John Taylor’s WSJ op-ed column

John Taylor, professor of economics at Stanford, former Fed official and formulator of the “Taylor rule” for money policy, wrote an op-ed piece in last Friday’s Wall Street Journal

The article has a very simple message, illustrated by an accompanying chart, which I’m paraphrasing as follows:

1.  The government budget was equal to around 18% of GDP in 2000, and had risen to about 19% by 2007.  This compares with Federal tax receipts of 18%-19% of GDP.  A problem, yes, but a small one.

2.  In response to the financial crisis, government spending has been upped to between 24% and 25% of GDP over the past three years.

3.  The Obama budget of February 14th, ignoring the recommendations of the commission on deficit reduction the President appointed, called for the deficit to remain at about 24% of GDP for the next decade.  A big problem!

4.  The Ryan budget passed by the House on April 15th reduces the deficit to 20% of GDP by 2016.

5.  Obama offered a second budget proposal on April 13th.  It pares back the original budget proposal, but still leaves the deficit at more than 22% of GDP ten years from now.

The virtue of Professor Taylor’s message is simplicity:  deficit reduction can be done.  And it seems to paint President Obama in a very unfavorable light, which, I suppose, is why the article appeared in the WSJ and not the New York Times. 

I understand that talking about political positioning risks diverting attention from the essential point, but I think several factors should be pointed out:

–according to the Congressional Budget Office, the main reason the original Obama budget proposal keeps the deficit so high is that the administration wants to keep applying a high degree of stimulus to the economy.  By itself, this increases the deficit.  But it also results in the return of a full-employment economy sooner than otherwise.  That brings with it higher interest rates and higher interest payments on the federal debt, creating much of the deficit blowout.

Of course, if history is any guide, the stronger the economy the greater the chances of Mr. Obama’s reelection, and vice versa.

–around 2015, large amounts of extra government spending on entitlement programs–especially medical care–begin to kick in, putting upward pressure on the deficit.  Congressman Ryan’s budget deals with this issue by more or less eliminating medical support for the poor.  Not so great, unless you’re sure you’ll be wealthy when you’re old.

–neither proposal touches the military, implicitly assuming that the country will be involved in a foreign war someplace elseor at least that the military will be paid as if we are.

To my mind, it isn’t just that today’s positions of the two major parties are so deeply rooted in partisan politics as they are.  It’s that both the Republicans and Democrats seem to be in a time warp.  What they are battling about and see as essential are issues from the 1940s and 1950s, which have long since been settled–or discarded as irrelevant–in the minds of average Americans, who are living their lives in 2011. 

Not a pretty picture.

There are some grounds for hope, however.  Most Americans want the deficit issue to be settled, so current elected official realize that their jobs are on the line.  S&P’s recent credit downgrade threat has highlighted the need for action now.  And, deep down, most citizens are aware that the country can’t pay for all the entitlement programs that Washington has promised to deliver.

For once in my investing career, I think that what Washington does is relevant.  Legislative action over the next couple of months will be interesting–and important–to watch.

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