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16 Tons of Keynesian Economics

Tuesday, January 22, 2013

As the old song goes, after 16 tons of Keynesian economics, all we have to show for it is that we are deeper in debt.

Should the United States adopt an amendment to the Constitution requiring a balanced budget?

Keynesian economists say no. They believe that Congress needs the discretion to be able to run deficits in order to fight recessions.

I say yes. I would be happy to see the debt ceiling eliminated permanently — as soon as a balanced budget amendment is approved by the states and goes into effect.

Without a taboo against deficits, deficit spending tends to become habitual. It is politically corrosive, because no constituency expects to be the one to have to sacrifice when the limits of borrowing have been reached. (See “Lenders and Spenders: Confronting the Political Reality of Debt.”)

No constitutional amendment will work perfectly. However, constitutional prohibitions against deficits make governments more fiscally responsible than they would be otherwise.

Nearly all U.S. states are prohibited from running deficits. In contrast, Canadian provinces face no such constitutional constraints. The result? According to a study undertaken by Marc Joffe for the Macdonald Laurier Institute, 8 of the 10 provinces have debt-to-GDP ratios in excess of 20 percent. Joffe told me that even in the most troubled U.S. states, this ratio is much lower.

In looking at the risk of government default, Joffe focuses on a different ratio, that of interest expense to tax revenue. He suggests that when this ratio reaches 25 percent, default becomes highly likely. For 9 of Canada's 10 provinces, the ratio of interest expense to tax revenue is currently between 5 and 9 percent. However, his simulation analysis suggests that for every Canadian province there is a high probability of crossing the 25 percent threshold over the next 20 or 30 years.

If it is necessary to run deficits whenever conditions are ‘not very satisfactory,’ when will we not run deficits?

Why are Canadian provinces at such high risk of default? Politicians in Canada are not less fiscally responsible than those in the United States. In fact, their national government's deficits and accumulated debt, relative to GDP, are much lower than ours. Canadian provinces are not using deficit spending as fiscal stimulus to fight recessions. The reason that Canadian provinces are in more fiscal peril than U.S. states is that Canadian provinces lack constitutional checks on deficit spending.

Many U.S. states evade the spirit of constitutional budget requirements through use of accounting gimmicks, such as rosy assumptions about pension fund returns. Even so, the restraints basically work.

The main argument against a balanced budget amendment is that it would tie the hands of Congress in dealing with economic downturns. Keynesian orthodoxy says that deficits are appropriate in a recession. The orthodox Keynesians are both loud and numerous within the economics profession. However, they may be wrong. Below is a list of reasons.

1. The historical record does not clearly support the Keynesian view. There are many instances in which fiscal expansions did not produce economic expansions and in which fiscal contractions did not produce economic contractions. For example, see some of the literature cited in a recent article by Robert Murphy, particularly footnote 5.

2. The macroeconometric models that are trotted out to support Keynesian policies are highly suspect. (See “The Soothsayers of Macroeconometrics.”) 

3. The Keynesian rationale for deficits would imply that when the economy is not in recession, a balanced budget or surplus is in order. However, the United States has run deficits nearly every year since the Keynesian framework was adopted in the 1960s.

4. As is well known, the Congressional Budget Office projects increasing deficits starting in about 10 years, as the full force of Baby Boom retirements hits the budget. From there on, the CBO projects ever-widening deficits. Yet no Keynesian is coming forward to suggest that perpetual deficits are appropriate. We are not always going to be in a recession. Why is there no plan to balance the budget? 

5. Technically, according to the National Bureau of Economic Research Business Cycle Dating Committee, the most recent recession ended in June 2009. In theory, the rationale for deficit spending ended on that date as well. Of course, economic conditions today are not very satisfactory. But if it is necessary to run deficits whenever conditions are “not very satisfactory,” when will we not run deficits?

In short, giving governments the discretion to run deficits does not work out well. In theory, government is supposed to fight recessions with deficits, which should then be replaced during normal times by balanced budgets and surpluses. In practice, deficits do not necessarily have the expansionary effects predicted, nor does deficit reduction necessarily exhibit contractionary effects.

All of the major countries that have used the Keynesian rationale to justify deficit spending are now on unsustainable fiscal paths.

Moreover, in practice, deficit spending tends to become permanent, not temporary. All of the major countries that have used the Keynesian rationale to justify deficit spending are now on unsustainable fiscal paths. It is all too easy for politicians to provide current services and future promises without raising enough tax revenue to pay for them. Once they are permitted to go down this road, legislators are like drug addicts. The political pain of withdrawal (returning to budget balance) is too high.

How should a balanced budget amendment be formulated? There are a number of ideas. For example, Glenn Hubbard and Tim Kane report on a proposal by Congressman Justin Amash (R-Michigan) to constrain outlays to the average of revenues for the previous three years. Anthony Randazzo and Marc Joffe have proposed a constitutional version of what Congress calls “pay as you go,” which they describe as follows:

A strong PAYGO amendment would require that all new legislation be deficit neutral (or negative) over periods of 2 and 10 years, as scored by the CBO and approved by the special court’s budget office.

I do not much care which balanced budget amendment is passed. Any amendment will be imperfect, and Congress can probably find a way around any amendment if it wants to. But having an amendment in the Constitution would send a strong signal that the public expects the budget to be balanced. This signal itself would provide the best mechanism for enforcement.

Keynesian economists will insist that a balanced budget amendment will prevent the government from achieving an ideal countercyclical fiscal policy. But the reality has been far from ideal. As the old song goes, after 16 tons of Keynesian economics, all we have to show for it is that we are deeper in debt.

Arnold Kling is a member of the Financial Markets Working Group at the Mercatus Center of George Mason University. He blogs here.

FURTHER READING: Kling also writes “Skin in the Housing Game,” “What Would Churchill Do?” and “The Risky Mortgage Business: The Problem with the 30-Year Fixed-Rate Mortgage.” Norman J. Ornstein discusses “Why a Balanced Budget Amendment Is Too Risky” and Steve Conover explains “The Fatal Flaws of a Balanced Budget Amendment.” Alex Brill offers “A Debt Strategy for the Next 30 Years.”

Image by Dianna Ingram / Bergman Group

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