Deficits Are OK in the Short Run

Reasonable economic policy is always a balancing act. The short-term needs of the economy have to be balanced against long-term needs. Private interests have to be balanced against public interests. Policies to benefit the well-off and well-placed few must be balanced against policies that benefit ordinary folk, because economic strategies, whatever their intended purpose, tend to aid some groups and harm others.

To take an obvious example: Budget deficits play a useful role in a temporary recession when the basic problem is a shortage of buyers for goods and services. But over the long haul, chronic deficits can be a major drag, particularly if the basic problem is the need to build up productive capacity by investment and saving. Economic decisions are difficult, pitting one worthy goal against another: Should we improve education and infrastructure, say, or stimulate private consumption?

The Bush administration has failed to express coherent ideas about the balance between short- and long-term goals, simply reiterating a belief that cutting taxes is good, year in and year out. One effect of tax reduction is to cause revenues to disappear and thus make it harder for Congress to meet the popular need for public services. On the one hand, the administration wants to shrink and marginalize most functions of the federal government. But on the other hand, it advocates spending much more on the military and policing. This has been one persistent thread in the administration’s economic policy.

Another has been to transfer income and wealth from low- and middle-income families to the already rich. Last year’s showpiece tax bill was the major instrument, of course. But even the gutting of environmental regulations seems designed to favor large oil, timber and other companies. In one of the dramatic culture changes of recent years, it is no longer politically necessary to hide regressive shifts of income and wealth from poorer to richer in anything but the most perfunctory way.

How do these policies connect to the current scene? If the preliminary figures for third-quarter gross domestic product are about right, our economy will have grown about 3% in the last year. That is not a bad average rate of growth, but the fourth quarter of 2002 is expected to be noticeably weaker. In any case, the strong rebound that usually follows even a mild recession has not occurred. In the third quarter of 2001, we were in a recession, and average growth since then has left the economy with some slack. The unemployment rate is at 6% and could safely fall to 5%, which would add almost 1.5 million jobs. Capacity utilization in industry -- the country’s production capacity actually being used -- is now 75% to 76%; in the 1990s, it stood at 82% to 83%. There is clearly room for the economy to expand toward its productive potential. That is what a post-recession upswing is supposed to do. Instead, we have a hesitant economy, with investors and consumers worried about the stock market, Iraq and corporate swindles.

So there is a case for a short-term stimulus. The economy would sooner or later recover without one, but there is no virtue in waiting around while capital and labor are standing idle. The administration has talked about a package in the $250-billion-to-$300-billion range, a substantial amount representing 2.5% to 3% of the gross domestic product.

The trouble is that some of the elements being proposed would provide no stimulus at all:

* Ending the double taxation of dividends (corporate profits are taxed at source, and then again if and when they are paid out in dividends) may be a good thing or a bad thing, but it would have trivial short-term effects on the economy. If it is, as expected, in the administration’s package, it would be merely another step in the regressive redistribution of income.

* Making the 2001 tax cuts permanent and accelerating their implementation would be somewhat stimulative, but there are more effective ways to stimulate the economy. Clearly, the main purpose of that proposal is to take purchasing power away from the federal government and deliver it to the wealthy.

* More-favorable treatment of depreciation for corporate-tax purposes would probably elicit very little new investment, given that we have excess production capacity. But such action would surely elicit thanks from corporate treasurers.

So, what might the Democrats propose instead?

* The extension of unemployment insurance benefits is as close to a no-brainer as one is likely to find. (It should have been enacted months ago and might appear in a Bush bill.)

* Temporary tax reductions are generally not very powerful incentives for immediate consumer spending, but a one-year forgiveness of the Social Security payroll tax might work because much of it would go to working families of modest means. The paper loss to the Social Security Trust Fund could be made up from general Treasury revenues.

* There is urgent need for substantial revenue-sharing from the federal government to the states, cities and counties. The recession and slow recovery have gutted state and local revenues. Since they operate under constitutional balanced-budget constraints, governors and mayors are being forced to make drastic cuts in basic and necessary public services. This weakens the economy -- states and cities spend twice as much as the federal government -- and could spell disaster for many low-income people who are the main beneficiaries. An increase in the federal reimbursement for state spending on Medicaid is an obvious candidate.

Such moves would be expensive, certainly, but it all goes back to that short-run/long-run distinction: When the economy is weak, as it is now, there is no reason to shy away from deficit finance. What is damaging to the longer-run growth of the economy is the accumulation of debt into the future, when it runs the risk of shifting investors away from private securities.

One obvious possibility for preventing a long-term debt pileup is to cancel as much of the regressive 2001 tax cut as necessary. Getting rid of it will shore up federal revenues when the economy has recovered and shortage of demand is no longer the problem. I think Democrats could learn to like incentives for private and public investment, but that is an issue for the longer run. The problem now is to get there.