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.

Note to Congressional Democrats

(This means you, Senators Edwards and Clinton.)

If Congress passes a stimulus package full of new programs and all sorts of bells and whistles and tinsel and lights and stars and angels and golden balls with glitter on them, one that President Bush is almost certain to veto, and one that he, given his ideological preferences, could very easily justify vetoing, and indeed would have a hard time justifying singing signing, then it will be your fault, not his fault, if the recession turns out more severe than expected. I will hold you responsible. I suspect that voters will hold you responsible too.

If, on the other hand, Congress passes a simple if imperfect stimulus program that works on the revenue side -- say an across-the-board one-time tax rebate -- one that President Bush may not be happy with but will have a hard time justifying a veto, then if he does end up vetoing it, that will be his fault -- and all the more reason to elect a Democratic president. And if he signs it, well, I guess you'll just have to take the risk that the stimulus will actually work and that it will make things look a little better on election day than they otherwise would. A non-recessionary economy in 2008 -- seems to me that's a risk worth taking.


[Update: I should proofread these posts better. I don't think we're going to be seeing "Recession -- The Musical" any time soon.]

[Update2: ...and I should check my facts, too. Brock points out in the comments section that John Edwards is no longer in the Senate. Edwards does seem to have his own stimulus plan, though, and I hope he isn't thinking that it can wait until 2009 to be implemented. I guess I should include Senator Obama in my warning, too, but his suggestions have come closer to the sort of thing of which President Bush would have trouble justifying a veto, so I kind of felt he didn't need to be warned.]

The New York Times on Exchange Rates

Greg Mankiw and Dean Baker are beating up on an editorial in today’s New York Times. I think their attacks are a bit unfair. The editorial says that the Bush administration is reducing the trade deficit by “letting the dollar slide,” which the Times suggests is not a good idea, but instead, “to be truly effective, a weaker dollar must be paired with higher domestic savings.” Greg and Dean ridicule the editorial by pointing out that a weaker dollar is exactly the mechanism by which higher domestic savings would reduce the trade deficit. (Dean also allows for the possibility that higher savings could cause a recession, which would reduce the trade deficit but obviously would not be desirable.) So if “letting the dollar slide” is a bad thing, they suggest, how could increasing domestic savings be a good thing, when increasing domestic savings would only cause the dollar to slide further?

I grant you the editorial does not appear to have been written by someone who had just finished getting an A in a course in open economy macroeconomics, but I think the editorial has a point, which Greg and Dean are missing. There are two reasons that the dollar can weaken. First, it can weaken because US interest rates fall (relative to foreign rates), making dollars less attractive. That is a “movement along” the demand curve for dollars. Second, it can weaken because people demand fewer dollars at any given interest rate. That is a “shift” in the demand curve for dollars*. What the Times is saying is that the right way to weaken the dollar is by inducing a movement along the demand curve, whereas Bush administration policies are instead causing the curve to shift.

While it’s debatable just how much influence public policy has on the position of the demand curve, it certainly has some influence. Surely Dean Baker, who perpetually complains about the Clinton-Rubin strong dollar policy, will not deny this. I’m personally skeptical about Dean’s maintained hypothesis that Clinton-Rubin policies had much impact on dollar demand, but I think there is a good case to be made that the Bush policies identified by the Times do have considerable impact. When a nation continues to run budget deficits in the face of a negative personal savings rate, there is a tendency for investors to lose confidence in that nation’s currency and to demand less of it at any given interest rate.

The difference in effect between a shift in the demand curve and a movement along the curve is important, though I don’t think the Times identifies that difference quite correctly, or at least the Times doesn’t make the true difference clear. The editorial implies that a shift in the currency demand curve is more inflationary than a movement along that curve. That may be true in the long run, but it's not obvious that it’s true in the short run. The true difference (assuming monetary policy is working well) is that, with a shift in the demand curve, the stimulus from the improved trade balance is offset by reduced domestic investment, whereas, with a movement along the curve (assuming that movement results from increased domestic savings), the stimulus is offset by reduced consumption. I think Greg and Dean will agree that the latter is preferable.

In the long run, less investment leads to a lower growth rate of productive capacity, which slows the rate of labor productivity growth, and much contemporary opinion holds that slowing productivity growth brings about an unfavorable shift in the Phillips curve, causing inflation to accelerate more rapidly (or decelerate less rapidly) at any given level of employment. Thus, in a sense the Times is right to argue that the “shift” strategy is inflationary (because it reduces investment). Perhaps the anticipation of such future inflationary conditions is what reduces the Fed’s “room to maneuver” in the face of a weakening currency. The Times doesn’t spell out this argument, but it makes some sense to me if that’s what they had in mind.


* In the model I have in mind, the quantity of dollars demanded depends on relative interest rates, and then the foreign exchange value of the dollar depends on the quantity demanded (as if the supply of dollars in the foreign exchange market were perfectly inelastic). The demand curve to which I refer represents the first relationship, and the value of the dollar is then determined by the second relationship. Obviously this is a simplification, since the bond markets and the foreign exchange market have to come into equilibrium simultaneously, and there really is not a perfectly inelastic supply of dollars. For purposes of the present analysis, however, I don’t think this simplification distorts the point I’m trying to make.

Taxes, Housing, Growth, and War

The following seem to be a standard set of tenets for anti-Bush crowd:

• The Bush tax cuts were irresponsible.


• The housing boom was unhealthy.


• Employment growth over the past five years has been inadequate.

I’m no fan of W myself, but I’m puzzled by this triplethink. What macroeconomic policies were people hoping for? What policies would have increased employment without exacerbating either the budget deficit or the housing boom?

Let’s look at an alternative path in which the tax cuts hadn’t taken place. The tech bubble would have burst anyhow. (It started to burst long before the first tax cut.) Without the 2001 tax cut, the recession would have been deeper and lasted longer. Without the 2001 and 2003 tax cuts, the painfully slow recovery would have been even slower. Quite possibly the Fed would have cut rates all the way down to zero. (That’s only one percentage point away from what actually happened.) The housing boom – as the only major source of demand facilitating a recovery – would have been pushed to an extreme that would make last year’s experience look mild. (Exercise for the reader: calculate the present value of a perpetual stream of housing services discounted at 0%.)

If anything, the tax cuts were not irresponsible enough. Instead of tax cuts on capital income, designed to encourage virtuous activities like saving and investment, what we needed were sleazy, Keynesian tax cuts to encourage Joe Sixpack to switch to high-quality microbrews. (Fortunately, the tax cuts were entirely ineffective at encouraging saving.) Or perhaps, instead of tax cuts, we should have built a lot more bridges to nowhere back when we were facing an excess of unbroken windows.

The only alternative economic stimulus would have been a weaker dollar. You may recall, though, that Europe and Japan were facing inadequate growth at the same time, and the other Asian countries had plenty of unexploited potential. A deliberate weak dollar policy, back in 2001-2004, would have fallen into the classic “beggar thy neighbor” category. And with the rest of the world playing the same game, it’s implausible that ordinary fiscal, monetary, and “talking down” policies could have made the dollar so weak as to substitute for the stimulus of the tax cuts. That would have required dramatic intervention against the dollar, on a scale never even imagined, and with the explicitly aggressive intent of forcing the Asians (under threat of bankruptcy) to give up their own intervention policies. I don’t recall anyone advocating such actions at the time.

If you want to blame Bush for the economic problems of this decade, don’t blame his economic policies; blame his foreign policy. Whatever its ex ante merits may have been, the Iraq war, along with the atmosphere of tension it induces in the region, has clearly been partly responsible for the rising price of oil, which is exactly what has placed such a tight limit on the current recovery. (Try this thought experiment: assume the actual path for the cost of non-energy value added in the US, and suppose that the price of oil had risen much less. What would the inflation rate be? Would the Fed have kept tightening so long?)

Don’t Blame Rubin

Things are back to normal: I disagree with Dean Baker. But there is still something not quite right. Usually he is the one more critical of the Bush administration. This time he seems to be the one defending Bush.

Baker argues that the New York Times is wrong to blame Bush’s budget deficits for the high level of US foreign indebtedness and its potentially destabilizing effects. The problem, he argues, is the strong dollar, and this, he contends, is not the result of the budget deficit. If any American is to blame, he suggests that (former Treasury Secretary) Robert Rubin is the man.

He’s wrong. (Ah, yes, that feels natural.) First of all, he’s wrong because Treasury policy has little to do with the value of the dollar anyhow. Granted, there are occasions when a strategically placed gust of hot air from the mouth of the Treasury Secretary can shift the winds of a volatile foreign exchange market, particularly if the gust is supported by well-timed intervention and cooperation from foreign authorities. And granted, the Treasury can exert a slight modicum of influence over monetary policy, at least in the short run, when it comes to the value of the dollar. All these mechanisms might have been operative in 1985, when the dollar made a dramatic shift in direction after the Plaza Accord. But ultimately, the subsequent weakness of the dollar depended on a loose monetary policy occasioned by the sudden drop in oil prices in early 1986, which reduced the inflation rate while causing a regional recession in the Southwest. (Interestingly, the rest of us seemed not to notice that recession. Here in the Northeast, I only became aware of it several years later when I was studying regional data for my thesis.) In any case, the Plaza Accord seems to be a unique event. There is no analogous reverse event in the 1990s that caused the dollar to strengthen. It was strong not because of US Treasury policy but because the US was perceived as a good place to invest.

Second, he’s wrong because a strong dollar in the 1990s was a good idea, whereas a strong dollar (or even a not-weak-enough dollar) today is a bad idea. In the 1990s, the capital inflows supporting the strong dollar were largely going to private investment (directly or indirectly). A weak dollar in those days would have either dried up that foreign investment or caused our economy to overheat. Today, the capital inflows are largely going to consumption. A weak dollar today, properly engineered, could be associated with a higher savings rate rather than less investment.

Finally, he’s wrong because the budget deficit is the reason for the strong dollar. If the US were not trying to borrow so much, dollar interest rates would be lower (relative to other currencies), there would be less incentive to hold dollars, and the value of the dollar would be lower against those currencies that don’t peg to it (including that of our largest historical trading partner, the UK). (I’m glossing over a lot of details here, but that’s the gist of it.)

When I think about what might happen (or what might have happened) to the world economy without the US deficit (and the strong dollar), though, I wonder if it’s really such a bad thing. But that’s a big topic, and this post is already too long.

X or not X

Which of the following is closer to truth?

(1) The 2003 tax cut stimulated spending and thereby helped strengthen the current recovery.

(2) The 2003 tax cut did not stimulate spending and therefore is not contributing to the low national savings rate.

I tend to go with (1), but I’m willing to look at evidence for (2). What troubles me, though, is that most Democrats – including people like Paul Krugman and Brad DeLong, who should know better – seem to think the answer is “none of the above.” I happen to be a Democrat myself, but I also support the Party of Logic and Arithmetic, which somehow seems to be opposed by both major parties (not to mention most occasional third parties) most of the time. Either people spent the tax cut or they saved it, or perhaps they spent half of it and saved the other half, but you can’t say, “For purposes of calculating the short-run macroeconomic impact, they saved the tax cut, but for purposes of calculating the growth and balance of payments implications, they spent it.”

I’d like to suggest that, if you want to make the case for the Democrats, you’re better off with (1). Yes, you do have to acknowledge that the Bush administration did something that was not 100% stupid or 100% evil. But in return, you get to make a logically coherent case that they did something maybe 50% stupid or 50% evil, depending on how you look at it. After all, most economists consider the low national savings rate to be a big problem.

On the other hand, if you want to make the case for the Republicans, you’re better off with (2). Yes, you have to give up the argument that the tax cut saved the country from ruin. But in return you get – well, a free lunch. If the tax cut didn’t affect the overall savings rate, then young people will inherit the same savings, so there is no intergenerational transfer. Taxpayers overall are a little better off. If you’re a risk-averse taxpayer, you’re right where you started: just buy a Treasury bond and make your future tax payments with the proceeds. If you’re a less risk-averse taxpayer, you get to take advantage of the government’s credit rating and invest the money in something more profitable. So all these macro effects add up to a slight benefit, and the micro effect – less distortionary taxation, leading to a more efficient economy – is just gravy.

Of course, the Democrats could counter that this tax cut went to the rich, while the compensating future tax receipts (or benefit cuts) might come from the middle class (or the poor). But that argument only works if you expect the Republicans to stay in power. And frankly, personally, Democrat though I am, I would not be terribly unhappy to see the revenue made up with, say, a value added tax. I do like progressive taxes, but my feeling is, since people with nothing at all pay no taxes at all, any tax is progressive in the most critical income range.