Free Money

Alice M. Rivlin
Alice Rivlin
Alice M. Rivlin Former Brookings Expert

September 1, 2004

Fiscal irresponsibility is politically attractive, but it is equivalent to believing in something for nothing. Basing the policy of the world’s dominant economy on the hope that the normal rules of fiscal prudence do not apply is an exceedingly dangerous idea.

Large and sustained deficits in the United States threaten not only U.S. prosperity but the world’s economic health as well. Massive public borrowing in the United States is already absorbing other nations’ savings to finance the world’s richest country. And it may soon raise interest rates around the world and slow global growth. U.S. profligacy could even invite an international financial crisis that would bring enormous human costs everywhere.

Small countries cannot afford to behave irresponsibly for very long; their currencies lose value and their governments cannot borrow money. But investors give the United States more leeway. Its debt—the famed U.S. Treasury bonds—is still regarded as a very safe place to park money. The persistent appeal of U.S. bonds is leading politicians in the United States to believe that the ordinary rules of global finance don’t apply to them. When they realize that rules are rules, it may be too late; the world could be caught in a financial crisis that has escalated beyond control.

Sermons on fiscal rectitude often fall on deaf ears in the United States. Everyone likes a free lunch if they can get it. Raising taxes and cutting spending are always painful, and political leaders have to be convinced that the pain is worth it. But a glance at the recent past should wake the slumbering body politic.

In the early 1980s, the Reagan administration cut income tax rates and increased defense outlays without restraining other spending. Supporters of those tax cuts predicted they would stimulate economic growth so powerfully that deficits would vanish. They claimed that deficits did not matter because government borrowing did not raise interest rates. They were wrong on both counts, and the free lunch proved expensive. Fortunately, the costs of high deficits in the 1980s evoked a bipartisan response in the United States. Politicians in both parties voted for tax increases and forced themselves to restrain spending growth. Fiscal responsibility and a strong economy turned the deficits into surpluses by the end of the 1990s.

Irresponsibility is back. Once again, a U.S. administration is touting huge tax cuts as stimulants to economic growth and massively increasing military spending. Once again, deficits initially blamed on recession persist even as the economy recovers. If the United States does not quickly change course, deficits will remain around 3.5 percent of gross domestic product for the next decade and then escalate rapidly as an aging society forces more spending for social security and health care.

In many ways, the current deficits are even more dangerous than those of the 1980s. The retirement of the baby boom generation is two decades closer. Moreover, the United States has shifted from being the world’s largest creditor to being the world’s largest debtor, and a far more substantial portion of U.S. public debt is held by foreigners, especially Asian central banks. This dependence makes the United States vulnerable to the shifting moods of international investors. A day may come when wary foreign investors demand high interest rates as compensation for holding their assets in U.S. dollars. Worst of all, the political will to deal with deficits has evaporated. The spending rules adopted in the 1990s have lapsed, and the bipartisan coalition to restore fiscal discipline has splintered.

The most likely scenario is continuing deficits financed largely by borrowing from the rest of the world. The principal victims of this fiscal irresponsibility will be Americans, who will suffer higher interest rates, slower growth, more of their tax money going to debt service, and higher inflation. The larger debt will be passed on to future taxpayers, who will simultaneously have to grapple with the burdens of a rapidly aging population. Eventually, the government will raise taxes and cut spending by more than would have been necessary if action was taken earlier. The weakness in the United States will almost inevitably sap the strength of the world economy.

That’s the best case. An even darker possibility is that investors (including many Americans) will lose confidence in the ability of the United States to handle its fiscal affairs and will move their funds elsewhere. Such a massive migration of capital would precipitate a plunge in the dollar and generate a spike in interest rates and inflation in the United States. This tsunami in the world’s largest economy would disrupt international markets and devastate many developing countries.

Avoiding possible disaster, or even the more likely slow erosion of prosperity, will test U.S. political leadership. Will elected officials recognize that common-sense rules of fiscal responsibility apply to the United States as well as to other countries? Will they make the tough choices needed to restore fiscal sanity to the world’s most important economy?