The wrong budget analogy

Washington’s renewed obsession with government budget deficits has become a major obstacle to dealing with the U.S. unemployment crisis. At the root of this misplaced focus are widespread misconceptions about the role of deficits in the economy.

The fact that high unemployment and budget deficits are occurring at the same time has generated confusion about the real sources of the slump. The increased deficit is a consequence, not a cause, of the downturn. When economic activity falls, so does tax revenue. Some categories of government spending, such as unemployment benefits, automatically rise during a recession. This contributes to a higher deficit.

Politicians of both parties have furthered the misunderstanding by frequently drawing an analogy between the federal budget and household budgets. “Families across this country understand what it takes to manage a budget,� President Obama declared in a February radio broadcast. “Well, it’s time Washington acted as responsibly as our families do.� While this comparison appeals to a general belief that we should “live within our means,� it’s also misleading.

Decisions about the federal budget are fundamentally different from those of individual households, because policymakers need to account for how their choices affect the economy as a whole. It is more appropriate to liken government budget deficits to prescription medicine. Just as medication can be helpful to a sick patient, deficits can aid a failing economy.

The U.S. economy slumped largely because of a reduction in spending by households and businesses. For households, this was a reasonable response to declining property values, job losses and insecurity. Likewise, it made sense for firms to cut back on investment as their customers spent less. If the federal government were to act this way, though, it would reinforce the decline in economic activity, not alleviate it.

To stabilize the economy, the federal government needs to counterbalance the swings in consumer and business expenditures by moving in the opposite direction. When consumers and firms cut back, government can help replace the lost economic activity through direct spending (on infrastructure projects, for example) and through indirect means, such as tax cuts, which increase households’ disposable income.

This idea of “counter-cyclical� policy was the basic principle behind the tax cuts and spending in the stimulus bill of early 2009, as well as the one-year payroll tax cut agreed to as part of the budget deal at the end of 2010. Though the stimulus proved inadequate in scale, it helped reduce the depth of the downturn. Without it, the unemployment rate in 2010 would have been between 0.7 and 1.7 percentage points higher, according to an estimate by the nonpartisan Congressional Budget Office. That is, the economy has been lousy, but it would have been considerably worse without government action.

In short, the fact that the government is taking in less in tax revenue than it is spending is helping, not hurting, the economy. Immediate large spending cuts or tax increases to close the budget gap would be a severe blow to an already weak recovery.

This does not mean that deficits are always harmless. Like prescription medications, large deficits are appropriate only under certain circumstances. In a healthy economy, large-scale government borrowing can drive up interest rates and draw money away from private business investment. This is the main reason governments should not run large deficits when the economy is operating near capacity. The fact that long-term interest rates are at their lowest level in decades — and have remained so despite Standard & Poor’s downgrade — shows this is not a problem now.

After the economy recovers, it will be responsible to reduce the federal government’s borrowing. Doing so will require some difficult choices about taxation, defense spending and social insurance programs. Such discussions about the role of government in society arouse passionate feelings but, right now, are a distraction from the more immediate task of reviving the economy. It is a mistake to become entangled in a debate about taking away the medicine when the patient is still in the sickbed.

Bill Craighead teaches courses in macroeconomics and international economics at Wesleyan University and writes the blog Twenty-Cent Paradigms.