Deficit Reduction and the 1990s Boom

I was an enthusiastic supporter of Bill Clinton’s 1993 deficit reduction program. I’m on record saying at the time that the Republicans were doing Clinton a favor by filibustering his stimulus bill. I believe I was right to support deficit reduction. I believe that it was important, that it had results, and that the results were better than I had expected. But was the deficit reduction program responsible for the 1990s economic boom? The short answer is no.

At least that’s the easy answer if you use standard economic theory, and for the most part, I think it’s the right answer. Throughout most of the Clinton era, the US economy was close to what the Fed believed was full employment. The Fed provided enough monetary stimulus to approach what it believed to be full employment. In the absence of deficit reduction, that stimulus would have been provided by the deficit. Or perhaps not – if the deficit had a psychological effect that was depressing the economy. In that case the Fed would have provided roughly the same stimulus that it actually did provide – to offset the depressing psychological effect of the deficit. (Remember, the Fed was already starting to push easy money long before Clinton was even elected.)

There’s no obvious reason to think that the US would have been farther from full employment if the deficit reduction bill had not passed. The reason for the boom was that full employment turned out, by the end of the decade, to be much higher and much more productive than almost anyone originally thought. Deficit reduction was – for the short run, anyhow – a demand-side policy, but the boom had little to do with demand and everything to do with supply.

Deficit reduction almost certainly did have beneficial supply-side effects, but you’ll have a hard time convincing me those effects were large enough to account for a large part of the boom. Deficit reduction was partly – perhaps largely – responsible for the boom in private investment. Without deficit reduction – that is, with lower taxes and more government spending – consumers and government would have required more of the nation’s resources, which would have left less for private investment. Any incipient investment boom would have been resisted aggressively by the Fed to avoid straining the nation’s resources.

The US would also have drawn in more resources from abroad (a larger trade deficit), so the effect of deficit reduction on private investment was far from one-for-one, but because of home bias, imperfect asset substitutability, and the large size of the US economy, a large part of the resources freed by deficit reduction must have flowed through to private investment. More private investment means a larger capital stock, which means more production from a given amount of labor, which means that some part of the boom was indeed attributable to deficit reduction. But the beneficial supply-side effect of capital deepening is a long-term phenomenon. It’s just not reasonable to expect that the effect in the first few years would be large enough to account for a large part of the boom the US experienced.

Another possible beneficial supply-side effect of deficit reduction was on price-setting. With the apparently unsustainable fiscal policy in place before deficit reduction, there was reason to fear that the Fed would eventually be forced to monetize the debt. Accordingly, there was reason to distrust the value of the dollar and reason to raise prices in anticipation of a possible eventual inflation. The Fed had to fight the tendency to raise prices, and in the process, it may have had to limit economic growth more than would otherwise have been necessary. With deficit reduction, this problem disappeared and the Fed was able to support more growth. At least, that’s a story you can tell. I can believe it was a factor, but I have a hard time believing it was responsible for a large part of the boom.

And OK, maybe you can make up some other story about how deficit reduction caused the boom, but you’re not likely to convince me. The US would have had a boom – probably a big one – even without deficit reduction. But it would not have been the same boom. In all probability, it would have been largely a boom in consumption rather than investment. That follows directly from the fact that taxes would have been lower (provided one accepts the premise that consumption rises with disposable income). And it would have been financed – to a much greater degree than it actually was – from abroad. By the end of the decade, the capital stock would have been significantly smaller than what it actually was, and the US foreign debt would have been much higher.

Which, I suppose, would not have been so terrible in 2000. But then George W. Bush got elected. After 6 more years of easy fiscal policy – new tax cuts, increased military spending, and expanded Medicare benefits – leading to more monetary tightening, which would strangle private investment and run up even larger international debt: when I think what condition the US would be in today, I’m really glad we had deep capital and a manageable foreign debt in 2000. If I had to choose between the deficit reduction program of 1993 and the economic boom of the late 1990s, I’m not sure which I would pick. Luckily, we got both.