The Mixed-Up Politics of the Deficit

The New York Times, May 11, 2004

If soaring deficits are such a big problem, why haven’t long-term interest rates also soared? Could it be that John Kerry is wrong when he says that the Bush deficits threaten to become a “fiscal cancer that will erode any recovery and threaten the prospect of lasting prosperity in our nation” – and Dick Cheney is right when he purportedly told Paul O’Neill that “deficits don’t matter”? A lot hinges on the answer – for example, whether 74 million aging baby boomers will get the Medicare and Social Security they ’re counting on, whether millions of homeowners with variable-rate mortgages will be able to make future payments on their homes, whether the private sector will continue to get the capital it needs, and whether America faces an economic Armageddon if the Bush administration doesn’t mend its cut-taxes-and-spend-like-a-drunken-sailor ways.

The Democrats have become the eat-your-spinach party, preaching the virtues of fiscal restraint, while Republicans invite us to a free lunch. And what a feast it is! Upper-income Americans have been treated to vast tax cuts, with promises of even more are to come. Government spending, meanwhile, has ballooned – including Medicare drug benefits, farm price supports, and pork-barrel projects of every size and dimension. This year’s deficit, according to the White House’s own estimate, will be $521 billion – four and a quarter percent of the total economy. And then it’s at least $500 billion as far as the eye can see. If Bush succeeds in making his tax cuts permanent, reducing the alternative minimum tax, and summoning tens of billions more to war against terrorism, future deficits will be much larger.

Most mainstream economists, like Old Testament prophets, speak of a day of reckoning. Even Alan Greenspan, former enthusiast of the Bush tax cuts, now issues grave warnings. Surely this cannot go on, they all say. Surely bond traders will take their revenge. Long-term interest rates will rise sharply as lenders foresee that all this public borrowing will use up the limited supply of private savings. If the market is behaving rationally, long-term rates would already be rising in anticipation of crunch time. Who in their right mind would lend dollars today, to be repaid in three or five or ten years, without insisting that debtors pay substantial interest? John Kerry’s economic plan – rolling back the Bush tax cut for people earning over $200,000 and reestablishing strict “pay-go” rules requiring that any new spending be offset with other spending cuts or new revenue – is based squarely on this mainstream view.

Yet, curiously, Wall Street seems to have given the administration a free pass. So far, the vast increase in government borrowing made necessary in order to fund the budget deficit hasn’t affected long-term interest rates all that much. The benchmark 10-year note yield is still below the average yield of 5 percent in 2001, when the nation last posted a budget surplus. What gives?

Capital markets do not always behave rationally, of course. Perhaps bond traders aren’t paying attention to the gathering storm. Maybe they’ve been distracted by the Fed’s low short-term rates. Maybe they’re Republicans. Yet there’s another possible explanation, consistent with an exercise of complete economic and political rationality. Bill Clinton, and now John Kerry, have taught the bond traders on Wall Street an important and comforting lesson: No matter how big deficits grow under Republican presidents, eventually a Democratic president will come along to clean up the mess. That confidence is keeping long-term rates down, despite the current out-of-control deficits.

More than a decade ago, you’ll remember, the federal deficit was over $300 billion as far as the eye could see – approaching 5 percent of the economy. Clinton and congressional Democrats reversed this profligate trend by slashing spending and raising taxes. The strategy was hard to swallow, and not at all popular – not a single Republican member of Congress voted for Clinton’s 1993 budget. Some of us in Clinton’s cabinet thought he had gone further than he needed to; there was too little money left for education, job-training, health care, and all the other things Clinton had promised and the nation needed. But there is no disputing that the plan had the intended effect. Deficits that had ballooned under Ronald Reagan and the first George Bush were brought firmly under control. Bond traders breathed great sighs of relief. Wall Street beamed brightly.

John Kerry has responsibly decided to take the same route. If he becomes president next January, he will inherit a budget mess not unlike the mess Bill Clinton inherited. And Kerry has already committed himself to follow Clinton’s lead, and impose fiscal restraint. He has already scaled back some of his more ambitious spending plans, and has somberly told his Democratic audiences – as Clinton told his – that we must first get our fiscal house in order before addressing the larger the needs of our society.

Undoubtedly, Kerry’s resolve has contributed to the bond traders’ calm. In the event that Kerry is not elected and Bush gets a second term, the fiscal mess will become substantially worse. But bond traders will still take comfort in the knowledge that another Democrat will likely come along to clean it up, eventually.

You see, Democrats and Republicans are engaged in the economic equivalent of Nixon going to Peking: Republican presidents can get away with utterly irresponsible fiscal policies because there’s no one to their right who will make much trouble for them. Democrats can get away with fiscal austerity because there’s no one to their left who will make their life difficult. But the irony should not be missed. Kerry’s promise of fiscal responsibility might just save George Bush’s presidency.

* Robert B. Reich’s new book is “Reason: Why Liberals Will Win the Battle for America,” (Knopf).