Texas Republican Congressman Kevin Brady was doing a soft-shoe last week at the 2019 Fiscal Summit sponsored by the Peter G. Peterson Foundation. He was trying to defend the massive package of tax cuts passed in December 2017 – of which he was a principal architect – in the wake of a new analysis from the Congressional Budget Office showing that those tax cuts were ballooning federal deficits back toward $1 trillion a year.
The Peter G. Peterson Foundation was the creation of Pete Peterson, a prominent Wall Street financier, Nixon administration official and GOP wise man who famously sounded the alarm about growing federal deficits back when people cared about such things. Most recently, in the months before he died, Peterson opposed the 2017 tax cuts, arguing at the time that "Mortgaging our fiscal future for trillions in temporary tax cuts will hurt our economy over time, and every C.E.O. should know that. True business patriots need to advocate for their country as well as their company."
Brady – by Peterson's test less patriot than self-serving partisan – argued vociferously at the time that the tax cuts would pay for themselves. The truth is, his argument had less to do with economics than pure politics, as since the Reagan years, the notion that tax cuts pay for themselves has become a Republican shibboleth, whatever the data or circumstances might suggest. Forty years ago, in the post-Vietnam War stagflation years, when the top federal tax bracket was 90%, the unemployment rate was nearing double digits, and factory underutilization was rampant, one could make the argument for tax cuts with a straight face. As the Laffer Curve suggested, communities with high, confiscatory tax rates may be able to increase tax collections by reducing tax rates, due to the combination of increased economic activity and reduced tax avoidance that might result.
As top income tax rates were dropped from 90% to 35% or so, supply side economics and cutting taxes morphed from economic theory to political strategy, and – along with guns and abortion – became a cornerstone of the GOP coalition. As Reagan ally and GOP strategist Grover Norquist has argued for decades, if Republicans promise tax cuts, they will win most elections most of the time, and it makes no difference if they bother to cut spending along the way. No one, Norquist liked to explain, cares about deficits, other than a few old bankers sipping scotch in the Metropolitan Club. And now, a few decades later, most of those bankers are dead.
If there was a single moment when supply side economics was transformed into a political mantra, it was when Vice President Dick Cheney effectively fired George W. Bush's Treasury Secretary Paul O'Neill. O'Neill – an old school Republican of the Peterson mold – opposed the Bush tax cuts for exactly the reasons Peterson suggested. At a pivotal moment, in the wake of the 2002 mid-term elections, when O'Neill was arguing that proposed income tax cuts would turn projected federal surpluses that Bush had inherited into deficits that would damage the economy, Cheney retorted with words that would come to encapsulate Republican fiscal policy and political strategy: "You know, Paul, Reagan proved that deficits don't matter. We won the mid-term elections, this is our due."
Democrats have chafed for decades at watching Republicans cut taxes, knowing that fixing the ensuing fiscal mess would inevitably fall to them. Tax-cutting, budget-busting, new age Republicans describe themselves as 'fiscal conservatives' to this day, yet one Republican administration after another has left behind a fiscal catastrophe that has required "tax and spend" Democrats to do the fiscally responsible thing and seek to put things back in order. As newly elected Bill Clinton explained to his budget team as to why their panoply of new policy ideas would have to wait, "We are all Eisenhower Republicans now."
Seeing a new deficit crisis looming, and the possibility that if they win in 2020, they will once again find their policy ambitions frustrated, Democrats are finally getting religion. Republican rarely talk about the Laffer Curve anymore, but Art Laffer's spirit remains critical, as it provides a penumbra of justification for their tax-cut religion. A number of Democratic hopefuls have now found their own Art Laffer: Bernie Sanders' economic advisor Stephanie Kelton.
Kelton is the most visible proponent of Modern Monetary Theory (MMT). MMT suggests that new social spending can be proposed without having to answer the age-old gotcha question, 'how are you going to pay for it.' It offers a theoretical construct for Dick Cheney's hectoring of Paul O'Neill years ago: deficits don't matter.
For someone trained in traditional economics – think Paul Krugman, an MMT skeptic who has been engaged in an ongoing debate with Kelton – the problem may be with the word “theory.” A more apt term might be “observation.” After all, Modern Monetary Theory is built around the observation that for decades now the United States – and MMT poster child Japan – have been piling up deficits and debt, with no discernible adverse consequences.
Traditional economic theory suggests that massive deficit spending should create domestic inflation, as new money is infused into the economy driving up demand and increasing the money supply. The funding of deficits with increased public debt would, in turn, drive up long-term interest rates to lure investors to purchase the increased supply of bonds, and squeeze out the supply of capital available to the private sector. There have been myriad examples of countries that have gone through these cycles of overspending, growing debt and ensuing financial crisis, most notably in Latin America, and to a certain extent Greece.
But this has not been the experience in Japan, where despite decades of massive deficit spending and a piling on of public debt, long-term interest rates remain near zero and inflation is non-existent. The US experience has been similar. Even as we have run up massive deficits, inflation has remained low for decades, and interest rates on US Treasuries are near historically low levels.
Much has been made of the expectation that long-term interest rates would spike upwards should China and other countries stop purchasing new debt, and the Fed stop its quantitative easing and begin to reduce its own holdings of Treasury securities. Yet, over the past year, as deficits have continued to grow and interest rates have declined, China has reduced its investment in Treasuries by about 10% or close to $100 billion. Perhaps more significant, but less reported, the country whose central bank has trimmed its Treasury holdings the most has been ours, as the US Federal Reserve Bank has reduced its holdings of Treasuries by $300 billion over the same timeframe. These steps – China selling Treasuries and the Fed shrinking its balance sheet – were supposed to signal a coming economic armageddon. Now they both begun to happen, and the result... nothing; long-term interest rates have continued to slide downward and the private sector is awash in capital. As shown in the graphic here, in contrast with the widely held view that foreign governments and the Fed have been funding our deficits, holdings of Treasuries by foreign investors and central banks has been flat since 2014, and holdings by the Fed are trending down. Our deficits are being funded not by foreigners, but primarily by private investors here at home.
It may be that the phenomenon of growing debt and flat interest rates in Japan and the US is explained by demographics. The Japanese population is aging rapidly, with 20% of the population now 70 years old or older. As this graphic illustrates, the aging of Japan is coming more quickly than in other countries, though it is a global phenomenon. Older people buy bonds, and they hold them. The population in the US is aging as well – a factor that has argued for substantial growth in immigration, though that is not the direction our politics are heading right now – and that may partially explain the steady increases in private holdings of Treasuries.
The problem with the observations that underpin MMT and the rush by Democrats on the left to embrace Dick Cheney's political economic world view, is that as much as the post-2008 economic universe has strained economic central wisdom, that wisdom will, ultimately, rear its ugly head. They don't call economics "the dismal science" for nothing. Deficits may not have mattered for a while now, but give it time.
This was the dirty secret buried in recent CBO data. Private investors may continue to buy up Treasuries and fund our deficits, but that funding comes at a cost, illustrated in this graphic. In the CBO's 10-year budget projections, the interest cost on the federal debt – shown here as the blue dotted line – nearly triples from $325 billion per year to $921 billion. This means that by 2029, interest on the federal debt will be larger than the defense budget and larger than all non-defense discretionary spending.
And this is the optimistic projection. The CBO numbers suggest a very rosy view of interest rates, projecting that the average interest rate on Treasury securities will barely rise over the next decade – nudging upward by 15 basis points a year (0.15%) from 2.3% to 3.5% in 2029 – even as the public debt as a percent of GDP continues to grow. Should one be slightly more pessimistic, and project instead that the average interest rate on Treasury bonds rises to 5% – a level that approximates the level prior to the 2008 financial crisis – the annual interest cost on the federal debt grows four-fold, to over $1.3 trillion annually. At that point, as illustrated by the orange dotted line, interest on the accumulated debt would cost almost as much as defense and non-defense discretionary spending combined, and approach Medicare as the largest single area of federal spending. If there is a single chart that explains why millennials are skeptical about the self-serving nature of our politics, perhaps this sums it up.
It used to be axiomatic that mortgaging our fiscal future through massive deficit spending is bad economics and a crime against the citizenry of the future – particularly to Pete Peterson and the Republican Party, before the deconstruction of the GOP began under Ronald Reagan. It isn't anymore. Stephanie Kelton is far from being a Dick Cheney acolyte, but her thumbnail argument is the same: deficits don't matter because – so far – they haven't seemed to matter. That is music to the ears of those on the left who advocate for every manner of new federal spending – and to Democrats who loathe the prospect of economic circumstances once again forcing them to assume the mantle of Eisenhower Republicanism. But just because deficits haven't mattered for a while doesn't mean they won't matter in the future.
We have been down this path before in the economic realm, where conventional wisdom is cast aside in favor of a 'new paradigm,' only to see those old truths rear their ugly heads with a vengeance. In the last 1990s, after decades of steady shortening of periods of economic contraction, economists began to suggest that the business cycle – the inevitable economic cycle of growth and recession – had become a thing of the past. That fleeting moment of euphoria came crashing down with the 2008 global financial collapse, and the worst recession in nearly a century. The notion that deficits don't matter is politically attractive, but is similarly unlikely to stand the test of time. Just because most of the people who believed that deficits matter are dead, doesn't mean that it isn't true.
Follow David Paul on Twitter @dpaul. He is working on a book, with a working title of "FedExit! To Save Our Democracy, It’s Time to Let Alabama Be Alabama and Set California Free."
Artwork by Joe Dworetzky. Check out Joe's political cartooning at www.jayduret.com. Follow him on Twitter @jayduret or Instagram at @joefaces.
The Peter G. Peterson Foundation was the creation of Pete Peterson, a prominent Wall Street financier, Nixon administration official and GOP wise man who famously sounded the alarm about growing federal deficits back when people cared about such things. Most recently, in the months before he died, Peterson opposed the 2017 tax cuts, arguing at the time that "Mortgaging our fiscal future for trillions in temporary tax cuts will hurt our economy over time, and every C.E.O. should know that. True business patriots need to advocate for their country as well as their company."
As top income tax rates were dropped from 90% to 35% or so, supply side economics and cutting taxes morphed from economic theory to political strategy, and – along with guns and abortion – became a cornerstone of the GOP coalition. As Reagan ally and GOP strategist Grover Norquist has argued for decades, if Republicans promise tax cuts, they will win most elections most of the time, and it makes no difference if they bother to cut spending along the way. No one, Norquist liked to explain, cares about deficits, other than a few old bankers sipping scotch in the Metropolitan Club. And now, a few decades later, most of those bankers are dead.
If there was a single moment when supply side economics was transformed into a political mantra, it was when Vice President Dick Cheney effectively fired George W. Bush's Treasury Secretary Paul O'Neill. O'Neill – an old school Republican of the Peterson mold – opposed the Bush tax cuts for exactly the reasons Peterson suggested. At a pivotal moment, in the wake of the 2002 mid-term elections, when O'Neill was arguing that proposed income tax cuts would turn projected federal surpluses that Bush had inherited into deficits that would damage the economy, Cheney retorted with words that would come to encapsulate Republican fiscal policy and political strategy: "You know, Paul, Reagan proved that deficits don't matter. We won the mid-term elections, this is our due."
Democrats have chafed for decades at watching Republicans cut taxes, knowing that fixing the ensuing fiscal mess would inevitably fall to them. Tax-cutting, budget-busting, new age Republicans describe themselves as 'fiscal conservatives' to this day, yet one Republican administration after another has left behind a fiscal catastrophe that has required "tax and spend" Democrats to do the fiscally responsible thing and seek to put things back in order. As newly elected Bill Clinton explained to his budget team as to why their panoply of new policy ideas would have to wait, "We are all Eisenhower Republicans now."
Seeing a new deficit crisis looming, and the possibility that if they win in 2020, they will once again find their policy ambitions frustrated, Democrats are finally getting religion. Republican rarely talk about the Laffer Curve anymore, but Art Laffer's spirit remains critical, as it provides a penumbra of justification for their tax-cut religion. A number of Democratic hopefuls have now found their own Art Laffer: Bernie Sanders' economic advisor Stephanie Kelton.
Kelton is the most visible proponent of Modern Monetary Theory (MMT). MMT suggests that new social spending can be proposed without having to answer the age-old gotcha question, 'how are you going to pay for it.' It offers a theoretical construct for Dick Cheney's hectoring of Paul O'Neill years ago: deficits don't matter.
For someone trained in traditional economics – think Paul Krugman, an MMT skeptic who has been engaged in an ongoing debate with Kelton – the problem may be with the word “theory.” A more apt term might be “observation.” After all, Modern Monetary Theory is built around the observation that for decades now the United States – and MMT poster child Japan – have been piling up deficits and debt, with no discernible adverse consequences.
Traditional economic theory suggests that massive deficit spending should create domestic inflation, as new money is infused into the economy driving up demand and increasing the money supply. The funding of deficits with increased public debt would, in turn, drive up long-term interest rates to lure investors to purchase the increased supply of bonds, and squeeze out the supply of capital available to the private sector. There have been myriad examples of countries that have gone through these cycles of overspending, growing debt and ensuing financial crisis, most notably in Latin America, and to a certain extent Greece.
But this has not been the experience in Japan, where despite decades of massive deficit spending and a piling on of public debt, long-term interest rates remain near zero and inflation is non-existent. The US experience has been similar. Even as we have run up massive deficits, inflation has remained low for decades, and interest rates on US Treasuries are near historically low levels.
The problem with the observations that underpin MMT and the rush by Democrats on the left to embrace Dick Cheney's political economic world view, is that as much as the post-2008 economic universe has strained economic central wisdom, that wisdom will, ultimately, rear its ugly head. They don't call economics "the dismal science" for nothing. Deficits may not have mattered for a while now, but give it time.
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| Data source: CBO 10-year Budget Projections, May 2019 |
And this is the optimistic projection. The CBO numbers suggest a very rosy view of interest rates, projecting that the average interest rate on Treasury securities will barely rise over the next decade – nudging upward by 15 basis points a year (0.15%) from 2.3% to 3.5% in 2029 – even as the public debt as a percent of GDP continues to grow. Should one be slightly more pessimistic, and project instead that the average interest rate on Treasury bonds rises to 5% – a level that approximates the level prior to the 2008 financial crisis – the annual interest cost on the federal debt grows four-fold, to over $1.3 trillion annually. At that point, as illustrated by the orange dotted line, interest on the accumulated debt would cost almost as much as defense and non-defense discretionary spending combined, and approach Medicare as the largest single area of federal spending. If there is a single chart that explains why millennials are skeptical about the self-serving nature of our politics, perhaps this sums it up.
It used to be axiomatic that mortgaging our fiscal future through massive deficit spending is bad economics and a crime against the citizenry of the future – particularly to Pete Peterson and the Republican Party, before the deconstruction of the GOP began under Ronald Reagan. It isn't anymore. Stephanie Kelton is far from being a Dick Cheney acolyte, but her thumbnail argument is the same: deficits don't matter because – so far – they haven't seemed to matter. That is music to the ears of those on the left who advocate for every manner of new federal spending – and to Democrats who loathe the prospect of economic circumstances once again forcing them to assume the mantle of Eisenhower Republicanism. But just because deficits haven't mattered for a while doesn't mean they won't matter in the future.
We have been down this path before in the economic realm, where conventional wisdom is cast aside in favor of a 'new paradigm,' only to see those old truths rear their ugly heads with a vengeance. In the last 1990s, after decades of steady shortening of periods of economic contraction, economists began to suggest that the business cycle – the inevitable economic cycle of growth and recession – had become a thing of the past. That fleeting moment of euphoria came crashing down with the 2008 global financial collapse, and the worst recession in nearly a century. The notion that deficits don't matter is politically attractive, but is similarly unlikely to stand the test of time. Just because most of the people who believed that deficits matter are dead, doesn't mean that it isn't true.
Follow David Paul on Twitter @dpaul. He is working on a book, with a working title of "FedExit! To Save Our Democracy, It’s Time to Let Alabama Be Alabama and Set California Free."
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