Budget Commentary

The Long Term vs The Short Term

By Evelyn Jacks

In preparing to comment about the January 27, 2009 federal budget, my research activities took me to a number of excellent papers written over the past decade about the effects of public monetary policy and specifically debt and deficit spending on the wealth of nations.

A particularly excellent study I came across was done in January 1998 by Douglas W. Elmendorf or the US Federal Reserve Board and N. Gregory Mankiw of Harvard University and NBER. Their paper was prepared for the Handbook of Macroeconomics.

Some excellent points, very relevant to the analysis of this budget were made. I'd like to share some of these with you:

On Taxes and Spending Patterns:

• Current patterns of taxes and spending are unsustainable in most industrialized countries over the next twenty-five years.

• The primary causes of this situation are the aging of their populations and the rising relative cost of medical care.

• Between 1990 and 2030, longer lifespans and continued low birthrates will sharply increase the ratio of retirees to working adults.

• In most countries, health care has absorbed an increasing share of national income over the past several decades.

• The aging of the population and the increasing cost of health care will put a significant strain on government finances over the coming decades. The numbers show a marked deterioration in the fiscal situation of almost every country.

On the Effect of Debt on the Economy:

In the Short Run: an increase in demand will raise national income; this being a common justification for a policy of cutting taxes or increasing government spending by running deficits when the economy is faced with a possible recession.

In the Long Run: temporary increases in aggregate demand which matter in the short run are less important in the long run. Consider:

1. A country with a large debt is likely to face high interest rates. Monetary policy may reduce interest rates in the short run, but in the long run will leave real interest rates roughly unchanged and inflation and nominal interest rates higher.

2. A country with a large debt may have difficulty financing an ongoing deficit through additional borrowing and may be tempted to produce more money to finance it. This could lead to inflation.

3. A country with large debt loses the ability to use tax revenue for service requirements (ie health care and pensions) to service the debt.

4. The interests of future taxpayers are not be represented.

5. Fiscal flexibility of government is lost.

6. Government debt makes the economy more vulnerable to a crisis of international confidence.

7. Foreign investors could lose confidence in dollar-denominated assetsócapital flight would therefore sharply depreciate the dollar.

8. Diminished political independence or international leadership could result.

The authors conclude that a temporary change in taxes has only a small effect on the consumption of forward-looking consumers. Further, the most important long-run effect of government debt is to reduce national wealth.

Baby boomers planning for retirement are certainly forward looking, and concerned about their wealth, and that of the country poised to cover their needs in old age. For them, the question to consider is whether temporary tax reductions and deficit spending serve them and their heirs well in the long run?

Evelyn Jacks is President of The Knowledge Bureau and author of Master Your Taxes