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How Long Can the Economy Absorb Excessive Government Spending?
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How Long Can the Economy Absorb Excessive Government Spending?

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How Long Can the Economy Absorb Excessive Government Spending?

The taxes-versus-spending battle remains America's central fiscal, economic, and political debate. Even when apparently overshadowed by other issues, this conflict's ramifications maintain its primacy. It is paramount because it not only pits opposing policies and philosophies, but its outcome determines our trajectory as a nation.

The Congressional Budget Office's latest budget estimates showing a marked decrease in the federal deficit seem to indicate the fiscal fights that have rocked Washington for the last five years are over. However that is wrong, these conflicts are perpetual.

CBO's figures do project a significant fall in the deficit - to $506 billion, $174 billion below last year's, and 2.9% of GDP. But it has only dropped so far, because it rose so high. In 2007, the deficit was $161 billion and 1.1% of GDP. In 2009, it was $1.413 trillion and 9.8% of GDP.

Washington has taken the federal budget to a higher plateau on taxes and spending, and will climb higher from there. However, just because the debate will resume again, and likely more virulently, why is it important?

While heresy to some, budget deficits in themselves are not the issue initially. It is the often overlooked debate concerning the allocation of a society's productive resources and the implications arising from those decisions that are truly important in the first instance.

Government deficits can be like personal debt. With an economy growing fast enough, low and stable deficits can be sustained. The US has managed relatively stable deficits (averaging 3.1% of GDP over the last 40 years) throughout the post-WWII period and, for the most part, our economy has performed well.

It is when deficits' growth outstrips the economy's that fiscal pressure translates into economic pressure. This began happening in 2008: the economy sank, spending soared, and revenues fell. The result has been an explosion in federal debt held by the public, which more than doubled from $5.035 trillion and 35.1% of GDP in 2007, to $12.797 trillion and 74.4% of GDP today.

Increasing debt relative to economic growth puts pressure on the economy in several ways. First, it increases the government's borrowing in the debt markets, making it a growing competitor with the more productive private sector. Private sector borrowing, which cannot compete with the government's ability to finance its borrowing through its ability to tax, drops.

Increasing debt also begets more spending and borrowing. Debt service costs eventually increase - a product of increasing debt and increasing interest rates. Rising public sector spending also means directing more resources away from the private sector. This ultimately drives economic performance below what it otherwise would have been - and reducing revenues below what they otherwise would have been - further fueling the spending and borrowing engine.

Inevitably these forces produce an attempt to break the negative fiscal cycle by increasing taxes. Rather than government simply reallocating resources differently than how the private sector would have, increased taxation also extracts them from the private sector.

These revenues do not come just from the general credit markets, but from the private sector's producers themselves. This extraction is not determined according to what is least economically harmful, but by who is most politically powerful - not on economic viability, but on political vulnerability.

All told, this has transpired over the last seven years.

Far from being the least important component of the fiscal-economic-political triangle, politics is the most important. Left to its own workings, adverse fiscal and economic effects would enforce their own rebalancing. By constructing a taxing and spending mechanism based on taxation of a minority and spending on a majority, imbalance can be sustained for some time - pushing beyond first its adverse fiscal, and then its adverse economic, boundaries.

Again using personal finances as an analogy, few people would continue borrowing to spend beyond their means. Even if so inclined, consequences quickly eliminate this as a viable option. People would be even more loathe to let an outside entity garnish their wages indiscriminately (which is what taxation is to the economy) to pay for it. Most would succumb to the consequences, and their senses, and align spending with income.

Politics thwarts this analogy from playing out in government. It is all too easy to be seduced by siren songs of increased spending, when others beckon us to it with justifications. It is easier still if the political process can insulate us from the obvious impact - subsidizing us via spending, and taxing others to pay for it.

Politics is the enabler. It can start us on the path and propel us well down it, beyond its natural fiscal and economic limits. We face that now and increasingly will. CBO projects by 2023 federal spending will be 21.9% of GDP and revenues 18.2% of GDP - both far higher than their 40-year averages.

These are levels of spending and taxation unseen on a permanent basis. The question then becomes how long the economy can withstand it for a prolonged period. And the political question remains: How do we wean ourselves off excessive government spending?

It is impossible to see an issue so fraught with import, short of war and peace. Yet, questions of war and peace are not perpetual, thankfully only occurring periodically and at crucial junctures. The question of taxing and spending is perpetual - and perpetually crucial.

How Long Can the Economy Absorb Excessive Government Spending? | RealClearMarkets

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