A n important debate over fiscal policy is beginning to take place within the Democratic Party. For the past 15 years, deficit hawks within the party have argued that addressing America’s fiscal challenges should take priority over our public investment needs, suggesting that, in effect, we cannot afford to increase public investment until we have reduced the federal deficit.

But there is an alternate view, holding that the deficit hawk position neither accurately reflects America’s true economic strength nor represents good policy in light of the very significant changes that have occurred in the economy over the past decade and a half. In fact, the nature of the American economy today is radically different than it was in the early 1990s, when the current notion of fiscal responsibility took shape. Over the past decade and a half, the economy has become more globalized, knowledge-based, and wealth-driven. Behind this transformation have been major structural developments in the world economy, most notably the increased integration of the world’s financial markets; the dramatic improvement in productivity growth associated with the information-technology revolution; and the expanded supply of labor, savings, and productive capacity that has resulted from the integration of China, India, and the former Soviet Union. Together, these developments allow the American economy to grow more rapidly with lower wage and goods inflation than was possible in the supply-constrained, slower-growth period of the early 1990s.

Deficit hawks seem not to have fully incorporated these changes into their understanding of the U.S. economy, nor have they changed the way they measure the economy’s output to reflect the increased importance and value of wealth and intangibles. As a result, they underestimate the capacity of the economy. Misjudging the economy’s potential, much like misunderstanding the economy’s challenges, can lead not only to bad policy choices but also to missed opportunities for policy reforms that would help ensure future economic prosperity. This is the case today when it comes to the question of public investment in our physical and innovation infrastructure.

Contrary to the opinion of the deficit hawks, the United States can comfortably afford a robust public-investment program without first reducing the deficit. Indeed, given excess global savings and historically low interest rates, increased spending on productive public investment is a fiscally responsible and effective way to put excess global savings to work to ensure future economic prosperity. It is also a proven way to stimulate private investment and job creation and, at the same time, distribute more widely the capital and skills for wealth creation, thus achieving a fairer and more balanced society with higher living standards for all Americans.

New Economic Realities

The current conventional wisdom within the Democratic Party regarding deficit reduction is an outgrowth of the successful experience of the Clinton Administration. Faced with congressional opposition to its initial fiscal package, which included some added public investment spending, the Clinton White House opted for measures that would reduce the budget deficit in a bid to gain the cooperation of Federal Reserve Chairman Alan Greenspan to lower interest rates. No doubt the Clinton years produced outstanding results in terms of job creation, economic growth, and business investment. But how much the Administration’s measures to cut the deficit contributed to this economic performance is open to debate. Arguably, structural changes in the economy–such as improving productivity associated with the information revolution and the coming online of massive new production capacity in Asia–were more significant to the economy’s performance than were any of the Administration’s budget measures.

But even if one accepts that the budget deficit was a problem in the early 1990s and needed to be addressed, it does not follow that putting deficit reduction ahead of public investment is the correct policy today. Economic conditions are far different than they were in 1993, and what was appropriate 15 years ago is wholly inappropriate for 2008.

Deficit Reduction Is Less Important in Today’s Economy
To start, the federal government has much more room to run deficits than it did 15 years ago, when the budget deficit stood at 4.7 percent of gross domestic product (GDP). By comparison, the 2006 budget deficit of 1.9 percent of GDP is relatively small, and it is projected to decline further to about 1.5 percent of GDP this year. Even with President Bush’s tax cuts and the escalating cost of the war in Iraq, the deficit is below America’s norm of 2.2 percent of GDP over the last 40 years. Likewise, the federal debt held by the public is below its average for the 20-year period since 1987 and lower than it was in 1993. Gross federal debt in 1993 was 49.4 percent of GDP; by 2006, it had fallen to 36.8 percent.

The current budget deficit and federal debt would be even lower if we properly accounted for national income and the increased importance of wealth and intangibles in today’s economy. Business investment in intangibles, such as research and development, are critical to long-term profitability, but most economists don’t count them as national output. Yet, according to an estimate by BusinessWeek’s Michael Mandel, spending on unmeasured intangibles is almost as large as spending on physical capital and software. For the period 2000 to 2003, the annual average of investment in intangibles was $978 billion, or almost 10 percent of GDP. In other words, if we properly accounted for intangibles, national output would be nearly 10 percent larger, and the budget deficit and federal debt would be proportionately smaller as a percentage of GDP.

The same problem of measurement affects how we view America’s current account deficit. At first glance, the U.S. current account deficit, now running at 6.5 percent of GDP, may seem worrying. But as it is currently calculated, this measurement understates America’s financial position. For one thing, it misses a big portion of the export of know-how and intellectual property that enable U.S. multinationals to reap high returns on their overseas investments and operations. Mandel estimates these hidden exports may be as high as $100 billion a year. Harvard economists Ricardo Hausmann and Federico Sturzenegger argue that they are even larger–large enough, in fact, to bring the U.S. trade deficit in balance. This argument gains further support from the fact that the United States has, until this past year, continued to enjoy net investment income in spite of its external debt.

Nor does the current account reflect the fact that a sizeable portion of U.S. imports are the products of American-owned and -controlled companies that operate worldwide. If those imports were accounted for in the trade figures, the U.S. current account would, again, be much smaller. The McKinsey Global Institute, for example, has calculated that trade with foreign affiliates accounted for one-third of the U.S. current account deficit in 2004. As it is, that unaccounted-for production generates well-paid jobs in U.S. corporate headquarters and shows up as increased profits, and thus as increased wealth. In other words, the current account deficit is less a reflection of a fatal weakness in America’s financial position than it is of the fact that American-owned and -operated companies have expanded abroad more quickly than foreign companies have expanded in the United States. It may affect who is benefiting from the new global economy, but it does not portend a major financial crisis.

A second reason to worry less about the budget deficit is that the economy’s capacity to borrow has increased significantly, largely due to improved productivity growth. In the 1980s, productivity growth was a dismal 1.46 percent. But over the past decade and a half, technological advancements and communications innovations, along with efficiency revolutions in finance and materials, have substantially accelerated U.S. and world productivity expansion: U.S. productivity growth has jumped from an average of 1.53 percent for the period between 1973 and 1995 to 2.7 percent for the period from 1996 to 2006. World productivity has shown a similarly impressive increase, and this has helped tame inflation worldwide and increase the wealth and profitability of American companies operating globally.

Stronger productivity growth means stronger economic growth and lower inflation, which in turn makes it easier to run deficits yet still reduce the overall public debt burden. As long as the economy is growing faster than the budget deficit, as it has in the last two years, the federal debt as a percentage of GDP will decline. Thus, stronger productivity growth has helped give the federal government room to run deficits to increase public investment and, if necessary, to counter an economic slowdown. (To be sure, productivity growth has slowed in the last three quarters, but some economists attribute this to a mid-cycle slowdown and expect it to pick up again as capital expenditures and economic growth increase.) Moreover, there are a number of reasons to expect further productivity gains from information technology as it diffuses more thoroughly throughout the economy, as workers gain greater competence in using it, as its cost continues to decline, and as its weight in the economy as a whole increases.