Trays of printed social security checks waiting to be mailed from the US Treasury. (AP Photo/Bradley C. Bower, File)
Believers in arithmetic are in full retreat in the national budget debate, thanks in large part to Pete Peterson’s Fix the Debt gang. The range of acceptable debate goes from yelling that the sky is falling because of the deficit to the more moderate perspective shown by President Obama and Democratic congressional leaders in favor of a gradual and balanced approach to deficit reduction. But stating the simple and obvious truth—that we have a large deficit because the economy collapsed—makes one an extremely nonserious person in Washington.
For all the debate, the facts on the deficit are not really debatable. We had a very modest deficit in 2007, before the collapse of the housing bubble sank the economy. The deficit that year was 1.2 percent of GDP, and it was projected to stay near 1.5 percent well into the current decade, even if the Bush tax cuts were not allowed to expire. The debt-to-GDP ratio was actually falling; we could run deficits of this size forever.
The deficit expanded enormously in 2008 and peaked in 2009 at 11.1 percent of GDP. But this wasn’t caused by some extravagant spending spree or an orgy of permanent tax cuts. It was caused by the fall in tax collections that occurs every time the economy goes into a downturn, coupled with the increase in spending for countercyclical programs like unemployment insurance and food stamps. There were additional spending and tax cuts associated with President Obama’s stimulus plan. But the overwhelming majority of them were explicitly temporary, and the impact on the deficit would be negligible by 2011.
The large deficits of recent years are not an accident caused by recklessness or irresponsibility; they’re a deliberate policy aimed at supporting the economy. We designed a tax code that collects less revenue when the economy shrinks. And we have programs like unemployment insurance that pay out more benefits when a shrinking economy causes people to lose their jobs. The resulting deficits are meant to fill the gap in demand created by the collapse of the housing bubble, which caused residential construction to fall by more than four percentage points of GDP. This is more than $600 billion a year in today’s economy.
Similarly, the $8 trillion in bubble-generated housing equity led to a consumption boom, with the savings rate pushed down to nearly zero. Now that this equity has disappeared, the savings rate has risen to a more normal level of close to 4 percent of disposable income. This higher level of saving has cost the economy more than $400 billion in annual consumption demand. In addition, the loss of tax revenue from the collapse of the housing bubble and resulting downturn has forced well over $100 billion in state and local government cutbacks.
It is this gap in demand of more than $1 trillion that we are trying to fill. We can love the private sector to death, but people will not consume more just because happy Republicans are smiling at them. Nor will firms invest more when they see no demand for their products. In fact, investment in equipment and software is almost back to its pre-recession share of GDP, which is impressive given the large amount of excess capacity in the economy.