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The Fatal Flaws of a Balanced Budget Amendment

Tuesday, November 8, 2011

A bad idea whose time should never come.

The idea of a Balanced Budget Amendment (BBA) enjoys broad populist appeal and strong support from the field of Republican presidential candidates. Mitt Romney, Rick Perry, and Herman Cain all support it.

But the sentiment for a BBA is by no means unanimous, even among conservatives; many have concluded that it is a bad idea, for several good reasons.

Anyone who currently favors a BBA should take a few minutes to consider two things: (1) the four fatal flaws of a BBA, and (2) a superior alternative to the BBA.

Flaw #1: The BBA is based on a false conception of the "debt burden"

BBA falsely presumes that the proper balance is 0 percent debt and 100 percent equity financing.

The “debt” is not the same as the “debt burden.” Although a deficit increases the debt level, it doesn’t necessarily increase the debt burden. Any given level of debt can be either (a) easily affordable, or (b) financially unbearable. It all depends on the borrower’s ability to service the debt, not on the debt level per se.

For example, the bank loan for a private business jet would instantly crush a median wage-earner; however, it would amount to mere peanuts for George Soros. The debt level would be the same in both cases, but the debt burdens would be completely different.

The same financial principle applies to the federal government’s debt: it gets more affordable the more our economy grows relative to the debt level. If our economy grows faster than the debt grows, our debt burden decreases. Our financial well-being depends far more on growing the economy than it does on reducing the debt.

Flaw #2: The BBA is based on the false premise that extra debt harms future generations

Debt is not automatically harmful. In reality, when government outlays exceed tax receipts in order to enhance national security or boost private sector growth and vitality, the resultant borrowing not only enhances future generations’ safety and prosperity, but can also reduce their debt burden.

The BBA would amend the Constitution to read: ‘Provide for the common defense ... that is, unless it would require borrowing money from anyone.’

To balance its intake with its outlays, the government takes in money in two ways: by collecting taxes and by selling Treasury securities. In effect, it is employing the common practice of financing its outlays by using a mix of debt and equity (to borrow terminology from private-sector finance). Instead of harming the future, a prudent measure of debt financing enhances prosperity, security, and well-being not just for businesses, but also for families, state governments, and local governments. The federal government is no different in that respect; debt financing can improve the future. It has happened in the past—for example, borrowed money enabled the purchase of the Louisiana Territory in 1803, which most historians consider a good investment—and it can happen again, provided that a Balanced Budget Amendment is not standing in the way.

The proper debate is about the mix of debt versus equity financing. For successful families and businesses, zero debt is seldom if ever the answer that optimizes security and prosperity. But the BBA is based on the implied premise that, somehow, the federal government is different; it falsely presumes that the proper balance is 0 percent debt and 100 percent equity financing.

Flaw #3: The BBA gives short-run accounting a higher priority than future security

Equipping the next generation to thwart future military threats, such as cyber warfare or a rogue state’s nuclear missile, requires investing for future security, not just present-day security. But a constitutional ban on borrowing would preclude many such investments by giving today’s accountants veto power over future generations’ defense capabilities.

Would that make future generations better off, or worse off? An imaginary scene from America’s wild west days might help us decide:

Wagon train captain: “Circle the wagons, there’s danger ahead!”

Wagon train CFO: “Sorry, sir, it was illegal to get a loan for the equipment and training we needed for a full circle—so we’ll have to settle for a semicircle.”

In his 1776 book, The Wealth of Nations, Adam Smith made it clear: “limited government” meant that the list of government’s duties was a short one, not necessarily that the government’s budget for fulfilling its duties should be a small one. At the very top of the list was national security. Our Founding Fathers made the same point: providing for the common defense was at the top of their list, too. Carrying out that duty properly requires funding not only for current-year activities, but also for investing in future security.

Will the next generation be better off if we arbitrarily cut another half-trillion dollars out of the defense budget, or whatever additional cuts a BBA would mandate on top of that half trillion? Newt Gingrich hit the nail on the head in the October 18 presidential debate:

Now, the idea that you have a bunch of historically illiterate politicians who have no sophistication about national security trying to make a numerical decision about the size of the defense budget tells you everything you need to know about the bankruptcy of the current elite in this country in both parties. The fact is, we ought to first figure out what threatens us, we ought to figure out what strategies will respond to that. We should figure out what structures we need for those strategies. We should then cost them.

...to put the security of the United States up against some arbitrary budget number is suicidally stupid.

But the BBA would forbid any peacetime borrowing, even for investing in future generations’ security. Paradoxically, it would permit borrowing money to win a hot war in progress, but would forbid borrowing intended to prevent future wars.

In effect, the BBA would amend the Constitution to read: “Provide for the common defense ... that is, unless it would require borrowing money from anyone.”

Flaw #4: It ignores the difference between capital budgets and operating budgets

Instead of harming the future, a prudent measure of debt financing enhances prosperity, security, and well-being not just for businesses, but also for families, state governments, and local governments.

Conventional wisdom tells us that states must balance their budgets; governors running for president are fond of reminding us how many times they did that at the state level. But there’s a big difference between state budgets and the federal government’s “unified” budget: states typically separate their capital budgets from their operating budgets. Although operating budgets must be balanced by current tax receipts, capital budgets are typically funded with the help of bond issues—i.e., by borrowing money. The governors are talking about having balanced their operating budgets.

The federal government’s “unified” budget simply combines the operating budget and the capital budget. It thereby hides the fact that some expenditures are investments for the future (capital investments), not expenses for present operations. But even though federal investments are hidden inside the “unified” budget, the same logic applies: borrowing money for investing in the future is harmless, even desirable.

So this flaw boils down to an inherent contradiction: If it’s commonly accepted practice for states to borrow money for the airports, bridges, dams, and water systems our kids will inherit from us, why on earth would we want to make it illegal for the federal government to borrow money for the satellites, aircraft carriers, Aegis anti-missile cruisers, computer systems, and basic research those same kids would also inherit from us? It just doesn’t make sense.

Good investments improve the future, and borrowing for good investments is sound financial practice. A BBA would impede or preempt good investments, and would thereby create the tragically ironic condition of harming the future generations it was supposedly intended to help.

The superior alternative: a budget focused on security and growth

Carrying out that duty properly requires funding not only for current-year activities, but also for investing in future security.

There’s near-unanimous agreement—going all the way back through the Founding Fathers and Adam Smith—that the federal government's first and foremost responsibility is to provide national security. Gingrich’s point should not be ignored: getting national security wrong just to get somebody’s accounting number right is suicidally stupid. Getting national security right means investing for the future, and as the federal government demonstrated during the Reagan era, investing for the future frequently requires borrowing money—i.e., employing a mix of debt and equity.

Most importantly, underlying everything is a healthy, growing economy. Our ability to tax, to borrow, and to afford the cost of borrowing ultimately depends on the underlying economy. It does not depend on balancing the federal government’s unified budget, but instead on a large, healthy, growing economy driven by the private sector.

Pro-growth conservatives—especially those in either the national security camp or the Chamber of Commerce camp—should reject the idea of a balanced budget amendment. A better alternative is a budget focused on security and growth, funded by a prudent mix of borrowing and taxation.

We’ve done it successfully before; that’s what happened in the Reagan era. We can do it again—but not if a BBA is in the way.

Steve Conover retired recently from a 35-year career in corporate America. He has a BS in engineering, an MBA in finance, and a PhD in political economy.

FURTHER READING: Conover also contributes “How Democrats—and the Tea Party—Get Reagan Wrong” and “The Myth of Middle-Class Stagnation.” John Yoo and Todd Gaziano write “Just Say No to Judicial Enforcement of a Balanced-Budget Amendment.” Norman J. Ornstein discusses “Four Really Dumb Ideas That Should Be Avoided,” and “Why a Balanced-Budget Amendment Is Too Risky.”

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