When Deficits Make Sense

Friday, June 27, 2008

Democrats and Republicans agree that the government borrows too much. This agreement, however, may not be the rallying cry for productive policy that it appears. Politicians of all sorts have an incentive to redistribute wealth for political gain, and balanced budget spending can actually facilitate unproductive tax transfers. A candidate may enjoy more success by promising tax benefits to 51 percent of voters than by vowing to spread fiscal responsibilities evenly across the electorate. Indeed, while the invisible hand of markets pushes for win-win bargains, the visible hand of government favors a plurality of voters at the expense of others.

In this light, running deficits appears to be more solution than problem. Because voting “markets” tend to take from those without a voice, tax-financed spending often channels resources to politically attractive (though not always productive) uses. Financial markets, on the other hand, reward making more than taking. Having to fund deficits can thus replace political maneuvering with market discipline.  

To be sure, the argument here is not that more (or less) government spending is necessarily better. Rather, it is simply that financial markets, despite recent credit channel difficulties, discipline public spending better than voting markets do. A “bridge to nowhere,” such as the multimillion-dollar span recently proposed in Alaska, would have a hard time attracting financial capital on a cost-benefit basis. But voting markets can forge ahead anyway, spreading the tax costs of unproductive projects widely while concentrating the benefits onto politically attractive constituencies. By more transparently distinguishing between political redistributions and sound public investment, running deficits can improve government quality.

A candidate may enjoy more success by promising tax benefits to 51 percent of voters than by vowing to spread fiscal responsibilities evenly across the electorate.

To see how this works, consider a $100 spending proposal that promises to return at most $100 in the future. Because this project does not strengthen the public ’s repayment ability, financial markets would be reluctant to fund it. Doing so would be like putting $100 in the bank with the prospect of getting no more than $100 in the future. Individual depositors do not willingly give up money in such circumstances; financial markets likewise are reluctant to fund unproductive investments.

Political markets that assign tax burdens ignore this discipline. Suppose, for example, that group A enjoys more political influence than group B and that a political entrepreneur proposes to simply give $100 to group A. In a case like this, which illustrates some aspects of Social Security, voting markets tend to fund the proposal as long as it asks for less than $100 in taxes from group A.

Even worse, rather than simply being redistributive, politically attractive tax-and-transfer projects tend to shrink economic opportunities. First, these projects encourage individuals to lobby to be members of favored groups (like group A in the previous illustration). Economies prosper, however, when governance institutions reward productive efforts, and suffer when individuals instead seek redistributive rents. Second, taxes create a wedge between prices that buyers pay and sellers receive and thus discourage mutually beneficial transactions. But it is those free exchanges, not mandated zero-sum transfers, that expand economic opportunities.

Politicians and the popular media frequently present the balanced family budget as an example for government to emulate. But although balancing budgets productively disciplines household spending, it opens the door for unproductive discretion over public spending. Households face the full costs of their own balanced budget spending and thus tend to wisely allocate those dollars. Balancing public budgets, however, means only that tax revenues fully fund expenditures, not that individual costs align with benefits. And, as noted, politicians on both sides of the aisle face strong incentives to divide those who benefit from public spending and those who bear the tax cost.

To maximize the benefits of public spending requires a funding mechanism that discourages inefficient but politically rewarding discretion. Corporations offer a more instructive comparison than household budgets. Voters in corporations —that is, shareholders—readily agree to run deficits, in part because debt capital offers important advantages in governing a firm ’s management. Likewise, government bondholders put their money where their mouths are and thus help rein in unproductive tax redistributions. Financial markets can give us a better idea of the appropriate scope of government activity and encourage a less wasteful employment of public resources once that scope is set.

To be sure, both borrowing and taxing offer channels through which politically influential groups can tilt resources in their favor. For taxes, this redistribution largely occurs across groups within a generation, while debt might transfer resources from future generations to the present. But debt also embodies a number of self-policing mechanisms, whereas taxes create relatively little discipline on how governments spend resources.

By selling off bonds when creditworthiness deteriorates, financial markets continually monitor the potential for public spending to decrease the government ’s repayment ability. Deficits that would redistribute from future to current generations, rather than expand economic opportunities, thus receive a forceful and well-timed check —namely, a hard-to-hide increase in borrowing costs. Tax-financed spending eludes this discipline.

Political markets give little weight to those who don’t vote, and thus tend to ignore the silent protests of those who would inherit inferior opportunities from unproductive tax spending today. By benefiting a dominant coalition of current voters, that spending can go forward anyway. Instead of blithely burdening future generations, deficits give financial markets (who share an interest in the future) a seat at the table today, where they can productively voice concerns about whether public spending redistributes a shrinking pie or creates new opportunities that can be widely shared.

Government bondholders put their money where their mouths are, and thus help rein in unproductive tax redistributions.

Economists have long debated whether deficits boost consumption during economic downturns or instead make their way into savings. Deficits do matter, but perhaps less for fiscal stimulus and more for disciplining public spending. To attract funding through debt markets, spending proposals must reasonably promise to strengthen society ’s repayment ability. Moreover, debt markets continually evaluate the price at which government obligations are traded and thus transparently report on the credibility of such promises. Running deficits, not balancing budgets, can productively constrain governments by raising the price on unproductive spending while readily supporting public projects that strengthen economic performance.

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