Keynesian Fiscal Policy

A conventional “Keynesian” view of fiscal policy holds that the government should run deficits when the economy is weak and surpluses when the economy is strong. Some commentators suggest (as Andrew Samwick does here; hat tip: Brad DeLong) that the budget should be balanced over the business cycle, with no net accumulation of debt. I consider myself a Keynesian, but I think this conventional view is consistent neither with that of Keynes himself nor with what we have learned in the subsequent years.

My alternative view, which I submit for Lord Keynes’ posthumous approval, is that fiscal policy should depend on nominal interest rates. When interest rates are high, for example, it makes no sense to run deficits no matter how weak the economy is. When interest rates are high, the central bank has the option of stimulating the economy by creating more money and pushing interest rates down. If it isn’t doing so already (which, by assumption, it isn’t; otherwise interest rates wouldn’t be high), either the central bankers aren’t very smart (in which case why should we expect the fiscal authorities to be any smarter?) or else they are deliberately keeping the economy weak for some reason. In the latter case, they can be expected to react to any anticipated fiscal stimulus by tightening monetary policy and raising interest rates even further. Indeed, this is just what the Fed did in response the Kemp-Roth tax cut in 1981. I would have recommended running a surplus instead of a deficit under those conditions, even in the depths of the 1982 recession. A fiscal surplus would have minimized the damage done by the tight money policy, and, my guess is, it would not have slowed the recovery materially, because the weak demand would have brought inflation down more quickly, and consequently the Fed would have loosened more quickly.

Now consider an example where interest rates are low. In this case the central bank has the option of slowing down the economy by tightening the money supply and pushing interest rates up, but it may not have the option of stimulating the economy by creating more money and pushing interest rates down. If interest rates are already low, there isn’t much room to push interest rates down, and the stimulus that can be accomplished by this process may be inadequate. And the business cycle is not very predictable. Therefore, even if the economy appears to be growing adequately today, there is no guarantee that it will be doing so tomorrow. In times of low interest rates, fiscal policy should plan for the possibility of a recession by running a deficit, even if economists don’t see a recession as a strong possibility (which, after all, they seldom do, but somehow recessions happen anyway). As long as the central bank isn’t worried about a recession, it can use monetary policy to prevent the economy from overheating, but if it does begin to foresee weakness, it will have room for a stimulus, since the budget deficit will have prevented interest rates from getting too low.

You might object, “What if interest rates stay low and the government keeps borrowing money? We don’t want to pass on these debts to our children (at least Andrew Samwick doesn’t).” My answer – and I think Keynes would have agreed – is, “So what?” For one thing, if interest rates are low, the cost of running a deficit is low. In fact, it can be argued that there is no cost to running a deficit when the interest rate is lower than the growth rate, because the revenue available to pay back the debt will be greater (relative to what needs to be paid) than the revenue available to avoid a deficit in the first place. My own belief is that marginal return on government investment will be sufficient to justify spending levels under these circumstances, but even if it isn’t, the harm done is not great. The harm done by not running sufficient deficits could be quite substantial. And recalling historical periods when interest rates remained low and the government continued borrowing money – the 1930s-1940s in the US and the 1990s-2000s in Japan – I don’t think they regretted the borrowing, and I think most economists would say they didn’t borrow enough.

Plus, I have a more fundamental objection to the idea that passing on debts to our children is unfair. Those who have read my blog from the beginning will feel a sense of déjà vu here, but: Is it unfair to bequeath your children a house with a mortgage? I don’t think so. And I expect there will always be a “house” to go along with the “mortgage” our government leaves to future generations of Americans. In the past it has almost always been the case (across times and places) that each generation left more net economic wealth to the following generation than it had received from the previous one. And in those rare situations where this wasn’t the case, it wasn’t because the generation in question had borrowed too much. My guess is it will continue to be the case in America’s future. If our generation does fail subsequent generations, it will perhaps be because we didn’t spend enough on finding solutions to global warming (or other problems that may plague future generations); it won’t be because we borrowed money to pay for those solutions.