Government Surplus Wasn’t the Problem; It’s the How That Matters

In his daily flurry of tweets, WPRI reporter Ted Nesi linked to an interesting article by Joe Weisenthal in Business Insider. Weisenthal’s conclusion is that the government surpluses of President Bill Clinton’s second term were, themselves, the cause of the late ’00s’ economic bust:

The bottom line is that the signature achievement of the Clinton years (the surplus) turns out to have been a deep negative. For this drag on GDP was being counterbalanced by low household savings, high household debt, and the real revving up of the Fannie and Freddie debt boom that had a major hand in fueling the boom that ultimately led to the downfall of the economy. …

So while Clinton will be remembered nostalgically tonight, for both the performance of the economy and his government finances, they shouldn’t be remembered fondly.

As if for authority, Weisenthal prints a PNG image of an economic formula (in a special formula font, even), but then he and his economist sources proceed to assert causation where there was only a temporary correlation in the parts of the equation during the Clinton era.

The equation is GDP = C + I + G + (X – M).  Put in ordinary terms to match my ordinary typeface, that’s essentially a definition of gross domestic product: It’s the sum of private consumption, investment spending, government spending, and the trade surplus/deficit.  It’s important to note, here, that investment spending is not the stock market or other such “investments”; rather, it means investment spending on productive goods and services, like a business’s buying property.  And it’s interesting (but not essential) to note that Weisenthal proceeds never to mention “I” again.

The summary of the first part of Weisenthal’s economist-approved analysis is that the government surpluses pulled money out of the economy, while the trade deficit expanded, leaving only consumer spending (and investment) to keep GDP growing.  To bolster their variable in the equation, households stopped saving and took on more debt.  This debt grew until it could grow no more, and the bubble popped.

The problem is that this analysis requires two improper assumptions:

  • That GDP is destined to increase at a particular rate during a particular period, and all of the other variables have to reach equilibrium.
  • That people respond to that economic imperative like formulaic automatons.

Neither assumption is accurate.  Government surpluses could suck money out of the economy even as the trade deficit drifts out to sea, and consumer spending could still stagnate.  All of this can happen simultaneously and be the cause of preventing GDP from growing.

This is possible because of the second bullet point.  Households don’t increase their spending because the government is taking in more in tax revenue than it’s spending, and they don’t decide to go into debt in order to compensate for a trade deficit.

As I’ve suggested, the equation is a definition of GDP, not a mathematical representation of a force of nature.  There is no Law of Conservation of National Product.  It is more likely, therefore, that the government surpluses were a symptom of something else in the economy, and that is what laid the seeds of our destruction. The dough was flowing into GDP from somewhere else, and it filled the government’s pantry more quickly than the government could dish it out.

As it happens, the actual “that” is the very thing that Weisenthal is writing to refute.  As Charlie Gasparino explains, President Clinton (in broad bipartisan company, to be sure) pushed risky mortgage lending, implicitly backed by the government via Fannie Mae and Freddie Mac, and cut loose the restraints on investment regulations (as well as cutting capital gains taxes).

The evidence that Weisenthal marshals to turn this thesis toward his preferred conclusion actually strengthens the case for the former (emphasis in original):

Bond trader Kevin Ferry, a veteran of the scene, told Business Insider about the panic that was unfolding over the government’s lack of debt.

“OMG, they were all saying… there wasn’t going to be any paper!”

How did the markets react?

“Lo and behold… [Fannie and Freddie] issuance “SURGED” in the late 90s,” said Ferry.

Everything changed. While the government dramatically slowed down issuance of Treasuries, Fannie and Freddie picked up the baton and started selling debt like never before.

“Prior to those years there were not regular [Fannie and Freddie] auctions.”

“The system wanted it.”

“The fear was that there wasn’t going to be any…. There was no bill auctions.”

“The brokers were calling up ma & pa and said there’s no more T-Bill auctions!”

In other words, Clinton administration policies created an influx of fake money from the future (loans that poorer people would never pay off) and made it easier to gamble on investments. Meanwhile, the government-sponsored enterprises (GSEs) handling mortgages began packaging them up as riskier-than-they-seemed securities to sell as sure-bets akin to government bonds.

It wasn’t that the market had some preternatural need for a bond-like replacement, but that the government had created incentive and cover to create one, and people looking to profit grabbed for the opportunity.  Again, that wasn’t a force of nature any more than a desire for profit ever is.

If there was a sin to the surplus per se, it was that the capital gains tax cut of the late ’90s wasn’t matched with reverses of the productivity-sapping tax increases of the early ’90s, on personal income, payroll, gas, Social Security, and corporate income.  Dispersing government surpluses in those areas wouldn’t have prevented the bust, but it might have expanded the productive economy and ultimately increased people’s ability to pay off their risky mortgages, although some of it might have gone to inflation.

In some ways, the story of the Clinton Years is very simple, and in some ways it’s very intricate.  Now that some of its long-term fruit has been borne, though, Americans should be leery of letting the complexity be distorted to support faulty conclusions.