The Fallacy in the Debt Limit Agreement

Republicans and Democrats in the Congress and in the Executive have been arguing back and forth about the duration of the debt limit raise. Democrats want it to go beyond the next election, Republicans want a shorter agreement.

The fallacy is that the raise in the limit has no duration – it is only a dollar amount. The assumptions being made are that the deficit will rise at a known pace, and that therefore one can have an expectation of when the next rise will be needed. The “2 year” rise that will probably be agreed on (given the Sunday negotiations) could be six months (if the deficit grows faster) or it could be three years, or more, if the deficit shrinks.

Keynes was right (although my fellow conservatives wouldn’t agree). Deficit spending is not a bad thing of itself. But if my memory of J.M.K.’s thesis is correct he would be rolling over in his grave at the current use of his theory. A debt that increases consistently at a faster rate than productivity is a recipe for disaster. In boom times the debt should be paid down by using the surplus of government receipts over revenues rather than increasing expenditure to match revenues. This has the effect of “cooling” an overheated economy and promoting sustainable growth, as well as bringing the growth of the debt into line with the long term growth of the economy.

We hear of the Clinton boom, but we often forget that much of that was in the “dot.com” bubble where there was no real productivity. If I may use an analogy, picture a steep hill with a winding path to the top. One can cut the corners and climb the pitch, but if one can’t sustain the climb one will fall back below the sustainable path. Sometimes we call that the “business cycle”, and it will always happen. But when one cuts the corner too far, and never takes a rest (i.e., a  bit of surplus to pay down the debt) then the fall becomes irrecoverable.

I hope we aren’t on that path, but I’m afraid we may be.

May I finish this by discussing the Laffer Curve, a  much maligned theory in the Reagan days. Academic economists called it wrong, and I agree to an extent. The shape of the curve is yet undefined, but the principle is a tautology. At a zero taxation rate there is no tax revenue to the government. At a 100% taxation rate there is no effective tax revenue to the government (it may be defined as tax revenue, but it is actually a form of slavery). Somewhere in between is a tax rate (or set of rates) that will optimize the revenue – and that is yet to be defined. I think it is at a lower rate (but with less adjustments to income) than it is today.

Enough, I digressed from the original topic.

Best, Jon