In thinking about the dangerousness of both the size and recent trends of both federal debt and deficits a multitude of viewpoints scream out at us. There are those who, simply, recite the mantra dealing with the sheer dollar size of the federal deficit and debt: "In 1992 the federal deficit was $399,733,000,000 while the federal debt was $4,077,510,000,000." This statement is normally followed by a widening of the eyes by listeners and an "Oh my gosh!". Both the suppliers and demanders of these facts I call "Absolutists" because their belief in the significance of absolute numbers is absolute.

Slightly up the rung in the economic evolutionary ladder are those natives known as the "Relativists." This species repeats without taking a breath between sentences: "Did you know that in 1991 the federal debt was approximately 70 percent of GNP, and in 1992 interest payments consumed 13.5 percent of the federal budget." Like the "Absolutists," "Relativists" believe that the sheer size of something, in this case a relative magnitude, conveys useful information.

Off the same branch as the "Absolutists" and the "Relativists" and "Extrapolists." "Extrapolists" love to predict some coming doom based on their forecasts of current debt and deficit trends which, through the mumbo jumbo of economic modeling, indicates America's forthcoming bankruptcy. Like those religious leaders who make their living predicting the Second Coming, "Extrapolists" claim it might happen next week, next year, next five years, next ten years, and so forth.

Of a completely different genus are "Inflationists" and "Intergenerationalists." "Inflationists" argue that deficits and debt cause inflation while "Intergenerationalists" emphasize the burden debt imposes on future generations of citizens.

On top of this taxonomic pyramid sits many economists and politicians with the one tale that sends shivers down everyone's back: federal government deficits and debt hurt the economy by crowding-out private investment. Normally, the following story is told (mostly in bars and restaurants and not around campfires) in support of this view. When the federal government runs a deficit it must turn toward its financial agent, the Treasury Department, to finance it. The Treasury Department, like any other borrower, must enter private financial markets and try to convince lenders to buy its bills, notes, and bonds it issues to finance the federal government's deficit. One method that Treasury uses to compete against private borrowers is to offer higher interest rates on its debt. This strategy boosts the cost of borrowing money for everyone. Since business borrows to finance capital investments, anything that makes it more expensive to borrow ends up discouraging business investment. When business invests less, workers in the future have less capital to work with which slows gains in labor productivity and the rate at which wages can increase. Now here is one scary story that both mainstream parties in America believe.

Let me address each of these arguments in turn. Citing absolute amounts of money owed, whether talking about a public or private entity, means absolutely nothing. If I tell you that XYZ corporation owes 2 billion dollars, and I ask if this is a large sum to owe, your response should be "insufficient information." If XYZ corporation is a "MOM and POP" business, then it is a large amount to owe. If XYZ corporation is some global behemoth, with hundreds of billions of dollars in world sales, it might not be a lot to owe.

Given what I just said, you must be led to believe that "Relativists" arguments are close to the truth. Well, yes and no. Relative magnitudes, in general, contain more information than absolute numbers. The trouble with relative numbers is that in making historical comparisons, all kinds of different conclusions can be drawn. For example, in 1792 federal outlays for interest payments were over 50 percent of the federal budget (I bet you did now know that!). Does this mean that the 1992 number for this same statistic at 13.5 percent is small? And in 1945 federal debt was 122.5 percent of GNP. Does this mean that the current ratio of 70 percent is small? All one can answer to these questions is that it depends on historical circumstances.

What about the crashing trend lines produced by "Extrapolists"? Trend analysis suffers from its own set of problems. Human history is full of dire predictions based on extrapolating trends which were wrong—remember the Club of Rome forecasts? A good illustration of how trend line analysis can go awry is a prediction I made a short time ago concerning my daughter Esther. One morning, I found her scratching a small section of her left cheek. Based on the rate she was scratching, I forecast that in 14 months she would reach her right cheek. My wife and I were in a panic. I searched furiously through the yellow pages under the heading Child Psychologists. Guess what happened? Yes, you're right! Esther stopped scratching even before I could dial 1-800-281-Freud. My forecast was wrong. Long before she reached the other side of her face, either her itch disappeared or the blood from penetrating her skin stopped her from proceeding. These same sort of events seem to operate over and over again in human history. This is not to say that trends are worthless. It's just that one must be exceedingly careful in drawing conclusions from them, including the one about the "sky falling down" because of upward trends in a set of federal budgetary numbers.

If we define inflation as a continuous rise in the price level over time, then there is absolutely no empirical support linking inflation with federal deficits and debt. Across nations over time, the single most important variable in explaining inflation is excessive printing of money. During the 1980s, when the U.S. deficit and debt skyrocketed, inflation fell dramatically as the Federal Reserve bank regained control over the U.S. money supply.

My personal fondness for "Intergenerationalists" is based on a T.V. commercial they ran a number of years ago illustrating their argument. See if you recognize this scene. The commercial opens with a screaming baby all alone in a crib. Then a voice (from heaven?) informs us that this child owes $X@#$%*+ dollars on the federal debt, and wouldn't you be screaming if you owed this much? The commercial is intended to get you to give your best "Well, gee, gosh, I guess so."

The problem of screaming babies is easily resolved given the following two facts: first, what the T.V. commercial did not show you were all of those spoiled little smiling brats, who through inheritance, will receive part of the monies owed by the commercial's crybabies; second, while future generations inherit debt from today's generation, they also inherit federally financed goods like bridges, roads, national security, new knowledge supported by federal research grants, etc. Many of these are paid for with federal debt.

Crowding-out is a bit more difficult to address. Nonetheless, two arguments exist which at least put into question the crowding-out story. First, there is an alternative theory, attributable to David Ricardo, on how government borrowing impacts on the economy. The modern version of this view goes by the name Ricardian equivalence. In this view of reality, citizens view government debt as equivalent to government taxes. When the government wants to borrow, citizens recognize that this borrowing will in the future manifest itself as additional taxes which will have a present value equivalent to what is being borrowed today. In response to their predicted increased future tax burden, individuals increase their savings dollar for dollar with increases in government borrowing. The net effect of this is that government borrowing has no effect on interest rates. In addition, under Ricardian equivalence, borrowing and taxes have equivalent effects on the economy. What matters in this world is not how government finances itself, but the size of government. Bigger government means a smaller private sector, and a smaller government means a bigger private sector. If Americans want a larger and more robust private sector, the way to accomplish it is not by substituting taxes for borrowing, but by shrinking the size of the public sector.

Interestingly, there is some empirical evidence to back up this story, which is my second argument against the crowding-out approach. When economists try to measure the relationship between interest rates and government borrowing they either come up with no relationship, a weak positive relationship, or a weak negative relationship. This evidence can be viewed as supporting Ricardian equivalence and undermining crowding-out. Under the crowding-out approach, if interest rates don't rise then business investment won't fall. Unfortunately, part of the empirical evidence also goes against Ricardian equivalence, since private savings seem not to rise by the same magnitude as increases in government deficits. What does all of this mean? Am I saying that deficits and debt in the U.S. are not problems? At the least, theory and evidence suggest that any view we hold on this topic should be tempered with a question mark.

Given the ambiguous results on how federal deficits and debt impact on the economy, a tempting alternative strategy, based on public finance, is to study when the federal government should spend, tax, and borrow. This was the strategy President Reagan's advisors tried to present once they realized the extent of the federal deficits that were going to be incurred during his presidency. Unfortunately, their arguments had a disingenuous ring given their previous rhetoric concerning the evils of public indebtedness.

Nevertheless, from a public finance viewpoint I believe they were correct in what they were trying to say. What follows deals with the microeconomics of government spending, taxation, and borrowing.

Outside of the activities in support of a minimalist state, public finance argues that federal government expenditures should go either to offset various forms of market failure which reduce economic efficiency, or in support of income redistribution. Market failure includes public goods, externalities, imperfect competition, business cycles, and problems related to missing markets. Some common examples of each, stated in operational terms, are national defense (public good), anti-pollution laws (externality), Federal Trade Commission (imperfect competition), fiscal policy (business cycle) and federal flood insurance (missing market).

While market failure or redistribution constitutes a necessary condition for the existence of the federal government, neither of them constitute a sufficient condition. For example, let's say because of the existence of imperfect competition in the computer industry society suffers a loss of $100. It wouldn't make sense for government to spend $200 to fix this problem. More generally, the benefit(s) flowing from the federal government's use of resources should be compared to the benefit(s) those same resources would have produced in the private economy. Only federal government expenditures that can pass this type of benefit/cost test should be made. This sort of reasoning also applies to redistribution expenditures.

As important in knowing when the federal government should spend is to know when the federal government should tax and borrow. An important principle in public finance that gives us some guidance on this question is the benefits-principle. As a normative principle, the benefits-principle argues that citizens should pay, through taxes, for the benefits they receive from federal government expenditures. This principle also implies that the federal government, at least partially, finance itself through debt. To illustrate, when a nation engages in a (just) war, the benefits from this conflict accrue to many generations over time. According to the benefits-principle, each of these generations should pay for part of this conflict. They way to accomplish this is to tax and borrow from the generation which is alive during the war, and pay these debts back with taxes paid by future generations.

The benefits-principle also has some implications for economic efficiency. Assume that the federal government is contemplating the construction of a long-lived asset (e.g., roads). If the government's only financing tool was taxation, the generation of citizens alive today might vote against the construction of this asset—even if it could pass a benefits/cost test—based on benefits received today versus costs paid today. Yet these same citizens might be willing to engage in a project that has both current and future benefits and only current costs if future generations of beneficiaries of this asset could be forced to pay part of its bill. The only way this can be accomplished is through government borrowing.

Another reason for federal government borrowing is to achieve intergenerational equity. For better or worse, we have asset (e.g., roads). If the government's only financing tool was taxation, the generation of citizens alive today might vote against the construction of this asset—even if it could pass a benefits/cost test—based on benefits received today versus costs paid today. Yet these same citizens might be willing to engage in a project that has both current and future benefits and only current costs if future generations of beneficiaries of this asset could be forced to pay part of its bill. The only way this can be accomplished is through government borrowing.

Another reason for federal government borrowing is to achieve intergenerational equity. For better or worse, we have become a society that thinks it's reasonable for the federal government to take from those who have and to give to those who don't. It's simple enough, and even logical, to extend this reasoning to intergenerational transfers. The normal expectation is that future generations of Americans will, on average, be better off than the current generation. If that's true, why not remove wealth from richer future generations and give it to those who are alive today? One way of achieving this is for the government to finance its current consumption with borrowed monies that will be paid back by future generations.

A more subtle argument in support of federal government borrowing involves minimizing, what economists call, excess burden. Excess burden is the difference between the dollar pain associated with a tax and the dollar taxes actually paid. Take the example of the $100 I pay in federal income taxes every year. If the actual dollar pain of this tax equals $120 then my excess burden is $20. At least in theory, excess burden is exponentially related to tax rates. That is, if you double a tax rate, excess burden more than doubles. Under these circumstances, if government experiences the need to increase its spending, it might make sense to finance this increase both through borrowing and a small tax rate increase spread over time. This financing package would impose fewer excess burdens on taxpayers than one which increased taxes sufficiently to pay for the whole spending increase at once.

Given what I just argued, it's irrelevant that President Clinton's 1993 budget is called a deficit reduction package. It's also irrelevant what impact his budget will have on future deficits and debt. From a public finance perspective, what matters for any public budget, is its impact on improving economic efficiency—by correcting for various forms of market failure—and income distribution. Applying this reasoning to President Clinton's 1993 budget plan would begin by questioning each expenditure in terms of its purpose. Does it correct for some form of market failure? Does it improve income distribution? If not, it shouldn't be made. If yes, then the dollar value of the benefit(s) generated by the resources used in supporting this expenditure should be compared with the dollar benefit(s) those same resources would have produced in the private economy.