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False analogy
Take no comfort in the history of World War II deficits.

Wednesday, October 21, 2009

THE FINAL White House estimate for the fiscal 2009 budget deficit is in: $1.4 trillion, or 10 percent of gross domestic product. To mark the occasion, Federal Reserve Chairman Ben S. Bernanke called for "a sustainable fiscal trajectory, anchored by a clear commitment to substantially reduce federal deficits over time." President Obama's budget director, Peter Orszag, promised that very thing: "As part of [next year's] budget policy process, we are considering proposals to put our country back on firm fiscal footing," he said.

Recently, pundits who favor additional stimulus spending have been pooh-poohing the whole trillion-dollar deficit thing, arguing that the real worry is double-digit unemployment and citing a historical argument: The last time the United States ran deficits of this magnitude, World War II, the nation coped and prospered.

But today's deficits, though smaller as a percentage of gross domestic product than the post-World War II deficits that the U.S. economy ultimately weathered, may be more difficult to unwind. Defense spending was the sole cause of the World War II deficits; it totaled 90 percent of federal outlays in 1945. At war's end, the United States demobilized, moving from a deficit of 22 percent of GDP in 1945 to a surplus of 1.2 percent of GDP in 1947 -- a swing of nearly one-quarter of GDP in just two years. By contrast, as data compiled by Michael Cembalest of J.P. Morgan show, today's federal spending is driven by mandatory programs: In 2016, entitlements and interest will make up 69 percent of the budget (with defense accounting for 18 percent). These are not only hard to cut quickly; they also have a way of growing unexpectedly. Crushing the Axis powers might seem like a cakewalk next to taking on the lobbies that defend Medicare, Medicaid, farm subsidies, Social Security and the rest.

Here's another difference: The government met its World War II borrowing needs out of U.S. domestic resources, including the sale of $185 billion in low-interest war bonds. The soothing Keynesian adage on deficits -- "we owe it to ourselves" -- applied. In the three years just after World War II, the United States eliminated a lot of its debt through high inflation, which peaked at 14.4 percent in 1947 -- but all the repercussions were domestic. Today, foreigners hold nearly half the $7.5 trillion U.S. public debt. As a result, the politics of deficit reduction are not only extremely difficult, they are extremely difficult and international. Inflation could trigger a global run on the dollar and a nasty interest rate spike. In the deficit debates to come, Mr. Obama should heed the hawks.

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