Fiscal Policy and Changing Times

To anyone who is familiar with opinions I expressed (in real life) about fiscal policy during the 1980s and 1990s, it may appear that my opinions have changed dramatically, or indeed, that I have completely reversed myself. In particular, anyone who knows what I thought of the Reagan tax cuts (and how harshly a coauthor and I expressed it even 15 years later) will probably be surprised to hear me defending the Bush tax cuts even as Alan Greenspan tries to disown them (not to mention that I spent six posts last year on why I'm not convinced by various arguments for cutting the deficit and one on why the one convincing argument doesn't apply for the immediate future). But I don’t believe my opinions have changed much; what have changed are the economic conditions.

In particular, nominal interest rates have generally been much lower during the new millennium than they were during either of last two decades of the old millennium. (I have a vivid memory of walking through Kenmore Square in Boston in 1992 reading in the Wall Street Journal that traders weren’t willing to buy 10-year treasury notes at a yield below 7%. Today the notes yield 4.6%, and people are surprised how the yield has risen since the Fed meeting.) As I argued in two posts in July, nominal interest rates determine both the harm and the good that can potentially be done by budget deficits. When nominal interest rates are high, deficits are unambiguously harmful. When nominal interest rates are low, deficits may still be mildly harmful, but they can also be helpful and can even become critically necessary when rates fall to near zero.

This all seems to me a fairly straightforward application of textbook macroeconomics: when interest rates are high, budget deficits push them higher and crowd out private investment; when interest rates are low, budget deficits can provide a useful stimulus to keep employment high and avoid deflationary conditions, since monetary policy may not be able to provide a sufficient stimulus. Of course it’s more complicated for an open economy, but the same argument applies to the world as a whole, and the US is a big part of the world economy.