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The Next Economy / THE NEXT ECONOMY: ESSAY

So, Do Deficits Matter?

History teaches that public debt can lift a nation to prosperity or bring an empire to its knees. It depends on what the borrowed money is spent on.

October 13, 2011

In political Washington, a rare consensus has been reached: Federal budget deficits pose the direst danger to the U.S. economy. The summer’s agony over striking a deal to raise the debt ceiling and the creation of a congressional super committee to whittle down the federal deficit have turned on its head the axiom that then-Vice President Dick Cheney reportedly propounded as recently as 2002: “[President] Reagan proved that deficits don’t matter.”

Americans, by and large, agree with Cheney. According to opinion polls, the public worries more about the loss of jobs than about mounting deficits. Nor has business stormed the ramparts because of the imbalance in federal revenue and spending. More than half of the entrepreneurs in a recent Harris Interactive poll cited “economic uncertainty” as a major obstacle to hiring; they regarded the federal deficit and debt as a source of that uncertainty but not as any immediate threat to their businesses. Even economists are of varying minds, depending on their political persuasion, about the significance of deficits to a nation’s well-being.

Let’s consider, then, another means of judging whether deficits matter: the dispassionate lessons of history. What do they teach? That sometimes, a public deficit lifts a nation to prosperity and strength; at other times, it can bring an empire to its knees.

 

At first glance, the historical record looks chaotic. The Byzantine Emperor Justinian the Great inherited a full treasury but exhausted it on military campaigns and elaborate buildings—notably, the grand cathedral Hagia Sophia in what is now Istanbul—and left a weakened state to his successors. Germany’s Weimar Republic, unwilling to cover its deficits with taxes or loans, printed more money instead; this brought hyperinflation (200,000 marks for a loaf of bread) and undermined its legitimacy, fostering the rise of the Nazis. In fighting the resulting war, President Franklin D. Roosevelt presided over a surge in the American government’s debt to 115 percent of gross domestic product. But this didn’t stop the United States from reveling in a postwar era of unprecedented prosperity.

Deficit-ridden nations have variously prospered, muddled through, or disintegrated, seemingly with no obvious pattern. Yet as the historical examples accumulate, patterns do emerge. Public deficits aren’t always bad or always good. A lot depends on the circumstances and, especially, on the purposes to which the government puts deficit spending.

THE GOOD DEFICITS

Public deficits may be incurred, economic historians say, for any of four purposes: to help invest in a nation’s long-term prosperity; to merely keep pace with an economy’s growth; to sustain pleasing but unproductive “prestige” programs, such as social undertakings and foreign adventures; or, worst, to cater to social dysfunction such as by letting the moneyed classes exempt themselves from taxation.

Spending on long-term investments, even if it exceeds a government’s income, is the likeliest to prove beneficial—or at least benign—to the society’s future. The Louisiana Purchase, for instance: Thomas Jefferson’s 1803 acquisition doubled the size of the country and acquired all or part of 15 future states. The U.S. government paid France $3 million in gold but financed the other $12 million by selling bonds. Tangible, productive assets, bought for 3 cents an acre, proved a wise investment even though it added to the public debt.

Going into debt to build infrastructure can also add value. In ancient Rome, the vast expansion of the roads into a network of 29 highways facilitated trade and technological progress across Europe for the next millennium; it helped Rome keep its economic vitality long after its government had split into dysfunctional and warring states. Not so different was the U.S. system of interstate highways, championed by President Eisenhower in the 1950s, which fostered commercial development from coast to coast and ushered in benefits far exceeding its costs. This is China’s strategy now, as it speedily builds a high-speed rail system meant to link the huge nation’s disparate regions and reduce its dependence on oil.

Short-term deficits incurred in hard times have also been useful in bolstering economic vigor and protecting jobs. That was FDR’s strategy for easing the Great Depression, although it didn’t work as well as going to war. If the demand for products shrinks, government spending can pick up some of the slack until the private sector recovers—a Keynesian tenet that has lately become the object of partisan debate. A recent working paper for the International Monetary Fund examined the experiences of 17 industrialized nations from 1978 to 2009 and concluded that reducing the deficit in demand-constrained times, whether by cuts in spending or increases in taxes, had damaged the economy. Paring the deficit by 1 percent of GDP, the researchers suggested, reduced private consumption for the following two years by 0.75 percent and cut the inflation-adjusted GDP by 0.62 percent.

U.S. Debt: Bad to Worse

Under current law, federal debt will grow to 84 percent of GDP by 2035 as entitlement spending rises. But a bleaker scenario may be more likely—one in which expiring Bush-era tax cuts are again extended, holding down revenues.

Debt as a percentage of GDP
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Spending as a percentage of GDP
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Source: Congressional Budget Office

Indulging in deficit spending to fight a war can also act as an investment if it enhances the nation’s position in the postwar world. The United States benefited from World War II in two ways. Not only did new armaments plants add to its manufacturing base, but America emerged from the war as the only major country whose industrial infrastructure was undamaged. By 1950, the United States was responsible for more than half of the world’s economic production—and therefore had the loudest voice in organizing the international trade and monetary systems. All of this contributed to Americans’ astonishing prosperity during subsequent decades.

Other circumstances may produce deficits that don’t much matter either way; they’re neither all that beneficial nor particularly worrisome. The public debt may increase, but no faster than inflation or GDP or population—and thus no faster than the society’s ability to pay interest and repay the principal. From 1985 to 2007, for example, the U.S. public debt remained in the range of 40 to 60 percent of GDP without producing serious economic problems while encompassing periods of prosperity.

But even so, if a nation’s public debt increases relative to those benchmarks, at some point the risk to its economy grows. Economists differ on exactly where that point is, but they agree that it exists. Kenneth Rogoff of Harvard and Carmen Reinhart of the Peterson Institute for International Economics put it at 90 percent of GDP, a level that the Congressional Budget Office predicts the United States could reach in 2018. In Japan, the public debt amounts to 225 percent of GDP, and—while cause and effect is hard to prove—the once-mighty economy has lost much of its dynamism.

Deficits are especially harmful to a nation’s economic health if incurred for showy but unproductive purposes. Consider the Aztecs of a half-millennium ago in what is now Mexico. They went relentlessly to war in pursuit of victims for their impressive displays of human sacrifice. The hate that this stirred up caused adjacent tribes to treat the invading Spaniards not as conquerors but as liberators. End of Aztecs.

WEALTH, FRITTERED AWAY

A classic example of an unproductive reason to incur mountains of debt is military spending. A country besieged by enemies has no choice. But for a country that isn’t, this sort of spending all too often brings on distant expeditions, unnecessary wars, inessential alliances, and glorious ventures of colonialism with precious little benefit to the colonizer.

Think of Spain. It ruled the world in the 16th and 17th centuries and, at first, its empire expanded rapidly and profitably. After Christopher Columbus claimed new lands for the Spanish flag, a friendly pope confirmed Spain’s right to its discoveries in the New World, and exploration brought forth gushers of silver and gold. The wealth arrived in Spain so effortlessly that the nation’s rulers bought whatever they needed from somebody else and invested little in their own country’s productive might. Forests were chopped down to construct fighting ships and galleons; the royal encouragement for raising sheep produced quick profits, but the grazing meant the loss of greenery down to its roots.

Then, almost all of this new wealth was frittered away. Taking on the role of defender of the Catholic faith, Spain battled tirelessly against the Protestants of Northern Europe and supported the Holy Roman Empire. With more reason, it fought the encroaching Ottoman Turks in the East. Eventually, this habit of military expenditure became too entrenched, at an unaffordable price. Financing the Spanish Armada alone cost 10 million gold ducats, more than the king’s annual income. Without a commercial economy to fall back on, Spain entered a period of decline, the victim of its own wealth and unproductive spending.

Americans, take note: Spain lavished much of its resources on attempts to impose a particular philosophy—Catholicism—on a part of the world that had rejected it. Since World War II, the United States has spent uncounted trillions of dollars trying to export democracy and capitalism worldwide. In Japan and Eastern Europe, maybe in Russia, these Western ways have taken root. In Africa, parts of Asia, and the Middle East, however, the local cultures have been far less receptive, despite American-led wars costing an estimated $4 trillion.

It is not always obvious, of course, whether a particular piece of a budget deficit ought to be counted as an investment or a waste—hence the current battle lines in Washington politics. Spending on health care, child welfare, and education is on the chopping block. Republican advocates of smaller government see these programs as a poor use of a country’s resources. Democrats tend to view them as investments in a healthy and educated workforce, so that workers can feel free to change jobs and to move wherever the labor market beckons.

THE KINDNESS OF STRANGERS

Or consider the deficits caused by a persistent shortage of revenue because the powerful have exempted themselves from taxation. It has always been thus. In the Gospel of St. Matthew, Jesus inquires of his disciple Peter: “ ‘From whom do the kings of the earth receive toll or tribute? From their children, or from strangers?’ Peter said to him, ‘From strangers.’ ”

Throughout history, the unwillingness of the wealthy and powerful to pay taxes has often marked societies in trouble. As the Roman Empire was waning, the Emperor Diocletian exempted the senators’ landed estates from taxation. A similar forgiveness happened as the Han Dynasty in China was nearing its end. Late in the Byzantine Empire, the influential monasteries were mostly exempted from taxation, prompting emperors to contest the founding of new monasteries and to block existing ones from acquiring more land. Around 1500 in Spain, the nobility made up 1.5 percent of the population and controlled 97 percent of the land—but paid no taxes.

Letting the wealthy escape taxation can cause turmoil, both financial and social. For one thing, it places the financial burden on everyone else. “My friends and I have been coddled long enough by a billionaire-friendly Congress,” financier Warren E. Buffett recently wrote in The New York Times, calling on Washington “to get serious about shared sacrifice.” The fear is that the non-wealthy will feel put upon and less loyal to the state and, as a result, less willing to defend it. Check online reactions to news stories and see how often respondents decry the legislative and tax systems as rigged by—and for—the powers-that-be. In the United States, the rage has been confined to the blogosphere; in London, young people have taken it into the streets.

French historian Alexis de Tocqueville saw the biggest threat to American democracy arising from the possibility that the most affluent members of society might seize control of the political and economic system to ensure their privileged position. The debate over the federal deficit might offer such an opportunity. “If ever again permanent inequality of conditions and aristocracy make their way into the world,” de Tocqueville wrote, “it will have been by that door that they entered.”


Correction: The chart originally accompanying this article transposed the labels for Medicaid and Social Security spending as a percentage of GDP.

The writer is the managing editor of FTC Watch and the author of The Woman Behind the New Deal: The Life and Legacy of Frances Perkins. She is working on a biography of Queen Isabella.

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