Written by Gene Balas
As the fiscal cliff approaches on January 1, 2013, when automatic spending cuts, tax rate hikes and elimination of certain deductions goes into effect, we must consider how we got to this point – and how to get out of it, if we can. The effects are economic, but the causes are psychological, sociological and political. Let’s explore the causes of why we are here, with a mountain of federal government debt that rivals our economic output. While it may seem strange to consider, perhaps entirely logical decisions led to a rather illogical state of affairs.
First, politicians do not simply appear in office. We elect them. We should hopefully know what policies they support beforehand, and we might reelect them based on what they did while in office. If we had any objections, we could have made a different choice. Our obligation – and certainly that of all elected officials – is to vote for what is in the best interest our nation. As we will see, however, people acting entirely rationally can act in a way that is in the best interest of the fewest people at the expense of that of the most.
Politicians make all sorts of promises, and at least some of us seem to believe them. A car in every garage – with lower taxes at the same time to boot! Who wouldn’t vote for such things? But remember, if it sounds too good to be true, it probably is. No matter how clever at legislating, politicians haven’t been able to outlaw the rules of simple math. To balance a budget, income must be greater than or equal to expenses. It’s just that simple.
Public Choice Theory
But really, it’s quite complicated. At this point, we must introduce a concept known as public choice theory. Public choice theory uses modern economic tools to study problems that are generally in the realm of political science. From the perspective of political science, it explains how voters, politicians and bureaucrats all act in rational self-interest, but which results in political decision-making outcomes that conflict with the preferences of the general public. Several public choice scholars have been awarded the Nobel Prize in Economics, notably James Buchanan (1986), along with others, including George Stigler (1982) and Gary Becker (1992).
Delving into how this theory works in practice, consider the example of special interest groups – those lobbying efforts by corporations or other agents who want spending for a particular project. Even though the public might oppose this type of spending on pork barrel projects in principal, few members of the public have the time or energy to combat the intensive lobbying efforts for the many individual projects that go before lawmakers.
Proponents invest much more in the outcome than those who might oppose the measures, simply because those few people stand to gain quite a bit, compared to individual members of the public, whose costs, individually, are quite small.
After all, one project by itself might not seem like a large sum to the government, but it is a very big deal to the special interest group in question. Not to mention, of course, voters in a district that benefits from these projects will certainly not complain. Instead, they might be more, not less, likely to vote for a politician who proposes these spending projects, even if it might be considered by others to be “wasteful.”
As such, the cost/benefit relationship is distorted. Proponents invest much more in the outcome than those who might oppose the measures, simply because those few people stand to gain quite a bit, compared to individual members of the public, whose costs, individually, are quite small. Suppose a new, hypothetical “bridge to nowhere” cost $30 million to build. Is it worth me fighting about it when its costs average out to be ten cents to me (and every other American)? Am I even a voter in that representative’s district, where the legislator will heed my complaints?
It’s in my own, individual best interests not to fight this one hypothetical project. This is not the most productive use of my time and energy, especially given my poor chances of succeeding in a one-man effort against a lobbying firm. Hence, even if I am angered by excessive spending, I am acting in an entirely rational fashion to ignore this particular project, preserving my own resources of time and energy, but acting against the nation’s long term best interest.
… many small bad decisions get multiplied into a much bigger problem.
Then there are other reasons beside the money involved. Politicians might feel a bit more powerful and might feel like they have a bit more clout on Capitol Hill, if they can get the project in question passed. More importantly, politicians might want a new career as a lobbyist themselves at one of those firms after leaving government. It always helps to play nice with someone who might be your new boss.
All of this means that many small bad decisions get multiplied into a much bigger problem. There are 535 members of the US Congress, with plenty of opportunity for special interest spending to be introduced.
Public choice theory - individuals acting in a rational fashion, focused on their own self-interests, can lead to a very poor outcome for the nation as a whole.
Meanwhile, voters in each district are focused only on the policies proposed – and the results delivered – by only their representative when casting a vote, reducing the accountability of the institution as a whole. Costs are diffused, while benefits are concentrated, and all of it is someone else’s money, anyway.
Thus, public choice theory shows that individuals are acting in a rational fashion, focused on their own self-interests, leading to a very poor outcome for the nation as a whole. When it comes to public policy, not free market enterprises, perhaps Ayn Rand might not be entirely correct in her views that there is a virtue to selfishness, or rational self-interest, as she describes in her writing, including her book, “The Virtue of Selfishness.”
Our Current Situation
That leads us to our current dilemma. We’ve seen debts grow and grow after many, many years of deficit spending. All those little sums of individual projects have added up in a very, very big way. What were we thinking?
Perhaps we were just hoping it would all go away. For decades now, we’ve engaged in mass delusion; that somehow, growth would subsume the need for restraint. We’ve believed that the magical powers of some yet-to-be-determined force would create powerful economic growth that would obviate our need for maintaining smaller deficits that won’t grow faster than the economy as a whole. But one must never build a budget or economic models based on just hopes and wishes; yet that is what we, as a country, have done.
We’ve had ample opportunity to see that this hasn’t worked, over decades, if not entire generations. We’ve spent more than we’ve earned in the difficult 1970’s and in the prosperous 1980’s. We did it again in the booming 1990’s, except maybe for a year or two, and then again in the austere 2000’s. We’ve had ample opportunity to see that there is no economic genie that will grant our wishes for the problem to simply go away.
But one must never build a budget or economic models based on just hopes and wishes; yet that is what we, as a country, have done.
We could have voted for politicians that were realistic, but people don’t like to hear Debbie Downer giving a political speech. A salesman always sells more cars than does the engineer who actually knows how they work.
Now, things have come to a head. We’ve seen the disaster that excessive debt has wreaked in Europe, and we’re eager to avoid those problems now. We do recognize the European model of generous spending has failed. But perhaps Europe’s attempt of a solution of immediate austerity does not work, either. Indeed, a starvation diet to wean us off gorging on debt spending can lead to problems with our economic health. Like a rubber band stretched too far and snapping back in the opposite direction, is our current fixation with rapid deficit reduction going too far in the other extreme?
Indeed, a starvation diet to wean us off gorging on debt spending can lead to problems with our economic health.
After all, deficits, like many things in life, can be beneficial in smaller, more moderate amounts, but can become problematic in excess. We should point out that our trade deficit and budget deficit are intertwined: the capital account must equal the current account. If we are going to tackle our budget deficit – remembering that foreigners buy many of our Treasury instruments – the corollary must be that our economy would slow from reduced government spending to the point that our imports would be reduced, unless our exports somehow increase.
So, we might ask, can we have a better solution, perhaps a more moderate approach to cutting the deficit rather than try to do most of it all at once? What businesses (and consumers) want mostly is to know what is going to happen with taxes and spending; they aren’t necessarily asking that all of these things happen right this second, as long as they know that there is a credible plan. And a more gradual implementation of this fiscal restraint can give both businesses and consumers more time to plan and adjust, rather than going off the fiscal cliff.
The Problem: The “Fiscal Cliff”
By now, many of you have heard about the federal belt tightening that is scheduled to begin January 1, 2013. This is because our two primary political parties are unable to compromise, the same factor that Standard & Poors cited when downgrading our federal government debt. The Congressional Budget Office (CBO) reports that fiscal tightening will lead to a recession in 2013. They detailed their findings with a number of economic projections, comparing if we go off the fiscal cliff (meaning lawmakers do nothing), or if politicians change the current law to reduce the impact of the fiscal restraint.
Specifically, here’s what the economy might look like without going off the cliff, that is, if current law is changed, but current policies remain the same. (Remember that the way the law is currently written, we will go off the fiscal cliff. Lawmakers must change the current law to retain taxes and spending as they are now to avoid the cliff.)
- In 2013, the deficit would total $1.0 trillion, almost $400 billion (or 2.5% of GDP) more than the deficit projected to occur under current law (but it is still $91 billion less than in 2012).
- Real GDP would grow by 1.7% between the fourth quarter of 2012 and the fourth quarter of 2013, and the unemployment rate would be about 8% by the end of 2013 (basically, right near where it is now), the CBO projects.
Now, here is what happens if we do go over the cliff (remember, this happens if lawmakers simply do nothing).
- The deficit will shrink to an estimated $641 billion in fiscal year 2013 (or 4.0% of GDP), almost $500 billion less than the shortfall in 2012.
- Such fiscal tightening will lead to a recession, with real GDP declining by 0.5% between the fourth quarter of 2012 and the fourth quarter of 2013, and the unemployment rate rising to about 9% in the second half of calendar year 2013.
- Because of resource slack, the rate of inflation, as well as Treasury yields, will remain low in 2013, in the CBO forecast.
Pick your poison: a recession now or more debt. The CBO notes, though, long term, our economy will be in much better shape with the deficit reduced significantly – though it does notneed to be eliminated entirely. We now must pay the price for decades of voters who seem to always want politicians to give us more spending with lower taxes. If we didn’t want to accumulate that debt in the 1970s, the 1980s, the 1990s and the 2000s, we sure had ample opportunity to break out of this debt snare long before it hit a crisis.
… people acting in a rational fashion can, ultimately, act against their own best interests when viewed as citizens, members of the nation as a whole, not individuals. That is the paradox.
But as we learned, in our nation’s journey on the way to the fiscal cliff, perhaps we weren’t as irrational, as individuals, as an outside observer might think. Yes, who would vote against the best interests of the country? But, as public choice theory demonstrates, people acting in a rational fashion can, ultimately, act against their own best interests when viewed as citizens, members of the nation as a whole, not individuals. That is the paradox.
Possible Solutions and their Impediments
No matter how we got to this point, or what theories explain it, we are in a difficult bind. Competing paradigms now battle each other. With gridlock in place, current law will undo decades of overspending relative to our revenues in just one short year. Yes, we need to move closer towards reasonable deficits over a reasonably short period of time, but a compromise solution certainly could allow for, well, compromise, from lawmakers on both sides of the aisle.
The only way that we can gradually descend from our mountain of debt, instead of tumbling headlong off the edge, is for the leadership of both parties to work together. Unfortunately, that is less likely than not.
Maybe deliberately jumping off the cliff could still be avoided. However, the problem is, economic troubles may start sooner if businesses and consumers start cutting back before the fiscal cliff arrives. By then, it may be too late, as a recession may start, based on worry and doubt. But relying on hopes and wishes rarely leads to prosperity, either. Can there be a middle ground, a rational decision process that leads to our mutual best interest, for all of us and our nation as a whole?
Finding a middle ground is vital. But few politicians seem to advocate for the solution that is most necessary: a combination of both spending cuts and revenue increases. Entitlements need to be addressed for younger generations, and we may need to cut defense spending.
But some good news is that we don’t need to eliminate deficit spending entirely…. additions to our debt would be no greater, proportionally, than additions to our aggregate economic output.
Otherwise, if we were to try to balance the budget through spending cuts alone, without addressing entitlements or defense spending, we would need to close every single government agency and department. (See table S-4 in the attached budget http://www.whitehouse.gov/sites/default/files/omb/budget/fy2013/assets/tables.pdf if you’re curious.) That’s everything from the FBI to the IRS and everything in between, whether it’s NASA, national parks, federal courts or Amtrak. Our nation would suffer enormously if we tried a rigid, partisan approach to balancing the budget, without compromise or consideration of realistic economic models.
But some good news is that we don’t need to eliminate deficit spending entirely. In the same general vein that a consumer may undertake some debt, such as to buy a house or car, or a business may borrow to expand, the federal government may find it beneficial to borrow a bit. The general thesis, though, is that the debt should not grow faster than the economy. This means that deficits should be in the general range of long-term, potential economic growth, say, perhaps 3% or so. Thus, additions to our debt would be no greater, proportionally, than additions to our aggregate economic output, and debt as a percentage of GDP will remain more-or-less stable over time.
Why would we want to have some deficit spending? One is our current environment. As consumers deleverage, and pay back debt, their consumption tends to fall, all things equal. That debt isn’t going to be replaced by more bank lending, and those funds basically get taken out of the economy. This can cause economic growth to be sluggish, or in some cases, even contract.
When the government steps in to be the “consumer of last resort,” government borrowing replaces consumer borrowing to goose the economy. Paradoxically, this is the exact opposite of “crowding out theory,” where government borrowing displaces borrowing by businesses and consumers. In normal times, this could limit economic growth. But now, in the “Great Stagnation,” to borrow a term from Boston Federal Reserve Bank President Eric Rosengren, we are not in a normal environment, when such theories tend to hold.
Perhaps the government could raise taxes when inflation rises and cut them when inflation falls below desired levels.
Instead, government borrowing, in moderation, can steady the economy, adjusting upwards or downwards to right the ship if more extreme behavior in the private economy takes place. This is the best use of deficit spending, when fiscal policy can expand during lean times and contract during strong expansions.
Such flexible approaches to deficits can help keep inflation from moving too far above or below the target, 2% or just a bit less, as well as keep economic growth from contracting too much in recessions. Perhaps the government could raise taxes when inflation rises and cut them when inflation falls below desired levels.
The trick is getting politicians to consider deficits through the lens of economics theory.
Coincidentally, this may tend to stimulate the economy when it needs to be juiced and recoup tax revenues to lower the deficit when the economy is more amped. This would help keep inflation and growth steady and our deficits under control.
The problem is that we haven’t been able to use deficit spending either appropriately or in moderation. Politicians don’t seem able to choose judiciously when to spend and when to use restraint. But as we have seen, public choice theory explains why our addiction to excessive debts can make logical sense when viewed as such, even if the result of our behavior does not.
The trick is getting politicians to consider deficits through the lens of economics theory, not economists viewing deficits through the lens of political science. For our economic well-being, one might come to trust an economist over a politician, even if their promises fail to excite.
About the Author
Gene Balas has over twenty years’ experience in financial and economic analysis. He is the Chief Investment Strategist for East End Wealth Management, evaluating economic conditions and other variables to develop investment strategy. He also writes economic commentary for TheStreet's RealMoney site. Previously, he was Director of Investments at Genworth Financial Asset Management. In this role, he performed forecasts on macroeconomic conditions and determined the influences of thematic drivers to develop investment strategy. He also headed the firm’s investment manager due diligence efforts. Prior to GFAM, Gene was Director, Investment Management & Guidance at Merrill Lynch & Co. In that role, he advised pension funds, endowments and foundations as to appropriate asset allocation strategy. In previous roles, he advised both institutional and individual investors on asset allocation and manager selection decisions, beginning his career in 1989. He has an MBA from Columbia Business School and a BBA in Finance from the University of Houston, where he attended on a full National Merit scholarship. He is a Chartered Financial Analyst.