Why Capitalism?

Editor’s note: The following is an excerpt of the book Why Capitalism? (Oxford University Press) by Allan H. Meltzer. In this essay, the author explains why we have big deficits now.

The United States government is on course in 2009, 2010, and 2011 to run the largest peacetime deficits in its history—at least $1 trillion a year for ten years or more—with no end in sight. Logic and history tell us that financing such enormous deficits will cause inflation and a depreciation of the dollar against other currencies. Every knowledgeable observer agrees that the projected deficits and debt are unsustainable. Studies at the Bank for International Settlements suggest that decades of surpluses will be required to restore the 2007 debt to GDP ratio.

It is a big problem, but not a new one. Historically, politicians have given lip service to fiscal restraint. Today, however, efforts to achieve budget balance or surplus in the United States are a rarity—apart from routine complaints from the party currently out of office about deficits attributed to their opponent. Once in office, the winner neglects fiscal orthodoxy and adds to the deficit.

   
 Illustration by Barbara Kelley

Although the 2010 midterm elections showed considerable public concern about spending, there are only two post–World War II exceptions to continued deficits: the Eisenhower and Clinton presidencies. Over the term of his presidency, Eisenhower achieved a balanced budget, though he ran a high (for the time) deficit during the 1957– 58 recession.

From President Washington to the Civil War, the federal government ran surpluses 75 percent of the time, except during years of war. Alexander Hamilton, the country’s first Treasury Secretary, paid off Revolutionary War debts but ran budget deficits in three of the first eight years of the new republic. Other peacetime deficits in our history have occurred during recessions. During the War of 1812, total outstanding gross debt rose from $45 million to a maximum of $127 million.

By the early 1830s, the federal government had retired almost all outstanding debt. As in most wars, Civil War expenditures greatly exceeded revenues. The $1.3 million in government spending in 1865 was more than 20 times government spending in the last pre-war year, 1860. By war’s end, the nation’s gross debt had reached $2.7 billion. The federal budget remained in surplus for the next 28 years. By 1892, gross debt was below $100 million. Despite the surpluses, or perhaps because they encouraged private investment, the economy grew.

During World War I, federal government deficits totaled $23 billion for the years 1917–19 and were $25 billion by war’s end. In the 1920s, Treasury Secretary Andrew Mellon reduced tax rates and controlled spending. By 1930, gross debt had fallen to $16 billion.

That was the end of a sustained effort to reduce government debt. During the Great Depression and World War II, the budget was in deficit every year. By war’s end, 1946, gross debt reached $269 billion, and in the following years, avoiding postwar deflation and unemployment took priority over debt reduction. President Truman raised tax rates to finance most Korean War spending. President Eisenhower, who spoke often about fiscal responsibility and balanced budgets, ran several budget surpluses. From 1946 to 1957, gross debt rose little, except during the deep 1957–58 recession.

The political system is making promises it cannot keep.

Today, government spending has increased greatly. At the beginning of the twentieth century, the federal government spent 2.8 percent of total output (GNP). In World War I, as in all wars, spending and taxes increased. By 1929, spending was 3.7 percent of GNP. From the mid-1980s to the present, government spending has fluctuated around 18 percent of GNP. In 2010, it was 25 percent of GNP. If the current large gap between revenues and expenditures is to be closed, taxes are likely to rise. Future unfunded liabilities add to the pressure for higher taxes when they are spent and debt service increases spending, as well as the total debt.

In the past, when the nation spent more than it collected in tax, it was to finance wars. When the war ended, deficit spending ended. Today’s deficits continue and grow in size, but defense and military spending, though large, are a greatly reduced share of spending. The big increases are for social welfare programs and redistribution.

After World War II, military spending related to the Cold War drove government spending, but military spending as a percentage of total government spending has since declined. The main driver of government spending since the mid-1960s has not been military spending, but regulation and income redistribution in the form of entitlements— Social Security, Medicare/Medicaid, and welfare. Estimates in 2009 of future medical costs exceeded expected revenues (“unfunded liabilities”), for which the government is liable, by $60 trillion or more.

From 1961 through 1977, the government budget was in deficit; the government spent more than it received in tax revenues during every year except 1969. President Johnson borrowed heavily to finance increased social spending and the war in Vietnam. Gross debt reached $369 billion when he left office.

President Nixon did more of the same. Domestic spending by government rose rapidly. By the 1980s, deficits of $150 to $250 billion had become common. President Reagan slowed the growth of domestic spending but greatly increased military spending in order to bring an end to the Cold War. After that, reduced defense spending helped President Clinton run budget surpluses from 1998 to 2001—the only period with a continuous surplus in the past 70 years.

The Bush administration increased social and military spending, reduced tax rates, financed a war by issuing debt, and added greatly to future spending for health care. Budget deficits and the gross debt rose and liability for future spending soared. The Obama administration greatly increased spending growth in 2009 and 2010. Gross debt reached $9 trillion, with additional unfunded promises of around $50 or $60 trillion. Foreign governments held about 25 percent of the debt, so much more of our future output must be used for exports to earn the money to pay the interest rate on the debt we owe. In 2009 the Obama administration proposed higher deficit spending to reduce unemployment and pollution, expand government-supported health care, and to redistribute income.

Historically, when America's wars ended, its deficits ended too.

The nonpartisan Congressional Budget Office (CBO) estimated that gross debt would nearly double in the next decade and said that without major policy changes, outstanding debt would reach 947 percent of GDP by 2084. Long before that point, a crisis would force policy change.

Reports of budget deficits and debt understate the government’s future obligations. Estimates of the federal government’s unfunded future liability for Medicare, Medicaid, and Social Security pensions range as high as $80 trillion, more than $250,000 for each currently living person. What this shows is that the political system makes promises that can’t be kept—our political arrangements make it easier to promise benefits than to pay for them. Our country’s choices are now restricted. Either we reduce spending to shift resource use toward more productive uses or we increase taxes to finance the welfare state. Welfare state spending helps the recipients, but it reduces national productivity, economic growth, and living standards.

The federal government is not alone. Many state and local governments have promised pensions to retired employees that can be honored only with much higher taxes. Or cities and states can renege on the promises, by making beneficiaries pay more of the cost. An alternative would shift the liability to the federal government, which is unlikely because the federal government has severe budget problems. Some estimates reach $2 or $3 trillion for these future state and local unfunded obligations.

Almost all state and local governments are required to balance their budgets annually. Instead of paying higher wages to teachers, police, firemen, and other employees, governments promised future pensions and health care that, being in the future, didn’t affect the current budget but would come due only after the officials who made the promises were out of office. These obligations are now coming due. Few were fully funded in the interim. And states avoided the balanced budget requirement by employing schemes such as chartering government corporations that they excluded from the budget, exempting capital projects, and many others.

There is a tendency to make estimates of future costs that are overly precise and that later prove entirely wrong—mostly too low. The future is uncertain. By any measure, the costs of fulfilling the promises that have been made in the past are unsustainable. Something must be done to reduce future costs and develop a feasible, believable plan.