The Budget Deficit and U.S. Competitiveness
Guest article, Council on Foreign Relations (www.cfr.org)
Greg Ip, U.S. Economics Editor, The Economist, May 6, 2011
Textbook economics tells us that government deficits eat up scarce savings, pushing up interest rates and the dollar. That discourages private investment and exports, a lethal combination for our productivity and competitiveness. The textbook does not apply to our current circumstance: Today’s deficit is occurring against a backdrop of deeply depressed private demand, which is evident from the fact that interest rates are so low. This argues against too rapid a cut in the deficit, because the Federal Reserve can’t compensate for fiscal austerity through lower interest rates.
At some point, though, the recovery will be more firmly established. If we still haven’t put the deficit on a firm downward path by then, interest rates will rise, reflecting not just competition for savings but compensation to investors who fear we’ll escape our debts via default or inflation. That interest rate penalty will add to the cost of capital of every business in the United States. A medium-term plan to reduce the deficit will help keep both interest rates and the dollar low, speeding the reorientation of the American economy from borrowing and consumption to saving and exports.
A medium-term plan to reduce the deficit will help keep both interest rates and the dollar low, speeding the reorientation of the American economy from borrowing and consumption to saving and exports.
There are no painless ways to reduce the deficit: Spending will have to drop and taxes will have to rise. But it can be done in ways that make the economy more productive. On spending, for example, gradually raising the retirement age to sixty-seven then indexing it to life expectancy will reduce future liabilities for both Social Security and (somewhat less) for Medicare, while at the same time expanding the supply of labor by encouraging Americans to work longer.
Taxes can be raised via reform that makes the entire system less of a burden to growth. Relative to other countries, America taxes income too much and consumption too little. This can be corrected either through a broad-based consumption tax or, more narrowly, by raising the gasoline tax. This would both not only raise revenue and cut carbon emissions, it would do more to make alternative energy viable than our current preference for subsidies and mandates. Rather than raise marginal tax rates, which discourages work and saving, better to eliminate distortionary exemptions such as for mortgage interest which tilts investment toward housing.
The original post is linked here.