Is Our Deficit Too Big?

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next year, the difference between what the government spends and what it collects in taxes will exceed $450 billion, thanks to two years of tax cuts, hikes in defense spending and a falloff in tax revenue. The ballooning deficit has sparked a fierce debate among economists. Deficit hawks argue that, like credit-card balances, deficits may not hurt much in the short run but will eventually wreak havoc. In the worst-case scenario, the government keeps borrowing to finance itself, and interest rates rise. That retards growth by making mortgages, car loans and corporate investment more expensive. The Bush Administration argues that by returning tax revenue to families and businesses, the deficit is fueling the economic engine, which as it revs up will start to create jobs. Which scenario is more likely?

TIME'S JYOTI THOTTAM asked our Board of Economists to sort it out. The panel includes Lakshman Achuthan, managing director of the Economic Cycle Research Institute; Gary Burtless, senior fellow at the Brookings Institution; Veronique de Rugy, fiscal-policy analyst at Cato Institute; Edward McKelvey, senior economist at Goldman Sachs; and David Wyss, chief economist at Standard & Poor's.

TIME: Are we more likely to see the deficit's effects in the short term or the long run?

EDWARD MCKELVEY: We'll see different effects. Right now we're seeing the effects of the tax cuts in the strength of consumer spending and maybe even some of the business spending. But as time progresses, if we continue to have the sort of deficit that we anticipate, hovering in the neighborhood of 4% of GDP over the next decade, then the effects will turn negative. They will come through in interest rates that are higher than they otherwise would be, and therefore growth will probably be less than it would otherwise be.

VERONIQUE DE RUGY: This deficit does matter because it shows that the government is spending too much. I think interest rates are very likely to go up, but it's going to be minor.

LAKSHMAN ACHUTHAN: It's very much a question of timing. Essentially, a weak economy trumps a deficit. Now, if we have an economy growing, it could put some wind at the back of interest rates and pose some hurdles for economic growth.

GARY BURTLESS: The short-term stimulus has undoubtedly helped reduce the severity of the recession, and it has helped buoy consumer spending. I would have to agree with Ed, though, that after three or four years, we're going to see a slowdown in the rate of growth.

DAVID WYSS: In the short term, we're at a 45-year low in interest rates — that's no reason to worry. Second, you have the lowest inflation rate we've seen since the Beatles were on the Ed Sullivan Show, which only a few of us here remember.

MCKELVEY: I remember.

WYSS: That's 1964, for the rest of you. But in the long run, we're going to have an issue. After 2010, when us baby boomers start to retire, that number is going to soar.

ACHUTHAN: So it's not that deficits don't matter — it's that sometimes they're at the front of the line and sometimes behind other concerns. Right now it's jobs.

TIME: I'm a little bit surprised that there is consensus about the tax cuts. Do you all agree that they were a good policy?

WYSS: Generally, I think the policy was correct. Deficits do work. The best advice that was ever given to a politician was what Joseph told the Pharaoh — you store up the grain in the good years, and you use it in the bad years. But they are taking only half that advice this time.

ACHUTHAN: There has obviously been some impact from the stimulus. But I don't know that it's had the desired effect. We have this jobless recovery, and this is not normal. You're losing jobs as the overall output is growing, in a way you've never seen before. So let's say you give tax cuts for capital investment. What is the result? You have a little bit of capital investment that increases productivity. That means that you don't have to hire someone.

MCKELVEY: The question is, How much can you use the budget, through spending or tax cuts, to stimulate the economy now? Then how do you peel back that stimulus when the economy's got momentum?

DE RUGY: You're saying we're spending a lot of money today, but in fact the cost of the tax cut is 25% of the deficit.

TIME: So there's room for more tax cuts?

DE RUGY: No, there's just no more room for spending.

ACHUTHAN: It's not that you're not getting something for your money. You're getting growth. It's going to go to 4% and 5% in the next couple of quarters. The problem is, it's not translating into the job growth you typically see. If you're a business, you take the tax incentive to invest in productivity-enhancing equipment, and you take the opportunity to move some labor costs abroad.

BURTLESS: Whether the tax cuts were well structured depends crucially on your view of the sunset provisions. The way the tax law is written, many of the cuts come to an end, but suppose they were made permanent. If you look ahead 40 years, taking into account the growth in Medicare, Social Security, Medicaid, we have the deficit at 4% of GDP. About 60% of that is due to the tax reductions of the first three years of this Administration.