Sunday, December 30, 2012

There's Only One Way To Fix The Deficit — And Actually It's Totally Painless

Joe Weisenthal | Dec. 28, 2012

People who insist that the US has a gigantic "spending problem" are ignorant of what really drives the deficit and the national debt, as Henry Blodget easily demonstrated in a series of charts.

Closing the deficit is not just about lowering spending, relative to GDP, but also about increasing revenue from our very low levels.

So how is that accomplished?

When people talk about the deficit, they almost always use the "pain" metaphor.


So this is just a popular idea: Take the pain now, be redeemed.

The good news is that in economics and when talking about the deficit it doesn't need to work that way! Fixing the debt is painless!

That's because the primary driver of deficits is a lack of growth.

A chart that everyone needs to have seared into their brains is this one, which shows the deficit as a percentage of GDP (red line) vs. the unemployment rate (blue line).


For 60 years (!) the pattern has held. When unemployment drops, the deficit as a percentage of GDP drops. When unemployment rises, the deficit rises.


This chart shows spending as a percent of GDP (red line) vs. the unemployment rate (blue line). Want to get the red line down to its historical range closer to 22 percent of GDP? Improve the unemployment rate! This makes total logical sense, of course, since lower unemployment implies reduced spending on all kinds or programs.


With zero actual "belt tightening" over the last few years, the deficit as a percent of GDP has been falling at its fastest pace since WWII, all thanks to people re-entering the workforce, and the pain of the economy being reduced.


In the debate over fiscal policy, you frequently hear liberals argue: "It's not time to deal with the deficit, we need to fix the economy first and then fix the deficit when the economy is stronger." While this has merit as a political concept, it's actually giving into a false frame that dealing with the deficit and dealing with unemployment are two separate things that you do at different times. Steps you take to improve unemployment are deficit reduction measures, as the above chart from IBD shows. While the government has done, technically, nothing to address the deficit in the last few years, the deficit is shrinking (relative to GDP) merely because the economy has improved, and more people are going back to work. If unemployment drops to 7 percent, or 6.5 percent, or 6 percent, we'll get quite a bit of deficit reduction then.


So what about taxes then? If closing the deficit and getting more revenue as a percent of GDP is all about growth, then why do we have to raise taxes on anyone?

Here it's probably best to think of Fiscal Policy not as a tool to create revenue and close deficits, but as a tool to shape society by incentivizing some kind of activity (e.g. tax credits for R&D), disincentivizing other kinds of activity (sin taxes) and redistributing wealth (progressive taxation). All of this is controversial stuff, but there's almost nobody on either side of the political spectrum at this point who doesn't favor some kind of redistribution of wealth so as to ameliorate extreme inequality. It's true that raising taxes on the rich to Clinton-era levels doesn't raise much revenue (just $40 billion a year, perhaps) but with income inequality at historical extremes (it's worse now than it was pre-crisis) it may still be a beneficial policy tool to smooth things out somewhat via taxes.


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