Viewpoints : Three Nobelists Examine the Budget Deficit

For weeks, all eyes have been on Washington as Congress and President Bush have wrangled about how to reduce the burgeoning federal budget deficit. Disagreement raged over proposals to raise income taxes for the wealthy, increase Medicare premiums, cut capital-gains taxes and increase taxes on cigarettes, alcohol and gasoline.

Sharon Bernstein interviewed three Nobel Prize-winning economists--Milton Friedman, 78, of the Hoover Institution at Stanford University, James Tobin, 72, of Yale University and Franco Modigliani, 72, of the Massachusetts Institute of Technology--for their views on the deficit reduction proposals and their possible impact on the economy.

What is your view of the negotiations taking place in Washington?

Tobin: I imagine that some kind of budget package will pass that won’t be too much different from the summit proposal (agreed to by the White House and congressional leadership) but will cut out some of the more objectionable proposals to both sides. But that doesn’t really do a whole lot to the deficit over the five years that are projected. I think it’s Ronald Reagan’s latest victory. Once again, the strategy is to run up a big deficit while claiming that you could never raise taxes because it will ruin the economy and getting the public to believe in the supply side fraud, which claims that it will all work out for the best. Once you do that, then on the other side you use the scare tactics of deficits to get rid of social programs you don’t like. So that’s happening once again. It’s been going on for almost 10 years now. Just another act in the same drama.

Friedman: I think Washington is a nuthouse. I think they’re arguing about all the wrong things. They ought to be concerning themselves with how we get the government out of agriculture, about how we get the government out of the school system, the transportation system and so on down the line.

The simple answer to taxes is that you ought to lower them. There is no evidence historically or otherwise that increasing taxes will reduce the deficit; it will simply increase government spending. The rule from history is that the government spends as much as it can from raising taxes plus as much more as it can get away with. The public at large does not believe it is getting its money’s worth.

Modigliani: First, Bush said that he wanted to raise taxes, then he changed his mind. It seems to me at this point it’s anybody’s guess whether they come up with a package, except that I do feel that the pressure is so high that somehow they’ll have to do it.

If they do come out with $40 billion to $50 billion in a deficit reduction now and $500 billion over the next 10 years, I would regard it as a good down payment. But it is absurd to think that you can do that kind of a deficit-reducing job by soaking only the poor. Certainly the rich have to share. I certainly think there should be a mild increase to the top brackets. You can’t ask people who are fundamentally poor and old to pay.

Is the U.S. economy too weak to handle a deficit-reduction package now?

Modigliani: No, I don’t believe that at all. Any weakening that may come from that side can be counter-balanced by several sources of additional spending. We of course need lower interest rates, and that will permit us to invest more and to export more. There will be ample ways of compensating the demand.

Nor are we talking about substantial amounts in cuts, so there is no excuse whatsoever. There is plenty of demand around the world if we only exported more.

Tobin: It is ironic that in a year which is the least opportunistic occasion to raise taxes or lower expenditures that suddenly the President got panicky about the size of the deficit. He should have gotten panicky two years ago. But the package is actually tailored so that most of the restrictive parts of it come later rather than in Year 1.

There is a good long-run reason for lowering the deficit, and that is to get lower interest rates and more savings in the long run, which will increase productivity. I think the Federal Reserve is capable of handling the economy and reversing recession even if some negative stimulus is given to the economy by this budget package.

Friedman: I don’t think the problem is deficit reduction. I think the problem is spending reduction. I believe it is ludicrous to argue that a government that is spending one-quarter of the national income doesn’t have enough money to spend. What we need is lower spending and lower taxes. Not lower taxes to offset recession; we need lower taxes because the taxpayers are simply not getting their money’s worth for the fraction of their money the government is getting.

Some argue that too much attention is paid to reducing the deficit. What do you think of that argument?

Friedman: The deficit in the last five years has been a good thing and not a bad thing because it is the only thing that kept Congress from spending more of our money. If you can think that in some miracle the deficit could have been wiped out, can you imagine how much the government would have been spending?

It isn’t necessary to reduce the deficit, it’s necessary to reduce spending. Those are not the same thing at all. Let’s suppose you reduce tax revenues by $100 billion and reduce spending by $100 billion. You would leave the deficit unchanged but nonetheless the government would be spending a smaller fraction of our money. The taxpayers would have that $100 billion back in their pockets. And what is the economy but all the people?

Tobin: It’s not necessary to reduce the deficit in a particular year, but it is necessary to reduce it over the long run. So it’s never absolutely necessary to reduce the deficit, but if you keep saying that year after year, you end up with a very large debt, very high interest rates, a lot of the federal budget used for debt service and a trade deficit such as we have been saddled with for many years, and a low rate of domestic investment, none of which is good for the economy in the long run. In addition to that you have a poverty-stricken federal government. In a very wealthy country you have no money to take steps to clean up the environment, to provide social services. It’s not that the economy is too weak and small to do these things, it’s that we can’t afford it politically because the public has been sold the idea that we don’t have to pay taxes.

Modigliani: I think saying it’s not necessary to reduce the deficit is the most ridiculous argument that I ever heard. If you want to destroy the country, I think they are right. If they don’t care what happens to the future, if they only want themselves to pay less taxes, then they may suit themselves. I think it would be a disastrous for the country. The payments that we make on interest on the deficit have increased by $140 billion since 1980, when Reagan came in. That is $700 per capita, per person in the United States. And to think that all the fight is about $40 billion; it doesn’t even cover half of the damage we have done.

Where do we go from here? Is the nation headed for a long economic slide?

Tobin: It need not be. We don’t know what’s going to happen with the Middle East crisis, but there’s no reason the economy should be in for a long slide. The recession is manageable by the Federal Reserve regardless of what happens to the deficit this year or next year. If we could get the fiscal house of the federal government back into the shape it was in before 1980, we could get interest rates down, we could get the public and private investment back to where they could be spending for the good of Americans.

Friedman: Nobody knows. However, there is no need for the United States to be in for a very long slide. The United States is fundamentally a very wealthy, healthy country. You sometimes feel that if you could just close down Washington, everything could be fine.

But as a matter of fact, we are in a recession. It will get deeper before it goes around, but there is no reason to suppose that it will turn into a major recession or depression. And there is every reason to expect the economy will turn up in the next year or so. If we could get in Washington a move to lower taxes on the part of the Federal Reserve toward steady money growth, the basic strength of the economy would have a chance to show itself.

The economy is relatively weak, we’re in a recession, we’ve been in a recession for a year, we’ve had recessions for 200 years. The world has not changed.

Modigliani: The American economy is essentially flat.

I would want to warn about two dangers: war and the deficit. First of all, in the case of war, I think the situation will get messy, because war together with the oil problem is likely to mean more inflation, and that is sure to lead the Federal Reserve to restrictive policies, which will actually create a drop in output. So we are perched in a delicate situation.

If there was no war, I would say we are flat; the economy is flat. With the danger of war, there is a danger that the economy will go down. If we get much higher prices for oil, that is surely to get us into inflation and into stagflation.

Second, failing to reduce the deficit will just mean that we keep not investing very much and we keep borrowing and borrowing and borrowing abroad. The immediate effect of the deficit is to make you feel good, like when you go on a trip and pay later. You feel good and then you get a hangover. The deficit makes you feel good--until you pay later.