As best I can tell, the idea is that budget “discipline” encourages investors at home and abroad to buy debt from the U.S. Treasury (raising demand) while reducing the supply of Treasury bonds available. This, in turn, lowers long-term interest rates, encouraging businesses and individuals to invest. What’s more, people would not worry about taxes rising in the future because government savings would offset increased expenses in the future, which would encourage consumers to spend more.
You can see here the edges of a very respectable economic idea known as the Riccardian equivalence theorem. Developed by Robert J. Barro in the 1970s from insight by 19th-century economist David Riccardo, the equivalence theorem holds that taxpayers react to government deficits by reducing household spending in anticipation of the tax hikes that will be necessary to pay off the debt.
In short, there’s not only no such thing as a free lunch—there’s not even a Wimpy lunch of a hamburger today in exchange for gladly paying for it Tuesday. (Read more: Why Raising Taxes on the Wealthy Won’t Work)
Macro-economically, Barro argues, we’re always paying for it today.
What the Clinton-era Democrats seem to have done is adopt half this idea. Because surpluses meant the government wouldn’t require future tax hikes, consumers would be more confident and spend more. And the economy would grow. The problem is that the Clinton-era tax hikes that were used to produce the balanced budget should have had, under the equivalence theorem, the same effects as a deficit: reducing consumption. The Clinton folks just ignored this part. The free lunch was back. (Read more: Sen. Corker Says Bernanke's Fed Feeds 'Perverse Addiction')
How did the Democrats justify the return of the free lunch? Pretty much the same way the Democrats today are justifying their predictions that Obama Tax Hike Austerity will somehow produce prosperity—by lowering long-term interest rates.
This should sound absolutely absurd right now. The federal budget deficit is enormous and the total debt just passed $16 trillion dollars. Yet interest rates are low as far as the eye can see.
What’s more, this isn’t just some weird hangover effect from the financial crisis or a result of the collapse in European sovereign debt. Nearly every study that has looked into the matter has failed to find a positive relationship between reducing budget deficits and falling interest rates. The size of the federal budget deficit just isn’t what controls interest rates.
What really created the “free lunch” was a bar tab that no one was paying attention to. When the government began to tax more money than it spent—which is the only way it can ever have a budget surplus—in the Clinton years, households were faced with a shortage of financial assets. This could have been met with household fiscal austerity, spending less because there was less to spend.
But, as we know, that’s not what happened. Instead, households kept up their spending by increasing their leverage. That is, they borrowed funds to replace the income the government was sucking out of the economy. What’s more, the dot-com bubble fueled a wealth effect that provided households with both more collateral for borrowing and confidence to incur more debt.
To put it still differently, the Clinton era budgetary “discipline” was dependent on increasing the debt burden on households.
I’m not sure the Democrats in Charlotte understand any of this. Which is deeply depressing. Ultimately, what they are proposing by positioning themselves as the party of austerity is a prolonged economic slump—or, somehow, convincing American households to take on even more debt. The latter seems improbable following so shortly after the mortgage crisis, which means the former—basically, another recession—is likely.
Want some cheerful news? Political platforms aren’t good forecasts of policy. George Bush ran on a “more humble foreign policy” and gave us Iraq and Afghanistan. Obama ran against the Bush deficits then exploded the deficit even higher. So perhaps we can hope that if the Democrats win, they’ll govern very differently than they campaigned.
- by CNBC.com senior editor John Carney
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