The Niskanen Center’s namesake, William Niskanen, is known for bluntly rejecting the “starve the beast” theory of spending cuts. Cutting taxes, Niskanen argued, does not automatically lead to spending reductions down the road. On the contrary: in the short term, deficit financing reduces the cost of government programs as experienced by the public, creating a “fiscal illusion” that increases the demand for greater spending down the road — a conjecture Niskanen went on to test empirically.
The failure of the “starve the beast” strategy is now well known, and yet that did not stop Congress from passing a deficit-financed tax cut in 2017, with the promise of its being paid for by future entitlement reforms. As a result, the U.S. federal deficit surpassed a trillion dollars. This historically unprecedented level of peacetime public debt was enabled by unusually low interest rates, but also by an equally unprecedented ebb in the political clout of fiscal conservatives on both sides of the aisle — and this was all before the Covid-19 pandemic.
Debt’s Democratic Deficit
The argument for budget sustainability has always been forward-looking. As economist Herbert Stein’s famous “law” puts the matter, “a trend that can’t go on forever won’t.” And yet budget hawks have tended to fight the last battle, either by seeking politically untenable cuts to popular programs, or by insisting on procedural gimmicks within the budget process that are routinely waived or easily gamed. Both these approaches fall victim to what economists call the “time inconsistency” problem, which is just a technical way of saying “today’s actions, tomorrow’s regrets.”
A deep appreciation for the political economy of debt and deficits, as captured in concepts like fiscal illusion and time consistency, can help to differentiate between those who care about fiscal sustainability and those who use fiscal sustainability as an excuse for generalized austerity. Understanding political incentives is also essential to designing budget rules that work as well in practice as they do in theory — a challenge our Niskanen Center colleague Ed Dolan took up in his 2021 report, “Rules for Sustainable Fiscal Policy.”
Unfortunately, the contemporary debate largely neglects the political dimension of deficit financing in favor of purely macroeconomic considerations. Consider the insolvent pension funds that the Biden administration’s American Rescue Plan bailed out to the tune of $86 billion. Such a large, no-strings-attached wealth transfer to union interests was only possible due to deficit financing, which divorced the link between the bailout’s benefits and its costs, thereby blunting voters’ ability to evaluate the trade-off in the here and now. In contrast, the analogous union-run pensions in Denmark — Bernie Sanders’ model of a socialist paradise — are fully funded by law. In fact, all the big welfare states in Scandinavia make a point of ensuring future obligations are financed and with some relationship to the beneficiary’s ability to pay, including through large value added taxes. They do so not out of an austerity mindset, or to the exclusion of taxes on the rich, but rather as a crucial aspect of good and honest government, ensuring that the public gets all the government it wants and is willing to pay for — but no more.
Relieved of having to make hard choices, lawmakers are free to pursue expedient reforms that reward politically favored interests with minimal resistance. The justification for linking spending to financing is democracy, not austerity — ensuring that claims on the public fisc are fully deliberated and justified in the light of other public priorities. Looking ahead, never-ending deficit financing of new programs thus risks enabling never-ending waves of rent-seeking by providers of cost-diseased goods and services.
The above is an excerpt from Cost Disease Socialism: How Subsidizing Costs While Restricting Supply Drives America’s Fiscal Imbalance, and part of our Captured Economy of Cost Disease series exploring the political economy of debt and deficits. It is made possible thanks to the support of the Peter G. Peterson Foundation.