a balanced budget amendment to the Constitution proposed

Over the weekend, Republican Senator Orrin Hatch of Utah, aware of the possible threat from the Tea Party to his reelection, proposed that the US should “solve” its budget deficit woes by passing a constitutional amendment ordering Congress to maintain a balanced Federal budget.

The idea has some initially plausibility.  After all, politicians of all stripes think they get reelected by delivering benefits to potential voters.  The bigger the largesse, the more certain the election victory.  How to pay for them is only a secondary consideration.  So there’s a natural tendency for Washington to provide benefits to constituents before/without figuring out how to fund them.  A balanced budget amendment is supposed to close the door on this tactic by forcing Congress to find the money to pay for new programs before enacting them.

Optimistic supporters of the idea also argue it will end waste and corruption in Washington, since there would be less potential for loose money to be floating around.  The idea of a balanced budget also appeals to a kind of reverse NIMBY feeling–the idea that others are somehow getting a bigger slice of the Washington pie and that a better accounting for expenditures would put an end to that.

The basic positives of the balanced budget idea are supposed to be:

–no more chronic deficits threatening the nation’s financial health, and

–politicians could blame higher taxes/lower benefits on the requirements of the new constitutional amendment, so they’d be more likely to enact them.

one fly in the ointment

Modern economics came into being after, and because of, the Great Depression of the 1930s.  Much of economists’ efforts since have been devoted to understanding what went wrong back then, and in devising was of preventing the Depression from ever happening again.

Perhaps the most basic lesson learned is that contractionary fiscal or monetary policy in an economic downturn just makes things worse.  This bad policy comes in two flavors:

–voluntary contraction, when, as they did in the Thirties, governments raise interest rates as a way of nursing an economy back to health.  This is sort of like the old medical practice of bloodletting that was supposed to cure you by freeing the body of bad humors.

–involuntary contraction.  When economic activity slows, so too does the flow of tax revenue to governments.  In fact, because income taxes are typically progresssive (meaning that added amounts of income are taxed at rising rates), in this situation government revenue falls faster than income does.  If government wants to spend no more than it takes in during a given year, the falloff in tax revenue means it has to lower transfer payments and lay government workers off.  That makes the downturn worse, not better.

the orthodox solution

Based on the terrible experience of the Depression (for example, 25%+ unemployment), economists began to realize that the better course of action is countercyclical government policy–that is, lowering interest rates and increasing net government spending, despite the decreased flow of revenues.  Doing so makes the downturn shorter and shallower.

In an ideal world, a government would also generate a surplus in boom times with which to fund the extra outlays during recession.

another one

For the idea of countercyclical policy to work, government must have enough resolve and foresight to “take away the punchbowl,” that is, to remove the extra stimulus, once the economy is expanding again.  That’s harder to do than it seems.  The George W. Bush administration, for example, started off with a government surplus but increased spending enough to turn that into a big deficit in less than a decade.  In hindsight, the career of the “Maestro,” Alan Greenspan, as head of the Federal Reserve can also be seen as a long series of failures to restore the status quo ante after crises.

the lesser of two evils?

It seems to me that the (unmade, but) most persuasive argument in favor of a balanced budget amendment is that–unlike the cases of Germany or the ECB–in the hands of Washington, countercyclical policy has become just another boondoggle.  Yes, the policy is sound, but Washington just can’t be trusted to implement it.

what about external shocks?

In my career, there have been three:  the oil shocks of 1973-74 and 1978-80, and the financial collapse of 2007.  One might add the stock market collapse of 1987 to the group, although it would have been the runt of the litter.  Both 1973-74 and 2007 have invited comparison with the early days of the Great Depression.

These downturns were so unusual and so severe that simply deciding to wait them out would have been a very poor option.  In 2007, which should be the freshest in memory, global commerce was frozen, brought to a halt by worries about bank solvency.  Money market funds, which supply short-term finance for industry, were on the verge of collapse.  Citigroup, among other banks, were about to become bankrupt.  Businesses were beginning layoffs on a truly massive scale.  A replay of the 1930s was staring the world in the face.

Luckily, the world understood the appropriate response and implemented it (in the two most important countries, China and the US, at least)–although the US stock market dropped by 7% when Republicans (inexplicably) refused to vote in favor of countercyclical stimulus–making matters that much more urgent.

like the gold standard

Advocates of a literal gold standard seem to me not to know what that means–or to be unaware of the example of the California gold rush that produced massive, destabilizing inflation in the US.  That’s why the gold standard is a rallying cry for monetary regimes which, when you examine the details, are anything but.  (See my posts on gold and the Gold Standard.)

I view calls for a Federal balanced budget amendment in a similar vein.  They’re rallying cries for fiscal programs that have got to have safety valves to address unusual situations–and therefore aren’t really mandating true budget balancing.

I think most Americans think the real solution to Washington’s dysfunction is systematic reform.  That’s what the country thought it was getting with Mr. Obama.