever one’s views on LBOs, they are hard to square with the notion of a deficit-starved capital base. Benjamin M. Friedman, a Harvard economist, makes a more sophisticated argument in his new book, “Day of Reckoning.” There is plenty of investment capital, Friedman concedes, but only because the budget deficit has sucked in massive foreign investment to the United States--in effect selling off our patrimony. With the national debt now at $2.6 trillion, the United States is the world’s largest net debtor nation, and the future flow of dividends and interest to foreigners, as much as $1,000 per year per worker, will leech away the wealth of our children.

Such views have wide currency, but they are either false or misconceived. In the first place, it is not true that the United States is now the world’s largest net debtor. The best measure of America’s net credit position is the international flow of interest and dividend payments--that is, the earnings on foreign debt held by Americans compared with the earnings on U.S. debt held by foreigners. Although the measure is a rough one, the most recent data showed that America’s books are still roughly in balance, probably somewhat on the positive side.

The alarmist debtor rhetoric stems from the Commerce Department’s insistence on valuing international assets at their purchase price. Since America’s overseas assets were mostly acquired in the 1960s, they appear to be much less valuable than foreign assets in the United States, purchased at the inflated prices of the past few years. But the comparison is meaningless.

But what about the notion that we are impoverishing our children? The question turns purely on the price received for the assets we sell. Americans are at least as able as Japanese to set a value on U.S. luxury hotels. They do so by assigning a value to the future stream of expected hotel earnings. Recently, Japanese have been willing to buy luxury hotels for at least twice what Americans think they are worth. If you are holding a bond for your children with a stream-of-interest payments worth $5,000, and someone offers you $10,000 for it, you do your children no favor by refusing.

But what if the Japanese suddenly want their money back? The fact is, it’s hard to move luxury hotels overseas. When America was on an overseas investment binge in the 1960s, the economic pundits complained that the investment would never be returned. They were partly right. Ford Europe is one of the most powerful of U.S. companies, and most of its earnings stay in Europe. There are few Europeans now who would argue that Ford’s investments impoverish Europe, but there were plenty of them in the 1960s. The enormous U.S. investment that companies like Honda are making should scare no one but inefficient U.S. auto makers.

Is there a danger in having so much debt held by foreigners? Foreigners now own about 15% of U.S. federal debt; but foreigners, including Americans, own about 21% of West Germany’s debt. And the percent of foreign holders of U.S. debt is actually lower than during the Carter Administration. The figures for private debt are even duller: Foreigners own only about 4.5% of U.S. corporate securities. There is a change: America once owned much of the rest of the world; now it is becoming more like other countries. But leveling the economic power of the industrial democracies was the main object of U.S. postwar diplomacy; our signal success on that is being misinterpreted as a sign of doom.

Financing the deficit is usually cited as the reason real interest rates have been driven to record levels. But the rate jump came in 1979-1981, when the Federal Reserve Bank drove up interest rates to staunch runaway inflation. That happened before the deficit took off in 1982 and 1983. The acid test is to compare U.S. rates with those in other countries. The spread between West German, U.S. and Japanese interest rates widened dramatically in 1979-1981--again before the run up in the deficit--and have been narrowing fairly steadily ever since.

Does the budget deficit cause the trade deficit? Explain why Britain has a sharply rising trade deficit and a sharply rising surplus. In fact, throughout the industrialized countries, there is no correlation between budget and trade deficits.

Is the budget deficit even that big? The boring answer is that, while it was big in 1986, it has been falling steadily since then. At about 3% of gross national product, the 1988 deficit is already lower than President Jimmy Carter’s 1976 deficit, and well within the normal practice of most other industrialized countries.

There are many reasons to cut federal spending. It is silly to spend $30 billion a year to raise food prices. U.S. admirals could well do with fewer aircraft carriers. Rich old people shouldn’t get welfare checks. There are also many proper economic worries--the savings-and-loan industry and overleveraged investment banks, to name two. The hysteria over the deficit is just a distraction over what is, relatively speaking, decidedly small change.