THE ECONOMICS OF THE BALANCED BUDGET AMENDMENT: WHY IT IS
BAD FOR AMERICA
A revised version of this paper was published as “The Sorry Politics of the Balanced
Budget Amendment,” Challenge, v. 40, May/June 1997, 5 - 13.
Thomas I. Palley
Assistant Director of Public Policy and Economic Research
815 Sixteenth Street, NW
Washington DC, 20006
The balanced budget ammendment risks seriously harming the long term health of the U.S.
economy. Initial implementation effects will lower aggregate demand, and risk sending the
economy into recession. Destabilization effects, arising from greater volatility of
government spending and taxation, will amplify the swings of the business cycle. They will
also generate more volatile interest rates as the Fed tries to offset the volatility of fiscal
policy. Negative growth effects, arising from a forced reduction in public investment
spending, risk lowering the economy's growth rate. Lastly, the ammendment creates
financial instability effects. By cutting off the supply of government bonds, the
ammendment will likely inject more risk into the portfolios of banks and financial
institutions, thereby resuscitating the possibility of old style financial crises.
Keywords: Balanced budget ammendment, implementation effects,
destabilization effects, growth effects, financial instability
The 105th Congress has just begun its deliberations. One item that is its agenda is the
balanced budget amendment (BBA). After years of gradually accumulating support, the
BBA may now have sufficient votes to pass in both the Senate and the House of
Representatives. However, President Clinton and Treasury Secretary Rubin both remain
staunchly opposed to it, and there are indications that the Federal Reserve is also opposed
to it. For opponents, the amendment threatens to reduce policy flexibility, and potentially
destabilize the economy by turning mild economic downturns into deep recessions. They
argue that the real challenge is to actually balance the budget, and the BBA is a circus that
obscures the difficult choices involved in achieving such an outcome.
SNATCHING DEFEAT FROM THE JAWS OF VICTORY
Ironically, after years of running extensive deficits, measured as a percentage of
national income, the federal government is shifting back toward budget balance. The push
for the BBA therefore represents an instance of snatching defeat out of the jaws of victory.
During the 1980s, the federal deficit averaged 3.6% of gross domestic product (GDP):
since the current economic recovery began in earnest at the beginning of 1992, the federal
deficit has steadily declined as a share of GDP, and was only 1.4% of GDP last year. Such
a percentage represents dynamic balance in the sense that the deficit is sufficiently small
that the national debt is actually falling as a percentage of GDP.
Though less widely known, state governments have run budget surpluses during this
period of federal deficits. During the 1980s, total state budget surpluses averaged 1.1% of
GDP: during the 1990s these surpluses have averaged 0.4% of GDP%, which is where they
currently stand. The division of fiscal responsibilities between state and federal
government is a political artifact. When the two are considered as a single entity, as is the
case in other countries, two important features emerge. First, state budget surpluses have
helped offset federal budget deficits. Second, both state and federal budgets have been
moving into balance, so that the BBA is redundant.
One cause for concern is the issue of projected future federal deficits. The
Congressional Budget Office projects that the federal budget deficit will start increasing in
the latter part of this decade, reaching $244 billion by the year 2000. There are two
important qualifiers to this observation. First, the economy will continue to grow: if it
grows at 4.8% per annum (2% growth plus 2.8% inflation), such a deficit will represent
only 2.7% of GDP. A $244 billion deficit is disastrous for an economy with a GDP of $500
billion: it is of much less consequence for an economy with a GDP of $9.2 trillion.
The second important feature is that 125% of the projected increase in the deficit is
attributable to increased medicaid and medicare expenditures. In the absence of these
expenditures, the deficit would actually fall. These increased outlays are not the result of
demographic developments associated with an increased aged and infirm population:
rather, they are the result of projected continued excessive medical cost inflation. The
deficit problem is therefore really one of medical cost containment. This is the issue
America needs to address: however, the BBA obscures this by pretending to solve the
problem with a unilateral declaration of victory. If passed, the problem will remain to be
solved, albeit now under the additional constraint of the BBA.
THE BUDGET AS A MISLEADING ACCOUNTING MEASURE
Not only does the balanced budget crusade obscure the true source of the nation's
budgetary difficulties, the budget itself provides a misleading indicator of federal fiscal
integrity. In effect, the BBA seeks to balance a deeply flawed accounting measure.
First, the federal budget fails to distinguish between "operating" and "capital"
expenditures. Operating expenditures are those incurred in running government and
funding the services it provides; capital expenditures relate to purchases of long lived
buildings and equipment, and include expenditures on infrastructure. The failure to
distinguish these types of expenditures is at odds with accepted accounting practice, and is
at odds with the accounting practices adopted by corporate America. It amounts to
claiming that expenditures on roads and buildings are equivalent to consumption, and that
these assets are fully used up in the year they are purchased. The result is to overstate
spending, and give government an air of profligacy. If capital expenditures were
appropriately capitalized, both government expenditures and the deficit would be lower.
A second failing of the federal budget is its incorrect accounting of the effects of
inflation. The government is the country's largest financial debtor. Just as inflation lowers
the burden of mortgages for households, so too it lowers the burden of the national debt.
Financial markets recognize that inflation erodes the value of loans, and interest rates rise
in inflationary periods to compensate for this. In effect, higher rates compensate lenders for
loan principal erosion, and are tantamount to early repayment of loans. From an accounting
standpoint, this means that the portion of interest rates attributable to inflation should be
treated as loan repayment rather than an expenditure. With inflation at 3% per annum, and
the publicly held portion of the national debt currently at $3.6 trillion, such treatment
would have reduced the deficit in 1996 by $108 billion. The federal budget would therefore
already be in balance.
THE ECONOMIC CONSEQUENCES OF THE BBA
Implementation effects: risking a recession
Passage of the BBA is likely to have a range of deleterious effects. In the first instance,
there will be negative "implementation" effects. The federal budget is in deficit, so that
conforming to the ammendment will require significant spending cuts. Aside from the
political problem of getting agreement on what spending will be cut, there is a danger of
such cuts causing a recession. Depending on when one dates the begining of the current
economic recovery, it is either five or six years old. This means that it is getting to be fairly
mature, and with maturity comes fragility. A negative demand shock, caused by a
reduction in government spending, could be sufficient to tip the economy into recession.
Destabilization effects: aggravating the business cycle
In addition to negative implementation effects, the BBA will likely have
"destabilization" effects. These risk turning mild recessions into severe economic
downturns, and possibly worse. The reason is that when the economy is down, tax revenues
decrease and the budget deficit increases. The BBA will force government either to cut
spending or raise taxes in recessions, which will in turn lower demand: this will make
recessions worse. An analogous logic applies to the case of booms, during which tax
revenues increase and the budget moves into surplus. In this event, the government will
have to increase spending and lower taxes, thereby adding to demand and inflationary
To offset these destabilizing effects, the Federal Reserve will be obliged to move
interest rates up and down like a yo-yo. To offset the BBA's negative effect on demand in
recessions, the Fed will have to lower interest rates additionally: to offset the positive effect
on demand in booms, it will have to raise interest rates additionally. Such interest rate
volatility will make business planning more difficult, and likely lower investment spending.
Worse than that, financial markets will come to expect interest rates to rise significantly
after recessions. To avoid incurring losses, financial investors will not bid down rates on
longer term bonds in recessions, and this means that the economy could get stuck in
recessions with high long term rates. The impact on housing and investment spending
would be disastrous. In effect, the economy could get locked into a self-fulfilling high
interest rate trap in which expectations of future high interest rates keep current interest
Keynesian economists emphasize the destabilizing "demand" effects of the BBA.
Supply-siders emphasize the destabilizing effect of volatile tax rates. Paradoxically, both
agree that the BBA is destabilizing. Under a BBA, the government would lower tax rates in
booms and increase them in recessions so as to maintain budget balance. This would make
tax rates more volatile, thereby making business planning more difficult. For supply-siders,
optimal tax policy calls for constant tax rates: the BBA produces the opposite result.
Growth effects: public investment and America's third deficit
The BBA will also have adverse "growth" effects that will lower the economy's long
run growth rate. Over the time, the economy is steadily growing owing to the effects of
technological innovation, investment, education, and population growth. This growth
manifests itself in a higher national income. If the BBA is passed, government will be
obliged to run a zero deficit, and as a result the national debt will cease growing. The
publicly held share of the national debt currently amounts to 50% of GDP. Overtime, with
national income growing and the debt constant, this percentage would steadily fall.
The fact that the debt/GDP ratio would fall, has significant implications for the meaning
of a balanced budget. In an economy with no growth, budget balance requires a zero deficit,
this being the only way to stop the debt/GDP ratio exploding. In an economy with growth,
the debt must also grow to stop the debt/GDP ratio going to zero. This implies that a
balanced growing economy should run deficits. The meaning of budget balance is different
for a static no growth economy versus a dynamic growing economy: this is a subtle point
that has been lost in the BBA hysteria.
If government is unable to borrow, this will have a severe negative impact on public
investment, which will in turn hurt growth. In the private sector, when a business wants to
expand, it does so by borrowing from a bank or having an initial public offering on Wall
Street. Such actions provide business with the finance to buy the plant and machinery
necessary for growth. Thus, business is not forced to rely exclusively on its existing profits:
if it were, start-up companies which have no profits could never get going. Instead, both
new and existing business borrows to finance expansion, and then uses the resulting profits
to redeem the debt. This is an unending process in a growing economy, and it means that
the total amount of business debt is always increasing.
Exactly the same logic applies to the government, which is in the business of being
U.S.A. Inc.. Government helps grow the economy by expanding the road and highway
network which facilitates commerce, building schools and universities which educate our
children and generate technical advances and higher productivity, and by providing the
urban infrastructure that supports business operations. These expenditures grow the
economy, which in turn generates the tax revenue to pay back the initial borrowing. In
effect, U.S.A. Inc. is just like private business: if the economy is to grow at its maximum
rate, U.S.A. Inc. must also be able to increase its borrowing.
The BBA prevents government from borrowing to finance public investment. Instead,
such projects will either have to be financed out of current revenues or through tax
increases. Whatever they are, politicians are not stupid. They know that taxes are
unpopular, and hurt the voters who pay them today: they also know that the benefits from
capital spending accrue to the future, and the future does not vote today. The logic is clear
and forceful. The BBA establishes an unambiguous incentive to cut back on public
investment spending, with adverse consequences for economic growth and the quality of
America's low rate of public investment spending has already been termed "America's
third deficit" (i.e in addition to the budget and trade deficits). Public investment has a high
rate of return, both in terms of improved quality of life, and in terms of its positive effect on
business productivity. The existing low rates of public investment spending are already
blamed for much of the slowdown in economic growth that has occurred since 1973. By
further lowering such spending, the BBA will compound this problem.
A reduction in public investment spending is also deeply at odds with the problems
posed by the greying of America and the need to fund social security. The putative problem
is that twenty years hence the demographics of the baby boom will produce a surge in
retirement. At that time, the nation will have to devote much of its resources to supporting
this elderly population. Far sighted policy should anticipate this scenario, and ensure that
the needed resources are in place. Unfortunately, it is hard to build the needed factories
today since they will be outmoded by then. However, public infrastructure is extremely
long lived, and offers the best means of anticipating these needs. The nation is still
benefitting from the interstate highway system and airports that were built in the 1950s.
Though many of our schools are deteriorating and require improvement, it is also the case
that they were built sixty to seventy years ago. Thus, they have been long lasting, and new
schools can be equally so. One of the best ways to prepare for the aging of America is to
increase public infrastructure investment, yet this is exactly what the BBA will inhibit.
Financial instability effects: restoring old style financial crises
Another serious implication of the BBA concerns its impact on financial markets.
Government bonds occupy an important place in the portfolios of households and financial
intermediaries. They are safe reliable assets that carry a reasonable rate of return, and the
markets in which they are traded are healthy. The BBA would put an end to new supplies of
government bonds. For financial institutions, particularly banks, this would have serious
consequences. Banks park their excess liquidity in government bonds since they are both
safe and earn a return: when they have excess liquidity, they buy bonds; when they are
short of liquidity, they sell bonds. In this fashion, government bonds help the financial
system buffer the demands of business for credit.
In the event that the supply of government bonds were to dry up, banks and other
financial institutions would look for other financial assets in which to park their liquidity.
They would likely start to increase their holdings of corporate bonds. However, such bonds
are risky, and their prices can fall in economic downturns owing to increased bankruptcy
risk. Consequently, such a portfolio shift would inject significantly more risk into the
financial system. In the 1980s, the S&L crisis cost the American taxpayer $500 billion: the
banking system also nearly went belly up, and the Federal Deposit Insurance Corporation
was close to insolvent. The system just managed to weather that storm: there is a risk that
future storms may be unmanageable if government bonds, which are the bedrock of the
financial system, are replaced by corporate bonds in private portfolios.
In sum, the BBA risks seriously harming the long term health of the economy. Its
implementation will lower aggregate demand, and risks sending the economy into
recession. Destabilization effects, arising from volatile government spending and tax
patterns, risk amplifying the swings of the business cycle. This will also result in volatile
interest rates that could place the economy in a high interest rate trap. Negative growth
effects risk lowering the economy's growth rate owing to a forced reduction in public
investment spending. Moreover, this is exactly the wrong strategy for dealing with the
coming "greying" of America. Lastly, by cutting off the supply of new government bonds,
the BBA will likely inject more risk into the financial sector, restoring the possibility of old
style financial crises.
Economic theory, both Keynesian and supply-side, provides no support for the BBA.
Over three hundred economists, including seven Nobel Prize winners, have signed a
statement declaring it to be bad for America. In his commencement address at Yale
University on June 11, 1962, President Kennedy spoke about fiscal policy and the national
"The great enemy of the truth is very often not the lie -- deliberate, contrived and dishonest
-- but the myth -- persistent, persuasive, and unrealistic. To often we hold fast to the cliches