Gale on Deficit Optimism

As we've said before, while the new budget projections from the CBO are an encouraging sign, it is easy to be overly optimistic about what the revisions mean for our fiscal outlook. While short-term deficits are falling, the long-term path is worrisome and insufficient progress has been made on that front.

In a recent Brookings opinion piece, economist Bill Gale argues that declaring victory on deficits and debt would be premature. Short-term deficits and long-term deficits have different policy ramifications, and it is the long-term that is ultimately important for fiscal sustainability.

Short-term deficits are a useful tool in a weak economy with very low interest rates. They boost aggregate demand and help close the gap between actual and potential output. If anything, current deficits should be larger than they are, given the $800 billion gap between what we actually produce and what we could produce. The policies that have brought this year’s deficit down – including the sequester, the tax increases on high-income households, and the expiration of the payroll tax cut – are holding the recovery back and are solving the wrong deficit problem.

The long-term deficit is where the real concerns about fiscal sustainability lie. When an economy is running at full steam, increased deficits crowd out private investments, boost interest rates, and reduce future living standards. They mortgage our future. So, while the headlines and commentators trumpet the reduction in the current-year deficit, the real fiscal concern is how we are doing on the long-term front. We are slowly recovering from the heart attack, but not addressing the chronic conditions.

Sequestration, which implements abrupt, across-the-board cuts to discretionary spending, ends in 2021, thereby enacting too much deficit reduction upfront, while doing little to help the long-term outlook. Using phased-in policies is why a plan like Simpson-Bowles 2.0 was able to achieve more savings while calling for less deficit reduction in the next two years than under current law.

Focusing on the long term begs the question, why the urgency? But as Gale argues, failure to address the long-term debt problem will lead to consequences that will accrue slowly, but with significant damage to the economy. The problem will grow larger the longer we wait and only by phasing-in policies gradually will we allow those affected time to adjust.

The long-term problems remain and in some ways are more serious than before. These concerns are inherently less dramatic than the events of the last few years, but that does not make them less important. Most economic models show that the long-term effects of debt buildup can be quite large, much larger than the impact of other policies, such as tax reform. But the effects are not sharp and spiked; they are gradual and persistent, without a particular drop-dead date. As a result, political leaders largely ignored the long-term problem before the recession and are now looking for a reason to ignore it again.

Policymakers need to be more active on both the short- and long-term fronts. Not only is the long-term imbalance not an excuse to avoid short-term actions, addressing short- and long-term problems at the same time would actually be more effective than addressing either problem in isolation. Carefully-crafted stimulus now would help the budget over time by boosting the economy. A long-term budget plan would increase the impact of a stimulus package by showing that the fiscal trajectory was under control What is remarkable is that policy makers’ response to both the heart attack the economy went through the last few years and the chronic conditions it faces is to do nothing on either front. 

The challenge of long-term deficits in particular is the one which warrants much more attention than it has been receiving. Importantly, agreeing upon a long-term deficit reduction plan does not mean implementing deficit reduction right now. Rather, a comprehensive plan should backload most of the savings to occur when the economy has had time to recover.  Gale's argument is yet another reminder to lawmakers that they must act sooner rather than later to come together on a plan to put our debt on a more sustainable path.