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What Washington gets wrong when it talks about the deficit

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Washington likes to talk about budgets and budget deficits, but it's almost always the wrong conversation to have if you're worried about the long-term future of the country. Rather than worry about debt's impact on the economy, we should be talking about how economic growth is the key driver of debts and deficits.

That's the real lesson of Monday afternoon's bad news Congressional Budget Office report saying we're scheduled for a renewed period of deficit increases after years of a rapidly improving budget situation. After all, the basic storyline that the deficit would go up in the future as baby boomers retire isn't new. What was alarming about the report — as the Committee for a Responsible Federal Budget points out — is that the CBO is now more pessimistic about future deficits than it was just last year

Now here's the important part. This deteriorating situation isn't because Congress enacted any new fiscally irresponsible policies. It's also not because we got any bad news about old policies. It's not that a tax hike didn't raise the revenue it was supposed to, or that cost estimates for old programs proved far too optimistic. On the contrary, the Affordable Care Act is looking to be considerably cheaper than once believed and health care cost growth has slowed in encouraging ways.

Growth in decline

So what went wrong?

Well, back in its August 2014 estimates the CBO thought we would see 2.7 percent GDP growth from 2014 to 2018. Now they've revised that down to 2.5 percent. This is driven by a downward revision in the CBO's estimate of "potential" output, the speed at which the economy could grow in a world where there's no shortfall in demand. This is a number that the CBO has repeatedly revised downward since the onset of recession. Basically, the longer it takes the US economy to return to robust growth the more pessimistic CBO becomes about the possibility of robust growth in the future.

One can question the methodology behind some of this work (see also the similar NAIRU idea), but the basic conceptual point holds. Even small changes in the future rate of long-term economic growth make a huge difference for the budget.

Three ways growth matters for the budget

Economic growth is such a big deal for budget deficits because faster growth reduces debt and deficits through three separate channels.

  • Denominator: Government borrowing is normally expressed as a ratio of debt to GDP. This means GDP growth matters for the very simple reason that a higher GDP mechanically reduces the debt:GDP ratio.
  • Taxes: The federal government's tax system has a progressive rate structure. People pay a higher rate as they become richer. If the economy grows faster, more people enter those high tax brackets and revenue goes up. Faster economic growth also means that there will be more capital gains and dividend income to tax.
  • Spending: The federal government spends a fair amount on means-tested social assistance programs, from Pell Grants to SNAP to Medicaid. Faster economic growth means fewer poor people, which means lower spending.

The conversation we need

Much of the political class has been trained to be reflexively fascinated by ways in which debt can impact future economic growth. Remember the huge controversy over Carmen Reinhardt, Kenneth Rogoff, an Excel spreadsheet, and an alleged tipping point at a 90 percent debt:GDP ratio? But the opposite relationship is much more important. It was rapid economic growth that let the United States get away with massive debt accumulation during World War II, and it was a severe recession in Europe that pushed the Eurozone into crisis.

One piece of good news that rings true in this week's CBO report and every report the CBO has done for years is that short-term budget deficits don't pose an immediate problem.

That means there's breathing room to think about long-term problems. And the biggest long-term problem to tackle isn't the budget per se, but how to speed America's growth rate. That's a long conversation, obviously. But there are lots of good ideas out there. In the short term, simply printing more money would help. In the longer term, the United States needs to improve its infrastructure, remove barriers to house-building, fix an anti-innovation patent system, embrace more legal immigration of skilled workers, and continue reforming a wasteful health care system. These aren't the kind of ideas that slot easily into the hike-taxes-or-slash-spending left/right debate that defines our political system.

And for that reason they're not directly "about" the budget. But the budget is about the economy, and it's time for a wider more ambitious debate about economic growth.

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