THE BLOG
10/12/2011 02:31 pm ET Updated Dec 12, 2011

Balanced Budget Amendment Follies

This post was co-authored by Marshall Auerback and Micah Hauptman.

"Balance the budget!" It's the endlessly repeated narrative heard in Washington. Implicit in this narrative is that budget deficits are crippling our economy and the U.S. government is on the verge of insolvency. If we only imposed strict fiscal discipline like Greece, we'd be on the road to recovery in no time! Ask yourself how that's working out for Greece right now.

We are currently in what Republicans in Congress are calling "Balanced Budget Month." But it's not just Republicans who have embraced a commitment to drastically slash deficit spending. Virtually everyone in Washington agrees that budget deficits are dragging our economy down and that they must therefore be dealt with swiftly and vigorously.

The solution for many policymakers is a balanced budget amendment. But the monomaniacal focus on budget deficits tends to throw up a series of perverse policy responses, which will actually have the effect of increasing, rather than decreasing, debt. It seems counterintuitive, but the public actually needs government spending to pay for its taxes rather than the government needing taxes to pay for highways, bridge repairs, schools, national defense, etc. For households and businesses, paying back debt means they have to sacrifice current consumption (spending). For the government, no such financial constraint is imposed. Its ability to spend now is independent of how much debt it holds and what it spent yesterday.

Budget deficits themselves are best seen as barometers of economic activity: when economic activity declines, tax revenues plunge and social welfare expenditures rise as more people are thrown out of work. As a consequence, in bad economic times like these, there are higher deficits; conversely, when prosperity returns, deficits decrease. This dynamic means that expenditures that help regular Americans are even more necessary during difficult economic times because they put a floor on aggregate consumer demand, preventing the onset of another Great Depression.

The establishment of a balanced budget amendment will utterly disable this process. In fact, common sense suggests that a drop in private income flows while private debt loads are high is an invitation to debt defaults and insolvencies -- that is, unless creditors are generously willing to renegotiate existing debt contracts en masse. An unlikely scenario.

Let's keep this simple: We can divide the economy into three major sectors: the domestic private sector (including households and businesses), the foreign private sector (including the import and export of goods) and the government sector. For an economy to properly function, the three sectors' spending and saving must all balance out, meaning if one sector spends, the other sectors must save, and vice versa.

If households and businesses save, for example, $10 of every $100 they receive, then that $10 is lost from the expenditure stream. If households save by spending less than they earn, and businesses save by reinvesting less than their retained earnings, then the production level will be too high relative to demand and unsold inventories will grow. The result will be deferred consumption and firms laying off workers; that is, unless output is offset by rises in the trade sector (i.e. more exports). But the way our trade sector is configured, a trade surplus is not likely anytime soon.

Now let's consider a different situation. Assume the government passes a balanced budget amendment, taking in more tax revenue than it spends, and the private and trade sectors rack up further debt. As we know, excessive private sector debt and trade imbalances got us into our current mess and continue to threaten our financial security. Why on earth would we want to embrace this type of system?

It does not have to be this way; the government sector can easily step in to pick up the slack, while giving households and businesses an opportunity to recover. Unlike private actors who don't have the capacity to create money, the government can issue money at the tap of a keystroke and spend much more freely to get the economy going. In troubled economic times, the government must insert itself in this capacity to maintain sector balance. It can do so by promoting policies that favor full employment and mortgage relief, so that households and businesses have money to pay down their debts and consume again. Full employment is also compatible with a healthy banking system: fully employed people have a greater capacity to pay off debt, making destructive loan write-offs for banks far less likely.

Spending and debt remain intrinsic features of a capitalist economy. The key question is, which sector is best positioned to service the debt: families and businesses, or the government? With a balanced budget amendment, the burden is forced onto families and businesses. The folly of this approach is obvious.

Marshall Auerback is a Fellow at Economists for Peace and Security and a Research Associate at the Levy Economics Institute. He also works as a global portfolio strategist for Madison Street Partner, LLC, a Colorado-based investment management group. Micah Hauptman is the Financial Campaign Coordinator for Public Citizen's Congress Watch division.