Deficit Doves v. Budget Hawks—Can America Grow Itself Out of Debt?
Business + Economy

Deficit Doves v. Budget Hawks—Can America Grow Itself Out of Debt?

Nick Bhardwaj/The Fiscal Times

If you are ever feeling gloomy about the prospects for your 401(k), spend some quality time with Jim Paulsen. The chief investment officer of Wells Capital Management has to be one of the least dismal economists the dismal science has ever known. In his June newsletter, for example, he manages to find a way to make you feel good about Greek debt levels (debt to GDP is not much higher than in the mid-1990s!); the U.S. job market (unemployment was high during the 1980s rebound, too); and even the U.S. trade deficit (now 20 percent narrower with emerging economies than in 2008). In a news cycle dominated by pelicans slathered in oil, Europeans drowning in debt, and investors mired in gloom, Paulsen's a nice break: the man with the rose-colored Bloomberg terminal.

One of the most hopeful assertions has to do with the federal deficit. "Most of the contemporary deficit," he says, "is cyclical, and should respond better than most anticipate to an extended period of economic recovery." In other words, the $1.6 trillion shortfall predicted for 2010 isn't the result of a systemic problem. Instead, it's largely a temporary plunge in tax receipts brought on by the recession:

'Currently both the budget deficit [percentage of GDP] and the percent by which the level of real GDP is below [its long term trend] are at about 9 percent. Seems reasonable—an almost 10 percent collapse in the level of real economic activity produces an almost 10 percent shortfall in the government budget…since the deficit appears mostly cyclical, government finance may look considerably better after a few years of persistent economic growth.'

Paulsen's view echoes that of deficit doves like Nobel economist Paul Krugman and Berkeley's Brad DeLong. The two right now are fighting a blistering op-ed page and blogosphere battle against economists who claim that the U.S. needs to start embracing the kind of fiscal austerity that Ireland, Greece and Spain have imposed, lest we end up in the same fiscal soup. After all, if deficit spending will solve itself by restoring economic growth, there's no reason to make the tough choices that an austerity program demands.

If only.

The problem, as The Atlantic's economics writer Megan McArdle puts it, is that deficit doves focus on the cyclical deficit, which is manageable, and the hawks worry about the structural deficit, which is unsustainable. The former is a question of a near-term gap drop-off in tax receipts, which can be restored by an economic rebound. The latter involves a long-term mismatch between the benefits we have promised each other as citizens and our willingness to pay for them. And that can only be solved the hard way—by cutting spending and raising taxes.

Budget projections show that both camps are right, as far as they go. Economic recovery should, in fact, chop the deficit over the next decade. The Congressional Budget office estimates that as GDP grows and unemployment falls, the deficit will drop from 9.4 percent of GDP this year to 2.3 percent by 2014 and then stay under 3 percent through 2020. If that's your focus, then the proper policy is to keep the economic stimulus coming. What matters is that the economy gets back on its feet.

If you focus on the structural deficit, however, what matters most is what happens when the boomers start to retire en masse. As that demographic bomb explodes, the federal debt soars past its previous peak of 108 percent of GDP somewhere between 2023 and 2033, depending on your assumptions—and only goes higher from there.

Unfortunately, you can't wait until the cyclical deficit has resolved itself to address the structural one. As Berkeley's Alan Auerbach and the Brooking Institution's William Gale point out, delay in addressing the structural deficit increases the amount of fiscal sacrifice called for. "Delays will simply increase the magnitude of required responses, as more debt will have accumulated and the demographic transition will have progressed further."

As the deficit falls through this decade, it will be tempting to wait and see what happens before addressing the structural deficit. But the boomers will still get older and retire and need medical care, and waiting to act will only raise the level of fiscal pain needed to get the budget back on a sustainable track. According to Auerbach and Gale’s intermediate scenario, doing nothing until 2020 will increase the size of the needed deficit reduction by one full percentage point of GDP. That's about $189 billion of additional tax hikes or spending cuts, put into place immediately and permanently.

"Given how difficult it will be to make the [tax and spending adjustments we already have to make], these further increases make quite clear how unrealistic an option a 'wait and see' approach is."

To return to Paulsen and your 401(k), then: Chances are, he's right. At some time in the near future the market may well be pleasantly surprised by an improvement in the deficit and your 401(k) may get a nice bump. That doesn't speak to what happens later, but that's the problem with rose-colored glasses: They only work if you're near-sighted.

Reporter: Temma Ehrenfeld
Eric Schurenberg is editor-in-chief of CBS MoneyWatch