Not very long ago, we were hearing that the federal deficit was a huge economic menace. The deficit-hawks were bipartisan. They included former Clinton Treasury Secretary Bob Rubin, the Blue Dog caucus of fiscally conservative Democrats, as well as Republican billionaires like Pete Peterson. And they were joined by legions of economists.
The main difference between the two parties was that the Republican deficit-phobes wanted to reduce the red ink by cutting social programs while the Democrats wanted to raise taxes on rich people. I wrote about exaggerated deficit-obsession in a recent American Prospect article, and in my book Obama's Challenge.
But suddenly, an administration that blames deficits for budget cuts in children's health, cuts in repair of decrepit infrastructure, education aid, green energy, and other useful outlays, is proposing to increase the deficit by $700 billion — more than four percentage points of GDP, because Wall Street made some bad bets. And Treasury Secretary Paulson blithely explains that this gargantuan increase in the deficit is no biggie, because some of it may even be paid back. What a difference a meltdown makes.
But this change of heart on deficits may actually be salutary. First, waiving the usual deficit-phobia sets the stage for deficit spending that an Obama administration will surely need to pull the economy out of a deep recession. I have been arguing that a deficit of several hundred billion dollars spent on the right social investments will be a necessary source of stimulus, and will actually help ordinary people.
The fact is that the ratio of public debt to GDP is actually quite modest by international and historic standards — about 37 percent, compared to 120 percent after World War II. The urgent imperative now is to get the economy back on course — and to do it by helping regular people. If the deficit temporarily increases to, say 50 percent of GDP, that's far better than a severe and prolonged recession.
Once Paulson gets his bill enacted, the danger is that Republicans and fiscally conservative Democrats will use the $700 billion dollar hike in the deficit to justify further cuts in spending that actually helps regular people. So the Democrats should take Paulson at his word. The money for this bailout should be underwritten for by a special issue of government bonds that are not counted against the on-budget federal deficit. These bonds, unlike the private sector junk that got us into this mess, will actually be paid back.
My friend James Galbraith observes that because investors and citizens are so frightened of Wall Street's junk, there is a huge demand for the government's bonds. The government can actually finance the public debt at a fraction of the usual interest costs. That's only fair. With all its flaws, government took fewer risks and ran its accounts a lot better than the geniuses on Wall Street.