Laurence Seidman – Professor, University of Delaware

September 9th, 2011

seidman_200x230 A Balanced Budget Amendement Would Turn a Recession into a Depression

Here’s a fact many citizens don’t know.  Without a balanced budget constitutional amendment, Congress kept the federal budget nearly balanced during the past decade and a half whenever the economy was prosperous.  In the prosperous second half of the 1990s (unemployment rate under 5%) it actually achieved small surpluses.  In the prosperous years 2005-2007 (unemployment rate under 5%) it kept the deficit small–less than 2% of GDP.

Whenever the economy fell into recession (2001-2003, and 2008-2011), the federal deficit rose for two reasons.  First, as household and business incomes dropped, income and payroll taxes owed and paid also dropped.  Second, to combat the recession Congress cut tax rates and/or increased government spending to stimulate the economy—exactly what it should have done in a recession.  The financial crisis and Great Recession of 2008 caused a plunge in tax revenue and required a large federal fiscal stimulus to avoid another depression.  That fiscal stimulus sent federal funds to consumers and state and local governments which prevented a drastic fall in their spending on goods and services.  Without that fiscal stimulus today’s unemployment rate would be 12% instead of 9%.

This sharp rise in the deficit since 2008, therefore, does not mean that Congress became fiscally irresponsible.  It demonstrates, instead, that a plunge into a recession causes the federal deficit to rise sharply, especially when Congress responds correctly to the recession by enacting enough fiscal stimulus to prevent a depression.

What would have happened if there had been a balanced budget constitutional amendment in place when the Great Recession hit in 2008?  Such an amendment would require Congress to balance its budget every year– even in a recession!  The answer is that today’s unemployment rate would be 15%, not 9% or even 12%.  Why?

Under such an amendment, as soon as the recession caused incomes and taxes paid to drop, the federal government would have been forced to promptly cut its spending in order to keep its budget balanced.  Private sector suppliers of goods and services to the federal government—for example, firms making military hardware, and hospitals and doctors treating Medicare and Medicaid patients—would have felt a prompt cut in their revenues.  State and local governments would have received a sharp cut in federal funds, thereby forcing layoffs of teachers, police, and construction workers on road and school projects.  Retirees and the unemployed would have received a cut in their federal benefit checks.  In turn, all of these recipients of federal spending would have been forced to cut their own spending on goods and services, causing layoffs throughout the economy.  If the Great Recession by itself would have raised the unemployment rate to 12% (it went to 9% despite fiscal stimulus), the federal spending cuts forced by the balanced budget amendment would have raised it to 15%.  Virtually every introductory economics textbook teaches that balancing the federal budget in the middle of a recession would turn it into a depression.

Once the economy has recovered from the Great Recession, Congress should once again run balanced budgets whenever the economy is prosperous.  Sticking to this fiscally responsible behavior will gradually become more difficult, however, because of the rapid growth in medical care costs and therefore in the bills that must be paid by Medicare and Medicaid.  It would therefore be useful for Congress to pass a statute called “A Normal Unemployment Balanced Budget Rule (NUBAR).”  A NUBAR statute would apply pressure to Congress to balance its budget whenever the economy is prosperous—whenever it has a normal unemployment rate.

Under NUBAR, Congress would be required to enact a planned budget for the coming fiscal year that technicians at the non-partisan Congressional Budget Office (CBO) estimate would be balanced if the economy has a normal unemployment rate.  If Congress won’t comply, then under NUBAR all planned spending programs would be cut X% and all taxes would be increased by the same X% to balance the planned budget.  Under NUBAR, in a recession Congress would be free to enact a large fiscal stimulus package provided it contains a “terminator clause” that would automatically phase out the stimulus as the unemployment rate declines to normal.  A NUBAR statute would pressure Congress to balance the budget in a prosperous economy, but it would not turn a recession into a depression, and it would permit Congress to enact a large fiscal stimulus to combat a recession.

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