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By Thomas Oatley

(Click to enlarge)

As threat of a government shut down looms and key players fight over the FY 2012 budget too, one might wonder, "have we have been here before?" We have indeed been here before, at least three times since 1965. The chart above highlights the path of the federal budget deficit as a share of GDP under the Johnson administration, the Reagan administration, and the George W. Bush administration. Each administration presided over a fairly large deterioration of the budget. Each deficit was generated by one of the three largest tax cuts in the American postwar era. Interestingly, tax cuts were followed quickly (within 18 months ) in each instance by a sharp increase in military spending (details and documentation here if you are interested). The combination pushed the budget into deficit.

Also interesting is how long it takes the budget to return to the status quo ante. Johnson and Bush took six years; Reagan took seven. Thus, if history is any guide, one shouldn't expect quick adjustment back to balance now.
Of greater importance is the politics of adjustment. Without exception, delayed fiscal adjustment was not a consequence of the failure to agree that adjustment was necessary. Instead, in each instance, the White House, the Senate, and the House leadership all agreed on the need for fiscal adjustment. However, they disagreed about how to adjust. One wanted to adjust by raising taxes and/or cutting military spending; one wanted to keep tax rates and military spending stable and cut non-discretionary spending. The resulting war of attrition delayed adjustment.

One might suggest that current events are the contemporary manifestation of a recurring pattern in postwar American politics. We cut taxes, we increase military spending, and then we fight about how to get back toward balance. Eventually, we get back to balance. And then we repeat the process again.

The most worrying element in all of this is consideration of the factors that ultimately spark agreement. In two of the three prior episodes, rather major episodes of financial instability sparked agreement on adjustment. A gold crisis in early 1968 (Time magazine called the crisis "the Greatest Gold Rush in History") broke the deadlock between the Johnson administration and Wilbur Mills. Black Monday of October 1987 (the single largest one-day "correction" in history) broke the deadlock between the Reagan administration and Congress.

Let's hope that this time the players reach agreement before they trigger a major sell off.

Source: Budget Politics: Reaching Agreement Before Triggering a Major Sell-Off