The Deficit is Good
I’ve said this before, but perhaps not in such bald terms. You can reasonably complain about the composition of expenditures or the composition of revenues under the fiscal policies of the last 7 years. But if you think the existence of a deficit – I mean a large deficit – has been a bad thing, you are just wrong. Back in 2006, I went into a lot of theoretical reasons why the deficit might be a good thing. But in the light of the housing crisis, it has become clear to me that there is a very simple reason why the deficit really has been a good thing: we have needed a fiscal stimulus this whole time (except maybe for, hmm, say February and March of 2006).
In fact we needed a much larger fiscal stimulus than what we had. Because we only had a relatively small fiscal stimulus, we had to rely on monetary policy to keep the economy going. That’s why we had a housing boom, and that’s why we are having a housing crash. Now I’ll grant you that policies such as better regulation could have reduced the severity of the boom and the subsequent crash. But that would have meant less aggregate demand arising from the housing sector (from the construction industry, mortgage equity withdrawal, etc.). And that would have meant a weaker economy. And as Paul Krugman suggests here, an economy with 63% of the population working was already nothing to write home about.
So…I’m not sure what to think about all the craziness that has been going on in the housing market. I’m not going to condone fraudulent mortgage originations or to say that it was a good thing that the bond rating agencies based their ratings on unreasonable assumptions. But all that was barely enough to keep our heads above water. I’m damn glad we’ve been running “large” budget deficits for the past 7 years. I’m glad Alan Greenspan made a ridiculous argument in 2001 about how terrible it would be to run out of Treasury bonds. It was the wrong argument, but the right conclusion.
I’m not glad about all the people that have died or been maimed in Iraq. Some things are clearly worse than a weak economy and a volatile housing market. But if the Iraq war hadn’t happened, I hope we would have found some other excuse to spend the money.
In fact we needed a much larger fiscal stimulus than what we had. Because we only had a relatively small fiscal stimulus, we had to rely on monetary policy to keep the economy going. That’s why we had a housing boom, and that’s why we are having a housing crash. Now I’ll grant you that policies such as better regulation could have reduced the severity of the boom and the subsequent crash. But that would have meant less aggregate demand arising from the housing sector (from the construction industry, mortgage equity withdrawal, etc.). And that would have meant a weaker economy. And as Paul Krugman suggests here, an economy with 63% of the population working was already nothing to write home about.
So…I’m not sure what to think about all the craziness that has been going on in the housing market. I’m not going to condone fraudulent mortgage originations or to say that it was a good thing that the bond rating agencies based their ratings on unreasonable assumptions. But all that was barely enough to keep our heads above water. I’m damn glad we’ve been running “large” budget deficits for the past 7 years. I’m glad Alan Greenspan made a ridiculous argument in 2001 about how terrible it would be to run out of Treasury bonds. It was the wrong argument, but the right conclusion.
I’m not glad about all the people that have died or been maimed in Iraq. Some things are clearly worse than a weak economy and a volatile housing market. But if the Iraq war hadn’t happened, I hope we would have found some other excuse to spend the money.
Labels: budget deficit, Bush, economics, government spending, housing, macroeconomics, taxes
posted by knzn at 1/22/2008 03:46:00 AM
16 Comments:
You are being cynical right?
Not particularly cynical, just Keynesian. People don't seem to remember that the classic successful (if accidental) Keynesian stimulus (World War II) involved a much larger taking on of governemnt debt, relative to the size of the economy, than anything we contemplate today. Back in the 80s and 90s, when interest rates were higher, it was reasonable to talk about monetary policy as the preferred exclusive type of stimulus. I don't think it is any more today. The international savings glut -- or whatever it is that brought us the conditions of the current decade -- called for a fiscal stimulus. What we got was not ideal, but it was better than nothing.
knzn,
Keynesian economics, if we say, arguendo, that it has a great deal of merit, only works when practiced in a balanced way -- meaning that we pay down debt during economic expansions -- and when a nation is not already in a deep hole in terms of projected long-term fiscal imbalance. Neither applies to the U.S., which means that in practice, it only exacerbates the enormous long-term fiscal imbalance that will most likely destroy our economy in a couple of decades unless we get started soon paying down debt or at least ceasing to run big annual deficits.
It took us 30 years to pay down (part of) the debt from World War II. Yet it's hard not to think in retrospect that the stimulus (if not the particular form that it took) was a good thing. That enormous fiscal imbalance didn't destroy our economy; it saved our economy.
It's true that, when interest rates are high, a fiscal stimulus over a long time frame is unsustainable, but interest rates have been low for most of the current business cycle, and forward rates are low into the distant future. I don't see how, under these circumstances, a fiscal imbalance of the size we have now would "destroy our economy in a couple of decades".
It's also true that, if we project Medicare into the future, it looks like we will end up with truly huge deficits that would be impossible to sustain even with the accommodating capital markets we have today. Medicare does have to be fixed somehow, but that's a problem about the future, not about the last 7 years.
There are more specific arguments that I've made about the deficit, which I wont try to repeat, but you can see them by clicking on the "budget deficit" label at the bottom of the main post. See particularly the bottom entries, from July and August 2006.
See also in particular this post in which I argue against the idea of balancing the budget over the business cycle.
Re: "It's also true that, if we project Medicare into the future, it looks like we will end up with truly huge deficits that would be impossible to sustain even with the accommodating capital markets we have today. Medicare does have to be fixed somehow, but that's a problem about the future, not about the last 7 years."
I don't see how you can just shove that aside as tomorrow's problem. I presume you are familiar with the magnitude of our projected long-term fiscal imbalance under current policies. And that the longer we wait to reduce the imbalance, the greater the ultimate pain will be.
Your logic seems to be "Yes, under current policies "we will end up with truly huge deficits that would be impossible to sustain", but no, it won't "destroy our economy in a couple of decades" because Medicare will be "fixed somehow, but that's a problem about the future", so let's not worry about deficits for now. I don't see how that thinking represents a responsible approach to fiscal policy. Perhaps you've thought it through much further than that.
I do think we have to fix the long-term path of fiscal policy, to prevent it from becoming explosive, but I think that's a separate question from evaluating the deficits we have actually run during the past few years and will run during the next few years. The long-term problem relates specifically to Medicare, and the appropriate fix doesn't necessarily imply that we would have smaller deficits over, say, the next decade. We should start addressing the long-term problem as soon as possible, but running smaller deficits today is probably not the right way to do so. In fact the best solution probably involves transitional costs that will raise the deficit in the short run. So I don't think we should worry about the next 10 years' deficits. We should make changes to reduce the projected deficits that come 30 or 40 years in the future.
Maybe the sticking point is the phrase "a couple of decades." Given a sufficient number of decades (more than a couple, in my terminology, anyhow) the fiscal policies implied by current law will "destroy our economy." But that is not because the deficits are too high today, or in the recent past, or in the near future; it's because current law includes some programs (one in particuar) that promise to become much more expensive in the long time-frame. And trying to balance today's budget is not going to help.
Partly the issue is first-best vs. second-best. I'm pretty convinced that the first-best path of fiscal policy would involve deficits over the past few years and the next few years that would be even larger than what we have already experienced. I'm open to arguments about the second-best, though, given the political constraints that may exist on future fiscal policy. This is probably worth a new post, but it may be a few days before I get to it.
I think that first-best -- for our long-term well-being* -- would be to start reducing deficits immediately, with the possible exception of the the coming several months. I assume we can agree that higher deficits over the next decade would add to the projected long-term (i.e., through 2040 and beyond)fiscal imbalance (annual deficits as a % of GDP). So the quesiton is, why would we want to dig ourselves even deeper into a hole?
Whatever "fix" we come up with for Medicare and more broadly for our long-term fiscal imbalance (and let's not forget that ANY spending contributes to that imbalance so ANY spending can, should and will be looked at to reduce that imbalance, along with tax increases) will involve major sacrifices -- reduced entitlement eligibility and/or benefits, lower discretionary spending (Defense, Education, etc.), and/or higher taxes (which are not only sacrifices themselves, but can also inhibit the golden goose who lays the eggs that pay for all this stuff).
However long we wait to mitigate the imbalance, and indeed the longer and the more we WORSEN it, the problem -- and the severity of the ultimately necessary sacrifices -- grows, due to the demographic/actuarial trends and to higher interest expense.
All of the above means that the sooner we start getting deficits down the better. Heck, we should be running surpluses now, and should have been over the past decade or so, in anticipation of the retirement of the baby boomers.
Check out:
http://youtube.com/watch?v=OS2fI2p9iVs
http://www.concordcoalition.org/events/fiscal-wake-up/fiscal-wake-up-call.htm
http://www.cbo.gov/ftpdocs/88xx/doc8877/12-13-LTBO.pdf
* I realize that there is obviously a trade-off between short term benefit and long-term cost (harm), but I mean on balance. Also, I realize there is an inter-generational aspect of this, and some would experience a net benefit even over the course of their lives while others (some future taxpayers) will be particularly screwed, but here, too, I'm saying "on balance".
I think if we had been running surpluses for the past decade, either the world would be in a depression or the US would have had a housing boom that would make the one we have actually had look small.
I guess I believe in something like a "Keynesian Laffer curve" -- except that unlike the supply-side Laffer curve it works better with spending than with taxes: you raise spending, and it ultimately reduces the deficit by increasing revenues. Everyone tries to adjust the deficit for the business cycle, but I think the business cycle (which, as I argued in the link above, is not really a cycle) is where the real action is.
Re: "I guess I believe in something like a "Keynesian Laffer curve" -- except that unlike the supply-side Laffer curve it works better with spending than with taxes: you raise spending, and it ultimately reduces the deficit by increasing revenues."
Are you serious or kidding? I'm not being snarky; I really don't know because I find that a very strange comment. Heck, if it were true Washington could just borrow a lot more and spend a lot more on an ongoing basis and our deficits would turn into perpetual surpluses. If you're serious, your argument seems as implausible as the extreme supply sider argument (a perversion of the Laffer Curve) that cutting taxes on individual labor and/or investment income from current rates would generate higher revenues and reduce the deficit.
No, if we raised total Federal Government spending (let's say evenly across the board) from where it's projected to be under current policies and maintained that incrementally higher spending year after year, it would NOT result in lower deficits over the long term. If you are contending otherwise, does anyone else that you know of contend such a thing?
You describe the extreme supply-side argument as a perversion of the Laffer curve, and you pervert my Keynesian Laffer curve in the same way. Obviously the "more spending reduces the deficit" process only works when you're below full employment (and interest rates are sufficiently low), just as the supply-side "lower taxes reduce the deficit" process only works when you're beyond the peak of the Laffer curve.
I think, just like the original Laffer curve, my Keynesian Laffer curve is something that, in the abstract, one cannot reasonably deny. The issue is what the parameters are relative to where the economy is at an actual point in time. I think that, over the past 6 years, the US has mostly been in the region where increased spending (and/or reduced taxes) would reduce the deficit (and you might notice that the deficit has actually been going down since 2003, when the Iraq war and the second Bush tax cut began). And if that's the case, then the high-spending, low-tax policies of the past few years have not (provided those policies are terminated at some point when they are no longer useful) contributed to the difficulties projected for the future.
Obviously if we keep increasing spending and/or cutting taxes, we will eventually get to a point where we are at full employment or where interest rates are too high, and then we're back "on the left side of the [Keynesian] Laffer curve." Obviously if spending and taxes evolve as currently projected, we will get to that point eventually. I just don't think we can assume that we are already there or that we have been there for most of the last few years.
Frankly, it sounds like your are imagining a sort of perpetual motion machine, or perhaps a better analogy is to a Steorn-like machine that essentially creates something from nothing. A policy of ongoing higher government spending (financed by higher taxation sooner or later) vs. current levels of spending (not to try to manage economic cycles, but permanently and for its own sake, until we hit some employment targets you suggest) to improve GDP over the long term could only work if government could allocate and utilize such funds more productively than the private sector. If that's your premise, fine, but it's one I don't accept, and I think most economists (of which I'm not one) would not accept it either.
"...could only work if government could allocate and utilize such funds more productively than the private sector..."
The point is that the private sector won't be utilizing all the available resources anyhow. Either the government utilizes (some of) the slack resources (and the rest are mobilized by the private sector via the multiplier effect), or they go to waste. In that sense the government could utilize them more productively, since working for the government is more productive than standing on an unemployment line.
You could say that the purpose is "to manage economic cycles" provided that you will allow a cycle to be defined as something that can last for a matter of decades (as surely was the case with the cycle that began in 1929). But since business cycles aren't really predictable, there is no way to know when you need to loosen policy and when you need to tighten, except to look at something like employment, or, as I would suggest, to look at interest rates.
It's an oversimplification to say that the spending has to be "financed by higher taxation sooner or later". The extent to which taxes need to be raised eventually is a function of the interest rate and the growth rate. If the interest rate is consistently lower than the growth rate, then the ratio of government dept to GDP tends toward zero in the long run, and taxes may never need to be raised to pay for the spending.
Re: "It's an oversimplification to say that the spending has to be "financed by higher taxation sooner or later". The extent to which taxes need to be raised eventually is a function of the interest rate and the growth rate."
You're misunderstanding. You are confusing "raising" taxes (which I wasn't saying) with "higher" taxes, ceteris paribus (higher than they would have been otherwise, which is what I WAS saying).
Re: "The point is that the private sector won't be utilizing all the available resources anyhow. Either the government utilizes (some of) the slack resources (and the rest are mobilized by the private sector via the multiplier effect), or they go to waste. In that sense the government could utilize them more productively, since working for the government is more productive than standing on an unemployment line."
Well, as I've established above with my clarification regarding taxation levels, more government spending ultimately means higher taxation vs. the level of taxation we'd have otherwise, unless you are saying that the extra government spending is so productive that it is self-financing (revenue-neutral) over the long term, which is a premise of which I'd be skeptical if we're talking about raising spending from where we are today. So basically your idea means taking more money from taxpayers to hire people to do things at whatever wages that the market (essentially those same taxpayers, but in the form of consumers and investors) did not value enough to hire them to do. I don't see that as a formula for improving the aggregate standard of living, only a means for wealth transfer.
note: By revenue-neutral, I didn't mean nominally or even just in real terms, but really neutral in terms of impact on debt-to-GDP.
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