Pop quiz on the deficit

Here’s a pop quiz for macroeconomic students from Economist’s View on how to deal with the deficit.

Mark Thoma suggests the following exam question:

You are in charge of your nation’s fiscal policy giving you full control of both government expenditures and taxes. Due to past decisions, wars, recessions, and some very unfortunate disasters you find yourself with a large government debt. In response, you should

  1. increase government spending
  2. decrease government spending
  3. do nothing
  4. increase taxes
  5. decrease taxes

Mark has some other possible answers that you may find amusing, but I didn’t want to make the exam too hard. Let’s see if we can figure out what the correct answer must be by ruling out the items that don’t seem to work.

(a) Increase government spending. OK, that’s obviously not the right answer. So now we already have a one in four chance of getting it right!

(b) Decrease government spending. Steve Slivinski and Chris Edwards at the Cato Institute have proposed $62 billion in spending cuts (hat tip: Economist’s View). But implementing these would require admitting that such measures as the energy bill and the President’s education initiative were a mistake. All of these items originally went into the budget because this spending was perceived to be beneficial, and unquestionably the legislation conferred political gains. Cutting any of these categories entails even greater political costs.

(c) Do nothing. That’s sometimes a good strategy, and it’s the one piece of advice economists could give that actually might be followed. The Skeptical Optimist argues that we can just grow our way out of the situation. But this only works if the rate of growth of government spending can be held below the rate of growth of the economy. Federal expenditures rose from 18.4% of GDP in 2000 to a projected 20.1% for 2005. Growing our way out of the federal debt burden requires some fundamental changes in Washington along the lines discussed in point (b), and runs into the same obstacles we encountered with that answer.

(d) Increase taxes. Both Democrats and Republicans see this as political suicide.

(e) Decrease taxes. There may be good arguments for trying to keep tax rates low (for example, see Mallory Factor or John Tamny). But it’s a rather rare scholar who would claim that cutting the federal tax rate from current values would actually increase total tax revenues, or that the Bush tax cuts achieved that result. Certainly it’s hard to see the great economic boom of which some speak in the current numbers. Real GDP over the last year has grown at an average annual rate of 3.6%— nice growth, but actually below average for an economic expansion. Personal saving has recently plunged into negative territory, which hardly supports the claim that existing tax cuts have spurred the saving that will set the stage for rapid future growth.

Hmm, those seem to be all the possibilities. All right, class, here’s a hint on how to answer multiple choice questions. If you think you’ve ruled out every one of the indicated answers, go back over your analysis. One of the options that you thought wouldn’t work has to be the correct answer.

29 thoughts on “Pop quiz on the deficit

  1. Matt McIntosh

    What about massive deregulation of everything they can get their hands on? That’s probably more politically doable than massive spending cuts, and would go a long way toward helping us “grow our way out” of it.

  2. Jim Glass

    “Due to past decisions, wars, recessions, and some very unfortunate disasters …”
    Hey, by far the *biggest* factor affecting the nation’s fiscal status item isn’t mentioned: unfunded retiree entitlement promises.
    They made the 2004 one-year deficit $11.1 trillion (with a “t”) dollars on an accrual basis, and total unfunded accured federal liabilities > $45 trillion, according to the Treasury.
    That $45T is of course several time the total debt from all the other mentioned causes combined.
    [Link to the Treasury data through:
    http://www.scrivener.net/2004/12/you-thought-2004-federal-deficit-was.html ]
    What to do about them?
    Well, from the example of real life, if I am …
    [] a Republican politician, “f(1) — put head in sand *and* create a new prescription drug benefit that accrues another $6 trillion in liabilities in one year”
    [] a Democratic politician, “f(2) — put head in sand *and* complain that f(1) is too cheap”.

  3. Tom Lord

    Wildcard answer:
    Establish a consumption tax on gasoline whose rate varies inversely with demand. Expend political and social capital to spark initiatives to rearrange the U.S. economy (for factors such as justice, growth, green-ness, etc.). To the degree the latter is successful, encourage new rounds of foreign investment. Grow out of of debt and deficit *that way*. The point being that the needed structural changes can get a boost up without increasing spending or changing (most) taxes.
    “It’ll never get traction,” of course.

  4. RayJ

    “d) Increase taxes. Both Democrats and Republicans see this as political suicide.”
    Why should an action seen to be political suicide be wrong? Sometimes leadership requires unpopular actions.
    If correctness is defined by what will be popular then a) and e) must be the answer, which is exactly what we have been getting and will continue to get.

  5. Mark Sullivan

    Just for the record, complaining that the unfunded medicare drug program is too cheap is a lot more fiscally prudent than passing it into law.

  6. RH

    d) is the right answer. On the wealthy and select consumption items.
    1) Burden-sharing in this country must be more equitable.
    2) Steps must be taken toward fiscal solvency or our creditors will stop lending us money.
    3) Americans must consume less and invest more. They’ve stopped believing a recession is possible, thinking Alan Greenspan will make everything all better somehow.
    4) But a recession must come to purge excesses. And a recession at least partially brought on by taxes that can be reversed should the need be is a better recession than one without any ammo at all to fight back with.

  7. Dave Schuler

    How about all of the above? What is really needed is a general re-ordering of priorities. For example, in my view the reason for the somewhat phlegmatic recovery is lack of business investment. Cutting personal income taxes has only a marginal influence on that—more attention should have been given to measures that would have given businesses more incentive to spend rather than individuals. Similarly, federal government payrolls should be cut, there should be more devolution of responsibilities to the states, and also more federal government “investing” which includes things like job training.
    So my answer would be spend less, spend more, tax more, and tax less.

  8. TI

    Growing out of debt is clearly not possible: the GDP has grown relatively well recently but this has not helped. How high should the US growth to be in order to make any diffrence here?
    So stimulating economy will not help. This is not a cyclical problem. Remains 3 options that can be combined: increasing taxes a lot, decreasing government spending or defaulting the debt some way or another (hyperinflation for instance).
    The situation in the US is so bad that only combining higher taxes with decreasing spending would help to avoid the defaulting. Ending the war in Irak and bringing the troops home would be the first measure. Raising income taxes and gasoline tax would be the next.
    But we all guess that the option that will be used is doing nothing. Chinese growth will keep the US afloat for a while. May be for five more years.
    I suspect that the answer of the “Goldilock paradox” lies in China. Every serious economist (like “we” here) sees that the double deficit is unsustainable and should have caused a hard landing already some time ago. This should have happened but has not.
    Nobody can take seriously the ideas that “deficits don’t matter”, that “the US economy is so dynamic and robust”, that “we will grow out of the deficits”. But nevertheless those who despise the pessimists as “girlie-men” have had it right.
    May be it really is different this time? Yes, it is. The US is not the sole engine of the world economy. The world is not US-centric any more. The Chinese growth has changed everything in about five years. China is now the most important real economy in the world. Its industrial sector is biggest in absolute terms. It is the probably right now the biggest export country in the world (extrapolated from the growth rate of the Chinese foreign trade). This makes it the leading real economy. The US is still the leading financial economy.
    We could say that the world economy today rolls around the Chinese-US axis. The Chinese real growth is felt everywhere.
    How long can this go on? The problem here is that the Chinese growth rates are so extraordinarily high and the absolute size of its economy is so huge that this kind of growth is unsustainable. So here we have the real weak point. So how long? Five years at most. Can the Chinese economy double in five years? It almost should if it wants to maintain the present growth.
    What will happen then? We might have some political conflict that changes everything but things will change in every case. The Chinese exports can not grow very much more. The trade surplus will start to decrease. The financial link between China and US will weaken. OK, you can continue from this.

  9. RH

    The GDP growth in the mid 3% range that so many tout as “healthy” growth should be viewed as dangerously low.
    After years of negative real interest rates, record tax cuts and home equity extraction of overwhelming magnitude due to bubble pricing, if 3.6% growth is all we get, we can expect very serious problems when/if those unprecedentedly stimulative imbalances start to adjust.

  10. Fred Hapgood

    How come inflation isn’t one of the alternatives on offer? Historically, lots of governments have been in this very position and virtually all of them (maybe all of them, I dunno) have inflated their way out of their dilemna. Is everyone assuming here that the discipline and dedication of the Fed is going to keep this that locked? Suppose the government tries to inflate and the Fed keeps raising interest rates in response, pitching the econony back the pleasant days of the late 70’s. Is that so unlikely? Why?

  11. Allen

    I like the idea of cutting taxes as a means to force spending to be held down. As pointed out, it’s politically hard to push through tax hikes or to severaly cut spending. It seems politically easier to get tax cuts. And yes, it doesn’t stop defecit spending, let alone reduce the debt, immediately but over time those gaps put greater and greater pressure to hold the spending down. That is, use choice E to get choice C.

  12. Aaron Chalfin

    B. Decrease government spending
    There are only three ways to pay down the deficit (assuming we are on the normal part of the laffer curve): raise taxes, lower spending, inflation.
    Inflation is extremely harmful. Let’s cross this option off the list.
    Given that government spends less efficiently than the private sector, it’s better, on average, to cut spending. This will result in paying down the deficit at the lowest possible cost to the economy.

  13. Fred Hapgood

    > Inflation is extremely harmful. Let’s cross
    > this option off the list.
    But since (as history teaches) it is almost certainly the only politically feasible response we shouldn’t forget about it entirely. It’s the only way of making ‘do nothing’ work — the only way of ‘growing’ out of a deficit when the deficit is growing faster than the underlying economy.
    I suppose it is possible that the Fed would raise interest rates so fast that even this option would be denied the government. Then we would be forced into still another option not appearing on the list here — repudiation. How about them apples? The United States of America
    in default. Think we’ll live to see it?

  14. howard weston

    re; the U.S.default? will we live to see it? Monetizing the debt is simply a slow default.right around 1980, the U.S. defaulted on half its debt.we screwed all our bondholders.if you want to see the thoughts of those who put their money where their mouth is,check out the price of gold.

  15. Limited Government

    First of all lets keep the government out of our lives as much as possible. Keeping congress from trying to implement fiscal policies is beneficial to all tax payers because the policy will take 18 months to take affect therefore making this approach impractical. The only thing congress should be doing is cutting pork barrel legislation and programs that duplicate other programs. We do not need different people doing the same job because it costs the government money. The federal and state governments need to pick issues to regulate and stick to them. To pay for these duplicate programs the government must tax citizens more or spend money it does not have. Taxing is a negative money multiplier negating any affect I am about to mention.
    Lets stick with the Fed buying bonds to increase the money supply on the money market. The US cannot completely default on its deficit because if it did, what would happen to the millions of people on fixed incomes? Retired citizens living on a pension are a nuisance, but they are still able to vote so any effort focused on trying to default the debt is a waste of time otherwise known as political suicide for any politician who suggests it. The benefit I see from inflating the value of the dollar would be the capital inflow of outside investors. The more investors that bring their money to the US means the rate of growth would be higher than 3% raising RGDP. The investment from foreign firms would raise the value of the dollar through a higher demand bringing it naturally back to where it was. Before anyone starts comparing the US to China let me remind you that the Yuan is pegged at 8.26 to every dollar. This is why China has been able to experience such high growth for so long. The natural forces of the money market are not being allowed to react.

  16. Rick

    There is an inherent problem with our elected representatives having no collective interest in budget balancing or cost cutting. Each representative individually when interviewed would doubtless claim to be in favor of reduced spending, but no one will surrender their projects to support the greater good of deficit reduction. It doesn’t seem to matter which party is in power, responsibility is simply deflected to earlier administrations, compromises, the momentum of the whole, etc. We need budget reponsibility to be formalized in definition and practice at the highest levels.

  17. Jim Glass

    “How come inflation isn’t one of the alternatives on offer?”
    The accrued $45 trillion of liabilites for retiree benefits is inflation indexed (SS literally, Medicare effectively) so inflation won’t work.
    The other $4.6 trillion of public debt held by the public is small potatoes. Focusing on that little amount and ignoring the $45 T is just silly.
    As to eventually coverig the $45T, the future is foreordained: means tested benefit cuts + tax increases. Both major — the $45 T figures to become a lot larger (it’s growing now by several $T a year) by the time the parties are forced to actually deal with it … which won’t be until they are forced to start *paying* it, still several years from now.

  18. Fred Hapgood

    > As to eventually coverig the $45T, the future > is foreordained: means tested benefit cuts +
    > tax increases. Both major ….
    Politicians will vote for that only at the point of a gun. What would be the gun? And are you so sure they wouldn’t vote to repudiate first? After all, most of the debt will be held by
    foreigners. Corporations. Capitalists. You know there will be plenty of Americans arguing to beggar the alien, and if we have to depend on ourselves as a consequence, so much the better. Is there some reason not to think they will be a majority?

  19. BK

    F) Measure results of the spending programs with affidavits such as in Sarbanes-Oxley that must be signed by each department head in the government bureacracy, including AmTrak, HUD, and the Postal Service… and PUBLICIZE IT.
    If decent transparent reporting were required before any spending permissions were granted. The flow of funds would be slowed to a manageable level by shear political pressure.

  20. Robert Cote

    What’s the old joke? If you need three opinions ask two economists.
    The two things that need to change at the Federal level are both of the “sunset” variety. Programs and taxes need definitive phase out terms of life unless renewed, also within a structured process.
    The second is obvious at both ends of the spectrum. “Savings” are not illiquid assets with current utility like primary residences. The unearned paper million in my home has a negative impact on economic productivity. At the other end structural subsidies like transit provision without means testing also make people make globally poor decisions because of distorted local conditions. Any bets that New Orleans survivors are going to go back to their transit dependent lifestyle or will they use their FEMA check to buy a Hummer? Ultimately government only has the power to tax or subsidize. We’ve been subsidizing globally poor decisions and we need to periodically review them with increasingly greater justifiction at every renewal. Heck, the same should go for politicians. Win with a plurality, reelect with a majority, subsequent terms 55%, 60% and higher. Back to our increasingly suicidal transportation policies, does anyone think the the Los Angeles County sales tax increments that currently go more than 80% to transit and less than 12% to roads investments would be renewed if given the chance? Just like the mobility impaired New Orleans residents, Angelenos would jump at the chance to unwind this fiasco. Sunset rules for all government policies is the ticket.

  21. Hal

    I’m guessing, based on the way the question is presented, that the answer is A: Increase government spending. We ruled that one out without much thought! So we should go back and take another look.
    The question never asked, after all, how to shrink the debt. It doesn’t seem to be doing any harm. So go ahead and increase spending, but do it in such a way as to encourage long term economic growth.

  22. TI

    But the a) option is the one that the US government has chosen. It has increased spending a lot. They even got economic growth. Do anybody think that the US could reach a longer time 10% growth level as China?
    Nobody really asks how high a growth is needed to diminish the debt and could it be attained. And what would happen to the trade deficit? Could the US increase its exports 35% a year? The debt has really not been any problem – yet. But is not going away.

  23. blah

    What’s wrong with decreasing govt spending and increasing taxes? Seems like the only logical course of action to me.
    The interesting thing is that you can do both pretty easily right now. There is so much fat in the US federal Govt that the middle class won’t even feel the pain
    Pull out of Iraq, make sure all the millionaires and billionaires pay all their taxes, abolish corporate welfare (when was the last time Microsoft and General Electric paid taxes anyway?), scrap the Dept of Homeland Security (which is such an efficient govt agency… NOT), and make sure every contract ever given to Halliburton & Co. is now properly accounter for and negociated. I bet that would do the trick!
    Best political gain: you are not touching the middle-classes, their taxes or their benefits. And you kick the fat cats in the nuts for good measure.

  24. Anonymous

    To blah:
    Well over the past three years, Microsoft paid more than a combined $10 billion in US federal taxes. What have you contributed?

  25. Terry

    A good solution to the long term problem:
    Pass the Fair Tax. Couple that with huge Govt. spending cuts including a returning our entitlement programs for the elderly to what they were originally intended to be.
    Of course neither will ever happen.
    I love all the suggestions to just tax the rich. Clearly, no Ayn Rand readers around here. Redistributionists come in so many flavors and colors… If you want to steal from Peter in order to pay Paul, just call it that.
    The answer to the original question, not the answer I would give but the answer our current leadership has given and will continue to give is C. They will do nothing.
    Eventually, this will leave no other option but one not listed: monetize the debt and deal with the resulting hyperinflation and destruction of the US monetary system.

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