The perils of Bush's binge borrowing

The perils of Bush's binge borrowing
By Jacob Weisberg
Published: February 9 2006 02:00 | Last updated: February 9 2006 02:00. Copyright by the Financial Times

This week, the White House announced its 2007 federal budget, which projected a shortfall of $423bn (£243bn) for the current fiscal year. The good news: budgeters predict diminishing deficits in years ahead, even while accounting for extending the Bush tax cuts. The bad news: for that to happen, Iraq will have to turn into Canada next year, Afghanistan into Sweden and the US Congress into an order of mendicant monks.

Mostly, the new numbers are shameful for the fiscally unbalanced Republicans who run the government. But there is also a shade of discomfort among those of us who love to hate deficits. We must acknowledge that the US economy has performed pretty well in the Bush years, in spite of a stupendous reversal in the nation's fiscal position. Gross domestic product grew by 3.5 per cent in 2005 on top of 4.2 per cent in 2004. The January unemployment figure was 4.7 per cent, within striking distance of its Clinton-era bottom. Long-term interest rates remain low and there is no sign of inflation. If deficits are so terrible, why is the economy so good?

One possibility is that Dick Cheney, US vice-president, was right when he said, "Reagan proved deficits don't matter". The theory behind this view, to the extent there is one, is that in a global market for capital, government borrowing does not "crowd out" private investment the way it does in an insular economy. A Federal Reserve Board model suggests that one percentage point of GDP in deficit spending raises long-term interest rates 50-70 basis points. We pretty clearly are not seeing such a strong effect, at least in real time. In 2003, when Washington decided to add another trillion dollars in deficit spending to pay for a Medicare prescription drug programme, rates barely budged. Perhaps bond traders are overdoing the antidepressants. Or perhaps the international appetite for US Treasury bonds means that deficits no longer move interest rates the way they once did.

But even if that change is real, Mr Cheney and others who wave aside the budget gap are still wildly, recklessly wrong. Deficits are as malignant as ever. The effects are just hard to make out at the moment. The basic problem is quite obvious: we are making ourselves poorer. Borrowing to consume, which is what the US is doing, as opposed to borrowing to invest, is a lousy long-range strategy unless you plan to die young. Because of the deficit, our net national savings now amount to barely 1 per cent of GDP. A country that saves and invests so little may be able to postpone a decline in living standards but it cannot do so indefinitely.

The Bush binge could end with a bang or a whimper. If confidence in the US economy is eroded, foreigners may stop financing our deficits. The Treasury would have to offer higher returns to sell its bonds, raising long-term rates. The withdrawal of foreign capital would also prompt a decline in the value of the dollar, as traders sold dollar-denominated instruments. Such trends can create a vicious cycle, in which misery is never at a loss for company. In a worst-case scenario, unchecked deficits could provoke a Mexican or Asian-type financial crisis. The Fed might be able to forestall a meltdown - or it might not. As Lawrence Summers, former US Treasury secretary, once put it, the thing about a dysfunctional relationship with the rest of the world is that it can go on much longer than you expect but it can also end much more suddenly than you expect.

Another hazard is losing what Robert Rubin, Mr Summers' predecessor as Treasury secretary and my guru on this subject, calls "resilience". A deficit of 3.2 per cent of GDP, which is what George W. Bush predicts for this year, curtails the ability of policymakers to respond effectively to the unforeseen and unforeseeable. The US economy absorbed the shock of the September 11 2001 attacks without falling into recession in part because of Washington's use of fiscal as well as monetary policy in response. But when the budget is already deeply in the red, the "break glass in case of fire" box comes pre-smashed. In the event of another major terrorist attack or natural disaster, Keynesian tools such as tax cuts and stimulus spending will be much harder to deploy than in 2001, when the budget was still in surplus.

Perhaps the gravest harm deficits do is to undermine the government's ability to take on the country's non-emergency problems - the healthcare mess, the education mess, the baby boom generation's under-funded retirement and so forth. Even into the 1990s, many Democrats tacitly approved of deficit spending, because it enabled them to do more without higher taxes. In those days, Republicans tended to oppose deficits because they wanted government to do less. But during the Bush presidency, these roles have been reversed. Republicans now see deficits as a way to disable the federal government by "starving the beast". Democrats, by contrast, have come to loathe deficits, because they prevent government from doing anything.

If we deficit hawks have failed to generate enough alarm to motivate action, it may be that our metaphors have become stale. Running a deficit is not so much like going on a spending spree or shooting yourself in the foot, which hurts immediately. It is more like smoking, drinking to excess and not exercising. It will in fact kill you - just not tomorrow.

The writer is editor of Slate.com and co-author with Robert Rubin of In An Uncertain World (Random House)