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Wednesday, May 18, 2011

Linking the Debt Limit Hike To Spending Cuts Is Good Economics

For months now top economic officials in Washington have been arguing that the Congress should vote to increase the debt limit without any reductions in the growth of spending—in other words a “clean debt limit hike.” Just last Thursday Ben Bernanke compared linking the debt limit and spending reductions to playing a game of chicken with U.S. credit worthiness, adding “I think using the debt limit as a bargaining chip is quite risky.” CEA Chairman Austan Goolsbee and Treasury Secretary Timothy Geithner have been saying much the same thing.

But these arguments do not take account of important economic advantages of linking the debt limit to spending reductions. Such a link is good economics in theory and in practice. It is essential to a credible return to sound fiscal policy and an end to the ongoing debt explosion.

Here’s why. In the current political and economic environment—where more people than ever in the United States and around the world are aware of, and paying attention to, the country’s debt problem—the decision about the debt limit will be precedent-setting. They also know that government spending has increased rapidly in recent years, rising from 18.2 percent of GDP in 2000 to over 24 percent now. If Washington does not change the budget game now, people will sensibly reason, it will never change the game. If politicians just increase the debt limit now when spending has been growing so rapidly compared to revenues without correcting that rapid growth of spending, then they will be expected to do so in the future. In contrast if they tie any increase in the debt limit to a halt in the explosion of spending, then people will be more likely to expect them to control spending in the future. Linking the debt limit vote with spending establishes a precedent and valuable credibility.

Another way to think about this approach is to contrast it with the debt failsafe mechanism that President Obama has proposed. Under the debt failsafe plan, if spending grows too rapidly in the future (after 2015) relative to forecast, and the debt thereby rises more than budgeted for, then there would be an automatic reduction in spending. In other words, debt increases and spending reductions are linked in future. But if there is no link in the present, as in a case of a clean debt limit increase, how can one expect one to be followed in the future? How can today’s politicians expect future politicians to adhere to such a policy if they can’t do so today? This is a common problem in economics, called the time inconsistency problem, covered from principles courses to Ph.D. courses.

The principle of linking the debt increase and spending reductions—put forth in a recent speech to the New York Economics Club by Speaker John Boehner—is therefore an important goal which is worth trying to achieve. True, it may run some risks as the deadline is approached, but those risks are far smaller than the risks caused by the debt explosion which is likely if the Boehner link is severed.