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Precariously close to edge of fiscal cliff

We've reached the debt ceiling. Now what?

While the national debt is large for peacetime and rising too fast, suddenly stopping this rise would create enormous problems for the U.S. economy: an abrupt and large reduction in government spending would practically guarantee a depression. Some see this as an opportunity to play a game of chicken, hoping to force the shrinkage of government entitlement programs in exchange for raising the ceiling.

But, why can't we live under this ceiling and stop this upward debt trend in its tracks? Several budget commission reports, most notably Simpson-Bowles and Rivlin-Domenici, argue that the best way to balance the budget is to do it gradually, making spending cuts and tax increases over a number of years. Why does prudence require a gradual reduction in the deficit? Why is it a bad idea to do it all at once?

We need common agreement on terminology. Debt results when government expenditures are not paid for with tax revenue. When this is the case, the government must borrow the money, usually by selling U.S. Treasury bonds. The deficit is one year's addition to the national debt. It represents the amount of government spending that exceeds the tax revenue received for that year.

The deficit in the final fiscal year budget of President George W. Bush was $1.4 trillion, and the deficit in the first President Barack Obama fiscal year budget was $1.3 trillion. The projected deficit for this fiscal year, which ends Sept. 30, is $1.6 trillion. A debt ceiling is the legal maximum national debt; once this is reached, deficits are forbidden.

Raising the ceiling requires formal congressional approval, hence the current standoff. Without an agreement to raise the ceiling, the government cannot add further to the national debt and must operate with a balanced budget.

Without an agreement, the federal government must cut spending by $1.2 trillion. To see this, note that currently the government takes in tax revenue of $2.2 trillion and spends $3.4 trillion, of which $200 billion is interest on the existing national debt that must be paid to avoid default. To stay under the current debt ceiling and operate with a balanced budget, future government program expenditures would have to be limited to $2 trillion.

If the government decided to take $1.2 trillion out of the $15 trillion economy all at once, massive increases in unemployment would immediately occur. Government is a key component of economic activity, which is the sum of personal consumption expenditures, private investment, net exports and government spending. The first three of these categories are down due to the weak recovery from the recession. Were the government to suddenly balance its budget with a spending cut of 8 percent of gross domestic product, the recession would resume and unemployment would rise.

It is a vital role of government to counter the business cycle — dampening an expansion to control inflation and softening a downturn to limit unemployment. We need not guess at the outcome of an abandonment of this role: Merry England is showing the way. The Cameron austerity program is in its ninth month, and so far the results are a disaster, as England's own Lord John Maynard Keynes would have predicted.

Current plans for debt reduction

Those seeking to impose an immediate $1.2 trillion reduction in government spending are targeting health and retirement spending but not the spending that was the root cause of today's deficits. The Congressional Budget Office reports that the Bush tax cuts, the cost of two wars and the stimulus funds spent in an effort to moderate the impact of the Great Recession were all contributing factors in reaching the current debt ceiling.

We are being told that we cannot afford our social programs when what we should be told is that we cannot afford both war expenditures and entitlements. If we want both, taxes must rise to pay for them. Only if we refuse to raise taxes do we need to choose between war spending and entitlement programs.

Charles O. Kroncke is associate dean in the University of South Florida College of Business. William L. Holahan chairs the department of economics at the University of Wisconsin- Milwaukee.

Precariously close to edge of fiscal cliff 05/22/11 [Last modified: Sunday, May 22, 2011 5:52pm]

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