St. Augustine

I guess I was a little early with the Augustine reference back in August 2006, and maybe I should have translated it into English, but it looks like it's finally catching on.

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.

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.

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.

More about knzn fiscal policy

Thanks to Mark Thoma for picking up my last post. I think I could fill my blog for a month with daily posts responding to Mark’s comment, the comments on my blog, and the comments on Mark's blog. For today, anyhow, I’m just going to address one issue. As Mark notes:

…there are two separate issues here, one is stabilization policy and for that part of fiscal policy I have no problem with requiring that the budget be balanced over the business cycle. The other is investments in, say, human and physical capital…

I’ll certainly agree there are (at least) two issues, and maybe in the future I will comment on how the two interact. For now, I want to address the first issue.

From a pure stabilization point of view, I don’t think that balancing the budget over the business cycle is a good idea, in part for reasons already discussed in my previous post, and in part because I’m not even sure I believe in the whole concept of a “business cycle” per se. Business, and the macroeconomy, unquestionably has its ups and downs, but so does, for example, the stock market. We don’t normally speak of a “stock market cycle” (although some people do). There are recessions, and there are depressions, and there are inflationary booms, and there are non-inflationary booms. Recessions are limited by definition, but depressions can persist for many years. Inflationary booms are self-limiting, but the jury is still out on non-inflationary booms. Even if recessions and inflationary booms were the only phenomena, they can’t necessarily be expected to alternate: you could have 3 recessions in a row, separated by incomplete recoveries, and followed by 2 inflationary booms in a row, separated by a “soft landing.” The word “cycle” suggests a symmetry which is not, in general, present.

On the purely semantic point, I can accept the use of the word “cycle” for want of a better term, but the argument to balance the budget over the business cycle seems to rest on a substantive presumption of symmetry. It presumes that the stimulus needed during times of economic weakness will be exactly compensated by the excess revenue available during times of economic strength.

You might argue this symmetry must apply in the very long run, because the government has to satisfy an intertemporal budget constraint. Even that point is debatable: in the very long run, the government’s budget constraint applies only if the interest rate is at least as high as the growth rate. Otherwise, if you look out far enough into the future, there will always eventually be enough revenue to pay off any debt the government might accumulate over any finite stretch of time. Some have argued that, empirically, the government typically has faced an interest rate that is less than the growth rate.

But that’s not really my point. I’m cognizant of Keynes’ famous warning about excessive concern with the long run. And a single “business cycle” isn’t much of a long run, anyhow. Conventional business cycle theory might argue for a certain symmetry based on the characteristics of the Phllips curve, under the assumptions that the curve is linear in the short run and vertical in the long run. Under those assumptions, deviations from the NAIRU in one direction are always compensated – let’s say in the medium run – by deviations in the other direction. For the sake of argument I’m willing to accept the vertical long-run Phillips curve, but the linear short-run curve seems to me to be more an econometric convenience than a credible assertion about reality. Back when people believed in static Phillips curves, they used to plot the curves. I’ve seen reproductions of such plots, I can’t remember ever seeing one that looked like a straight line.

Even if (counterfactually) the business cycle is symmetric, it isn’t well-defined, at least not until after the fact. The NBER can’t make the government retroactively balance the budget once it decides what the business cycle dates were. Even if our goal is to balance the budget over one “cycle,” there is no obvious policy that would result in such a balance. The closest we could come is perhaps to require the budget be balanced over, say, 5 calendar years, but that strikes me as a very bad policy: during the first 3 years, we won’t know in advance whether the next 2 are going to be stronger or weaker economically, so we won’t know whether to run a deficit or a surplus. Knowing Congress, I expect the tendency would be to declare the first 3 years a recession and run deficits, which would then require surpluses during the last 2 years and result in an actual recession.

So here’s my alternative proposal: pick a set of interest rates and make fiscal rules contingent on those interest rates. For example, when the 10-year Treasury yield rises above 4%, a deficit ceiling goes into effect; when it rises above 5%, pay-go rules go into effect; when it rises above 6%, a surtax and specific spending restraints go into effect; and so on. We can quibble about the details, and in any case they can be adjusted later if necessary. But this policy makes a lot more sense to me than some attempt to handicap a vague business cycle (or for that matter a vague “trend” in the debt-to-GDP ratio, which can also be hard to identify without benefit of hindsight).

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.

The Paradox of Thrift and Monetary Policy

Kash Mansori of The Street Light and Mark Thoma of Economist’s View argue that now may be a bad time to cut the US budget deficit, given the relatively slow economy and the risk of a recession. pgl of Angry Bear argues (in a post whose title I stole) that now is as good a time as any, provided that the Fed does its job. pgl's argument seems pretty solid, but there are a few possible reasons one might consider deficit-cutting dangerous:

1. From the time of implementation, fiscal policy operates with a shorter lag than monetary policy. Usually, there are long political lags before fiscal policy gets implemented, but during that period there is also uncertainty. The Fed would not be able to respond to a deficit cut until it could be confident about its taking place. That might be too late to prevent a recession.
   
   
2. Interest rate cuts would weaken the dollar, and dollar weakness could exert an inflationary effect independently of its stimulus effect, causing the Fed to be excessively cautious using this type of stimulus. Deficit borrowing, by contrast, would tend to keep interest rates high, thus keeping the dollar from collapsing. (On the other hand, deficit cuts might increase confidence in the dollar, in which case investors might continue to demand dollars even at a lower interest rate.)
   
   
3. Does the Fed have enough ammunition to fight, reliably, the depressing effects of a substantial increase in national saving? You might remember that, back in 2000, interest rates were higher than they are today, perhaps giving the impression that the Fed had plenty of room to cut them; yet three years later, the Fed was starting to debate the types of unconventional policies that might be necessary if short-term interest rates approached zero. With the international savings glut still on and plenty of room for retrenchment by US consumers, I wouldn’t want to be overconfident about the impossibility of a liquidity trap.
   
   
4. Although the world economy is growing rapidly, its potential seems to be growing even faster. The stimulus from the US budget deficit and consumer spending is helping the world make up this gap. US monetary policy would not provide such a stimulus for the world economy.
   

OK, have you got any better reasons? I’d be curious to know how Kash and Mark look at this.

Ways Fiscal Policy Can Cause Inflation

1. portfolio effects. I discussed this mechanism in my last post.
   
   
2. gradual loss of confidence in financial assets. (This could be considered an example of, or a justification for, portfolio effects, but I’ll treat it as a separate mechanism.) Ultimately, a looser fiscal policy may be unsustainable. If it is truly unsustainable, then it will eventually have to be reversed, and the reversal could take the form of either a fiscal contraction or a monetary expansion (the “inflation tax”). It is hard to know in advance whether a fiscal policy is truly unsustainable, and it is also hard to anticipate how it might eventually be corrected. As a loose fiscal policy continues (which is to say, as more time passes over which it is not corrected by fiscal means), the odds of its being corrected by monetary means will tend to rise. The greater the chance of a monetary expansion, the less valuable financial assets (money and bonds) are at any given interest rate. Thus there will be a gradual shift in portfolio preferences from financial assets to real assets. If the money supply is constant (or, more generally, if it grows with productivity) and the economy is at full employment, then prices will rise gradually over a long period of time: inflation.
   
   
3. gradual loss of confidence in the pricing structure. If price setting depends on expected price levels (as in New Classical and some New Keynesian models), the gradually increasing expectation of an eventual monetary stimulus will lead to a gradual shift in the Phillips curve, thus causing prices to rise gradually for any given level of nominal aggregate demand.
   
   
4. reduced productivity growth due to crowding out. At full employment, in a closed economy, a fiscal stimulus will crowd out private investment, thus causing the capital stock to grow more slowly. As a result, productivity will grow more slowly, and real income will grow more slowly. For any given path of money supply and money demand, this means the price level will rise more quickly.
   
   
5. a naïve Taylor rule. Thus far, I’ve assumed that the money supply is exogenous and inelastic. That’s clearly unrealistic. To get slightly more realistic, suppose that monetary policy follows a Taylor rule with a fixed estimate of the “netural interest rate.” A fiscal stimulus will raise the interest rate consistent with stable prices. If monetary policy continues to follow its Taylor rule, the equilibrium inflation rate will rise.
   
   
6. inertial inflation. In practice, when we observe increases in the price level, it’s very hard (even for economists, and all the more for naïve price-setting agents) to tell whether they are one-time increases or “true” inflation. When fiscal policy produces rising prices, these will therefore tend to increase expected inflation, and the increase in expected inflation will become a self-fulfilling prophecy.
   
   People are going to complain about #6, because the self-fulfilling prophecy ultimately requires monetary accommodation. Otherwise the rising rate of price growth will eventually result in a reduced level of output, and the expectations will eventually be corrected.
   
   But here is the thing: what we really mean by higher inflation – in this era of enlightened and hawkish monetary policy – is not a permanent increase in the rate of price growth; what we mean is an increase in the rate of price growth that will be of concern to a central bank that wants to prevent a permanent increase in the rate of price growth. When people complain about fiscal policy being inflationary, they don’t mean that it actually will result in persistent inflation; they mean that it will raise a red flag at the Fed. In a perfect world where price-setting agents were perfectly rational and could perfectly discriminate temporary from permanent changes in nominal demand (and where the simple version of the IS-LM model applied), a loosening of fiscal policy would not raise such a red flag. In the real world, it does.

Channeling James Tobin

Mark Thoma (with support from Frederic Mishkin) holds with those who insist that only money can cause inflation – at least if, by inflation, one means a sustained pattern of increases in the price level. I believe that, as a formal matter, the argument is somewhat circular tautological: the conclusion is based on comparative static models in which money is the only stock variable. Fiscal policy is, almost by definition, a one-shot deal in these models, so it cannot produce a sustained pattern of change in anything.

Consider the standard closed-economy IS-LM model, as I learned it in school:

IS curve:  Y = C(tY) + I(r) + G
LM curve:  M/P = L(r, Y)

where
Y = national output
C = consumption
I = private investment
G = government spending
t = tax rate
r = interest rate
M = money stock
P = price level

Applying the standard assumption of a vertical long-run Phillips curve, we can take the growth rate of Y as exogenous for our purposes. Without loss of generality, let’s assume Y is constant.

Now, we want to ask, can the growth rate of P (otherwise known as the inflation rate) be positive if M is constant? You can see immediately from the LM curve that, if P were rising and M were constant, either r or Y would have to be changing. Otherwise the left-hand side of the equation would be falling, while the right-hand side would be constant. However, we have assumed that Y is constant, and a look at the IS curve shows that, if r is changing, then one of the other flow variables (Y, G, or t) must also be changing. But, again, we have assumed Y is constant, so unless there is a constantly changing fiscal policy (e.g., the tax rate constantly falling or government spending constantly rising), the equations won’t balance. So without money growth, you would really have to do something bizarre to get sustained inflation.

But suppose we introduce a new stock variable, call it “B” for bonds (government bonds, that is). The stock of government bonds grows as the government accumulates deficits (or falls as it accumulates surpluses). Using the “d” operator to indicate a rate of change, we can describe this process as:

dB = G – tY

For completeness, we can add yet another stock variable, the capital stock (“K”). Without loss of generality, I’m going to ignore depreciation and just say:

dK = I

In principle, private investment depends not directly on the government bond interest rate but on the required return on private capital. Let’s call this required return “s” (for “stock market return” as a mnemonic, although you should understand that it is the general required return on private capital, not just for the stock market).

In the standard IS-LM model, it was assumed that s and r were in some fixed relation, but in a world where government competes with the private sector for capital, the relation between the two returns need not be fixed. Government bonds and private capital have different characteristics – different risks, different degrees of liquidity, and so on. Investors may have a preferred proportion of holdings between the two, and when the relative supply of one asset increases, they will require some compensation for changing their proportions. Call the difference in returns between the two assets “e” (for “equity premium”) and recognize that it will depend on the relative outstanding stocks of government bonds and private capital. That gives us the following model:

Y = C(tY) + I(s) + G
M/P = L(r, Y)
dB = G – tY
dK = I(s)
s = r + e(B, K)

We now have a wedge between money growth and inflation. As the government runs a constant (sufficiently large) deficit, B increases relative to K. Therefore e(B, K) increases, and s falls relative to r. In order for Y to remain constant in the IS curve, s has to be constant in absolute terms, so this means r has to rise. In the LM curve, as r rises, with Y and M constant, P has to rise. Fiscal policy does cause sustained inflation.

Deficit Reduction and the 1990s Boom

I was an enthusiastic supporter of Bill Clinton’s 1993 deficit reduction program. I’m on record saying at the time that the Republicans were doing Clinton a favor by filibustering his stimulus bill. I believe I was right to support deficit reduction. I believe that it was important, that it had results, and that the results were better than I had expected. But was the deficit reduction program responsible for the 1990s economic boom? The short answer is no.

At least that’s the easy answer if you use standard economic theory, and for the most part, I think it’s the right answer. Throughout most of the Clinton era, the US economy was close to what the Fed believed was full employment. The Fed provided enough monetary stimulus to approach what it believed to be full employment. In the absence of deficit reduction, that stimulus would have been provided by the deficit. Or perhaps not – if the deficit had a psychological effect that was depressing the economy. In that case the Fed would have provided roughly the same stimulus that it actually did provide – to offset the depressing psychological effect of the deficit. (Remember, the Fed was already starting to push easy money long before Clinton was even elected.)

There’s no obvious reason to think that the US would have been farther from full employment if the deficit reduction bill had not passed. The reason for the boom was that full employment turned out, by the end of the decade, to be much higher and much more productive than almost anyone originally thought. Deficit reduction was – for the short run, anyhow – a demand-side policy, but the boom had little to do with demand and everything to do with supply.

Deficit reduction almost certainly did have beneficial supply-side effects, but you’ll have a hard time convincing me those effects were large enough to account for a large part of the boom. Deficit reduction was partly – perhaps largely – responsible for the boom in private investment. Without deficit reduction – that is, with lower taxes and more government spending – consumers and government would have required more of the nation’s resources, which would have left less for private investment. Any incipient investment boom would have been resisted aggressively by the Fed to avoid straining the nation’s resources.

The US would also have drawn in more resources from abroad (a larger trade deficit), so the effect of deficit reduction on private investment was far from one-for-one, but because of home bias, imperfect asset substitutability, and the large size of the US economy, a large part of the resources freed by deficit reduction must have flowed through to private investment. More private investment means a larger capital stock, which means more production from a given amount of labor, which means that some part of the boom was indeed attributable to deficit reduction. But the beneficial supply-side effect of capital deepening is a long-term phenomenon. It’s just not reasonable to expect that the effect in the first few years would be large enough to account for a large part of the boom the US experienced.

Another possible beneficial supply-side effect of deficit reduction was on price-setting. With the apparently unsustainable fiscal policy in place before deficit reduction, there was reason to fear that the Fed would eventually be forced to monetize the debt. Accordingly, there was reason to distrust the value of the dollar and reason to raise prices in anticipation of a possible eventual inflation. The Fed had to fight the tendency to raise prices, and in the process, it may have had to limit economic growth more than would otherwise have been necessary. With deficit reduction, this problem disappeared and the Fed was able to support more growth. At least, that’s a story you can tell. I can believe it was a factor, but I have a hard time believing it was responsible for a large part of the boom.

And OK, maybe you can make up some other story about how deficit reduction caused the boom, but you’re not likely to convince me. The US would have had a boom – probably a big one – even without deficit reduction. But it would not have been the same boom. In all probability, it would have been largely a boom in consumption rather than investment. That follows directly from the fact that taxes would have been lower (provided one accepts the premise that consumption rises with disposable income). And it would have been financed – to a much greater degree than it actually was – from abroad. By the end of the decade, the capital stock would have been significantly smaller than what it actually was, and the US foreign debt would have been much higher.

Which, I suppose, would not have been so terrible in 2000. But then George W. Bush got elected. After 6 more years of easy fiscal policy – new tax cuts, increased military spending, and expanded Medicare benefits – leading to more monetary tightening, which would strangle private investment and run up even larger international debt: when I think what condition the US would be in today, I’m really glad we had deep capital and a manageable foreign debt in 2000. If I had to choose between the deficit reduction program of 1993 and the economic boom of the late 1990s, I’m not sure which I would pick. Luckily, we got both.

What is Inflation? (part 2)

Last August I argued (echoing a piece by Arthur Laffer) that recent US experience does not fit the etymological definition of the word “inflation” because nothing is really inflating. For example, the Fed is not “blowing up the balloon” by creating a lot of new money, so as to reduce the value of old money. (Laffer’s piece showed a chart of the sweep-adjusted monetary base – one measure of the Fed’s money creation – which at the time was clearly flattening out rather than accelerating.)

Recently I have been confronted with the need to deal with the subtleties in this etymological definition. In discussing the Romers’ recent paper on taxes in the comments section of Econbrowser, I asserted that “Romer & Romer also find that tax cuts increase inflation.” I was beset by (apparent) monetarists who suggested that I was “confusing price increases with inflation” and implied that inflation could not be produced merely by tax cuts because tax cuts don’t involve an increase in the money supply.

My response, in essence, was that, when tax cuts are funded by borrowing, they “inflate” the supply of dollar-denominated assets – in the form of bonds rather than money. I argued that, with more dollar-denominated assets around, the value of the dollar declines relative to goods and services, and that this process should be called “inflation.” They argued that bonds don’t inflate today’s dollar because they represent future dollars rather than current dollars. I argued that bonds are in some ways a substitute for money and therefore reduce the value of money just as an increase in nuclear power production would reduce the value of coal. If you pump up the economy by creating money substitutes, that’s just as much “inflation” as if you were to do so by creating money directly.

How do we know that bonds and money are substitutes? Because raising the price of one increases demand for the other. Raising the price of bonds (which is to say, lowering the interest rate) causes people to increase their demand for money. I gave a practical example of how they could be substitutes: checkable bond mutual funds. The availability of bonds enables me to hold my assets in the form of a checkable bond mutual fund, which I can use very much as I would use “money” in the form of bank deposits.

The ultimate issue here is money supply vs. money demand. Increases in the general price level are clearly to be considered inflation if they result from increases in the supply of money. But what if they result from decreases in the demand for money? That’s what happens when the government issues bonds, and that’s presumably the main reason that the Romers find tax cuts to be associated with inflation.

It seems to me that the definition of inflation becomes quite flimsy if you don’t allow it to take into account the demand side of the money market. In principle, the general price level can rise without bound just because of declines in the demand for money. When I was in graduate school, one occasionally heard the phrase “self-generating hyperinflation” when discussing monetary theory. Such a hyperinflation did not necessarily require any increase in the supply of money. It resulted from a loss of confidence in the value of the existing money supply. (After all, money has no fundamental value; it’s value depends entirely on individuals’ confidence that other individuals will consider it valuable.) In the event of such a self-generating hyperinflation, it would be little comfort to hear someone say, “Don’t worry; there has been no increase in the money supply; this is not inflation; it is merely price increases.”

One might still argue that the term “inflation” can’t apply unless something is “inflating.” In the case of a “self-generating hyperinflation,” the increase in the price level results from the spontaneous functioning of the market; there is nobody metaphorically “blowing up the balloon.” In the case of a budget deficit, however, there is somebody blowing up the balloon: the government is blowing bonds into the balloon, and even though their effect is arguably indirect, these bonds have the same effect (not dollar-for-dollar but in general) as blowing money into the balloon. Perhaps one could define inflation as “a rise in the general price level produced by a change in the supply of and/or demand for money induced by public policy or other factors exogenous to the money market.” (It should certainly include, for example, the effect that a new gold discovery would have on an economy that uses gold as money – or the effect of a new silver discovery on an economy that uses both gold and silver for exchange but measures prices in terms of gold.)

The Chinese Exchange Rate and US Borrowing

One cool thing about having my own blog is that I get to comment on Tyler Cowen even when he closes comments. (This is even better than bringing back deleted comments from Brad DeLong’s blog.)

Tyler Cowen argues against pushing for yuan revaluation on the grounds that revaluation would only tie the hands of the US:

The fundamental problem in the U.S., to the extent we have one, is our propensity to spend, especially given our long-run demographic position and our government's fiscal irresponsibility. I don't see how pressuring a more rapid change in one set of relative prices (namely U.S. vs. China), which are likely to change anyway, will cure that ailment in a significant way….

A key reason to be skeptical of yuan revaluation is that it tries to address a relative prices problem by shrinking the opportunity set facing the U.S. That is not obviously the right way to go. The point is not to claim that all elasticities are zero, but rather that a trade balance shift, through revaluation, really does require a loss of resources. What fact about the world would make that the best way to go?

What fact? Two words: sticky prices. Consider the four possibilities:

1. Weak yuan + US borrows


2. Strong yuan + US borrows


3. Weak yuan + US does not borrow


4. Strong yuan + US does not borrow

Which of these possibilities is optimal for the US? Tyler Cowen would probably choose #3, but he’s wrong. Not being a Keynesian, however, he won't appreciate why the correct answer is #4 (although Greg Mankiw should, so maybe he can tell me why I’m wrong).

Why not #3? Because if we choose what’s behind door #3, we get a huge and prolonged recession. A fiscal tightening, in the presence of a still-strong currency, will knock out the economy. (We kind of already tried that one back in 2000-2001. In that case the fiscal tightening came from the business sector, which continues to run a large surplus unto this very day. We have since had a recovery, a slow and painful one, brought about mostly by households and government, which are borrowing heavily, partly from China.) As long as China keeps our trade sector weak by keeping its currency weak, our optimal strategy is to borrow.

Furthermore, as long as the US is willing to borrow, it is in China’s interest (given the conservative preferences of its leaders) to keep its currency weak. If the US suddenly stopped borrowing, it would lower US interest rates and make dollars less attractive relative to yuan, forcing China to absorb incredibly huge numbers of dollars, and ultimately, I suspect, China would give up and let the yuan rise. As it is, the path of least resistance for China is to maintain the peg.

So there are two Nash equilibria, and we are stuck at the bad one. As long as the US borrows, it is optimal for China to peg. As long as China pegs, it is optimal for the US to borrow. Ultimately, both countries would be better off if the US stopped borrowing and China stopped pegging, but, as we say in Boston, you can’t get there from here.

I’m not sure how you get out of this bad equilibrium, but one possible way is by trying to change the preferences of China’s leaders, so that it will no longer be optimal for them to peg. I’m not sure how one goes about that, and Tyler Cowen may be right that political pressure is the wrong way, in which case I’ll concede the war but not the battle.

Da mihi castitatem, sed noli modo

If you look through my July archives (the early part of the month, which is lower on the page), you can see discussions of various arguments for cutting the US federal deficit and why I don’t find those arguments convincing. I’ve come up with an argument now that I do find convincing. That is, I would have found it convincing a few months ago, but now I think it is outweighed by other considerations. Here’s the gist of it:

Under current law, Medicare is going to become prohibitively expensive in another 10 or 20 years. The government will have to find a solution, and the solution will almost certainly involve either means testing or taxes. Economically, means testing is equivalent to a tax. Therefore, high taxes in the future are a virtual certainty. Optimal taxation theory says that, the higher a tax is already, the more damage is done by increasing it, and the more advantage there is to reducing it. Since taxes in the future will be high, there is a great advantage to anything we can do to reduce those taxes. One thing we can do to reduce those high future taxes is to cut the deficit today so as to reduce the debt burden that will have to be paid out of those taxes.

In general, I can’t argue with this logic, but the thing is, there is a good chance the US will go into a recession some time in the next year, and it could get quite ugly. Based on recent experience, I wouldn’t rule out a liquidity trap. So I have rather reversed my earlier position. My earlier view was, “All my logic says the arguments against the deficit are unconvincing, yet I still favor deficit cuts, because it seems intuitively like the right thing to do.” Now I would say, “I have a solid logical argument against the deficit, but I nonetheless oppose cutting it. Save the fiscal responsibility until the danger of recession has passed.”

Some people would say (1) a recession is the Fed’s problem, and the Fed can compensate for fiscal tightening, and (2) as for a liquidity trap, we can cross that bridge when we come to it, so (3) we should cut the deficit now, which will give us more of a chance to increase it later when it may be really necessary. But that strikes me as just the kind of timing mistake that has given macroeconomic fine tuning a bad name. Except for the dumb luck of the 2001 tax cut, fiscal stimulus during the post-World-War II period has always been applied much too late and succeeded only in accelerating already strong recoveries. This time around, why not try to prevent a recession? Or at least don’t deliberately make it worse. The Fed may need to bring the US to the brink of recession to maintain its credibility, but Congress has no credibility to lose. Somebody has to be the good cop.

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?)

Yet Another Unconvincing Argument

The deficit redistributes wealth from relatively poor workers to relatively rich asset holders. The rich make a lot of money financing the deficit, while the poor get bad jobs because the deficit crowds out private investment, making workers less productive than they would otherwise be. This is a nice, elegant, classical argument, and I used to like it a lot back in the 1980s.

Today I’m not so sure. Is anyone making a lot of money financing today’s deficit? US investors are making a little bit: about 2.5% after inflation (but before taxes), judging by TIPS yields. Fully hedged Japanese investors are making exactly nothing. (The cost of hedging US Treasury securities into yen just offsets the interest on those securities.) Unhedged foreign investors (mostly central banks) will probably end up losing money.

Is the deficit crowding out private investment? Probably not in the US, because Asian central banks are willing to finance whatever deficit we throw at them. Moreover, the elastic part of investment in the US today seems to be in housing rather than productive assets. Is the deficit crowding out private investment in the Asian countries that finance it? By most accounts, China has too much investment already. Japan has near-zero interest rates, so there’s apparently not much of a crowd at the investment market. Generally, in Asia, the product demand coming from the US seems to be doing more to encourage investment than to discourage it. The crowding out argument applies when the world economy is running at or above potential. Today, it’s not.

Come back in a few years. If Japan has been running a convincingly positive inflation rate, maybe I’ll try to revive this argument.

Another Unconvincing Argument for Fiscal Responsibility

In an earlier post, I pointed out that, with the government’s interest rate below the expected US growth rate, running a deficit is cheaper than not running a deficit. The usual counterargument is that interest rates are going to rise soon, and then running a deficit will no longer be cheap.

If this is really true, it’s mostly an argument for the Treasury to finance at longer maturities. If interest rates are going to rise, the Treasury has the opportunity to lock in today’s low interest rates, and then running a deficit would once again be cheaper than not running a deficit. (It’s possible that a shift to long-term financing would push up long-term rates to the point where running a deficit becomes expensive, but we’ll never know until we try.)

But I have a couple of reasons for questioning the premise. First of all, if interest rates are going to rise, then what kind of idiots are out there holding the long-term bonds? You might say they are being held by central banks that don’t care about profits and losses. I’ll certainly acknowledge that central banks care a lot more about macroeconomic conditions than they do about profits and losses, but I won’t concede that they ignore profits and losses completely even when macroeconomic conditions are not an issue. If anything, investing short-term would give them more flexibility to deal with future changes in the macroeconomic environment. Why would they take the risk of investing long-term when they are getting no reward (indeed, being punished) for taking that risk? I expect that the People’s Bank of China has a pretty smart research staff, and if the PBoC is choosing to invest long-term, it is because they have good reason to expect interest rates to stay low.

When I look at macroeconomic conditions in the world, I’m inclined to agree with whoever is telling the PBoC not to worry so much about rising interest rates. With so much new labor being integrated rapidly into the world economy, potential output is rising quickly, but businesses are still cautious about investing (or, as in China, they are not so cautious, but they are facing adjustment costs), so central banks have to keep interest rates low to help actual output catch up with potential. Some (e.g. Japan and Europe) may be entering a tightening cycle, but others (e.g. the US) are nearing the end of their tightening cycle. In general in the world today, the risk that overheating will require interest rates to rise seems less than the risk that fragile sources of demand (e.g. overextended US consumers, emerging market investors) will collapse and require interest rates to fall.

Actually, I have come up with some reasons for me to oppose deficit spending, but rising interest rates isn’t one of them. (And, I’m afraid, neither are the reasons I will discuss in the next two posts on this subject.)

The Deficit and Future Generations, part two

As I asked in the previous post, if our descendants are going to be richer than we are, then why should we leave more for them than we’re already leaving? Here’s one possible answer.

In economic terms, even if consumption is increasing, the marginal utility of consumption may be increasing too, because innovation may produce new types of goods that are expensive to produce and severely nonsatiating (or it may produce many, many nonsubstitutable new types of goods that are expensive and only moderately satiating, which I think would be equivalent). To put it another way, except for the necessities that we obviously won’t give up, the goods we have available today are all basically a bunch of crap compared to what our grandchildren will have available. Wouldn’t it make sense for us to give up some of our crap so that they can have more of the really good stuff once it gets invented?

That’s the kind of argument that seems interesting at first but starts to seem silly once you put numbers or pictures to it. Would it have been reasonable for our grandparents – who mostly had to make do with bulky AM radios – to make additional sacrifices so that we could have more iPods? I don’t think so.

But there is one area where the argument might make some sense: medical technology. You might think of “lifespan” as an expensive (on the margin) and severely nonsatiating good. Another month of life is considered very valuable even if you’ve already had hundreds and hundreds of them. The technology to prolong life can get quite expensive, and new types of expensive lifesaving technology are constantly being invented. Moreover, “health,” though in one sense highly satiating (once you’re cured of a specific disease, you don’t need any more of the cure), is in another sense quite nonsatiating: even if a health plan already covers hundreds of diseases and procedures, you’ll be willing to pay more for it if it covers one more disease that you might get (even if it’s not life-threatening) or one more procedure that you might need (even if it’s not life-saving). It was reasonable for our grandparents to make sacrifices so that we could have laser surgery and MRI scanners.

Of course, in addition to laser surgery and MRI scanners, we do also have iPods. So apparently our grandparents made more sacrifices than they really had to. But if you look at what’s happening today, the idea of sacrificing for the sake of future medical technology may not seem so unreasonable. For several years now, people in some income ranges have typically experienced declining real wages but rising real compensation. The major difference is health insurance. In other words, they’re getting richer, but they’re spending all of the new income – and then some – on health care. To the extent that these people consume a constant fraction of their income, their overall consumption is going up, but their consumption of most goods is going down, even though the new goods they consume (more health care) are not substitutes for the old ones (iPods? restaurant meals? gasoline?). If this trend continues, then we have a clear example of growth that raises the marginal utility of consumption.

The Deficit and Future Generations, part one

In an earlier post, I discussed the argument that the budget deficit is economically efficient because it allows people to “borrow” at a low interest rate by paying lower taxes today and higher taxes in the future. The obvious counterargument is that the people doing the borrowing are not the same people who are going to be repaying. Is it fair to expect our grandchildren to pay for today’s government services?

Philosophically, the question of what we owe future generations is a difficult and controversial one, but with or without the national debt, we are leaving them a lot: the houses and offices we’ve built, the books and software we’ve written, the music and movies we’ve recorded, the businesses we’ve created, the machines we’ve constructed, the skills we’ve taught them, the technologies we’ve developed. It’s not obviously wrong for the bequest to come with a mortgage. The real question is, once you count the value of the assets and subtract the liabilities, are we leaving them too little, too much, or just the right amount?

Being an economist and not a philosopher, the only approach I’m prepared to take to this question is the utilitarian approach. If we leave more to future generations, will the additional amount be worth more to them than it is to us? Will it be more useful for them than it is for us? Will it give them more happiness, or relieve more of their suffering, than it does for us?

Once we’ve asked these questions, most economists will have to admit that the most obvious answer is “no.” Because productivity is growing and will in all likelihood continue to grow, our grandchildren will almost certainly be richer than we are. Why should we give up the things we want and need so that our grandchildren can have even more than the more that they will almost certainly have anyhow? In economic terms, the marginal utility of consumption falls as consumption rises, and consumption rises over time, so the marginal utility of consumption falls over time; therefore present consumption (by us) is more valuable than future consumption (by our descendants).

One obvious counterargument is that, properly measured, our grandchildren’s wealth won’t really be greater than ours. For example, if we allow global warming to become an ecological disaster, they’ll need all the resources they can get just to deal with all the extra hurricanes, tsunamis, and such. But if that’s true, wouldn’t it be better to run larger (or at least equally large) deficits and spend the money on finding solutions to global warming? It may be stupid to ignore global warming, but it is still almost certainly the case that, if we do things in the smartest way possible, our grandchildren will be richer than we are. As it is, they can blame us for being stupid about how we spend the money, but not for borrowing it in the first place.

There’s another counterargument that I find quite intriguing, but I’m afraid it will take a whole post to discuss. Until tomorrow, the anti-deficit case is still looking pretty weak.

Is the budget deficit destabilizing?

Hoping to avoid a descent into fiscal silliness, I am looking for reasons to be against the budget deficit. One possible reason is that the deficit has destabilizing effects on the international economy. It is surely true, to the extent that the deficit props up the dollar against floating currencies like the euro, that it sets up the dollar for a more precipitous fall – with more troublesome and unpredictable consequences – in the future.

On the other hand, the deficit may have a stabilizing effect on countries that (like China) effectively peg to the dollar or (like Japan) often intervene to keep their currencies weak. By pushing up US interest rates and thus making dollars more attractive to private investors, the budget deficit reduces the number of excess dollars that countries like China and Japan need to absorb. This presumably decreases the risk that such countries will eventually provoke instability by changing their minds about their massive dollar holdings.

So the answer to the question in the title of this post is only “maybe.” While it seems unlikely that the deficit has a net stabilizing effect (at least in today’s rapidly growing world economy), it is not clear that it has a net destabilizing effect.

How the Budget Deficit Props Up the Dollar

In an earlier post about the deficit and the dollar, I admitted to “glossing over a lot of details.” I’ll never get all the details into one post, but here are a few more.

What would happen if Congress were to reduce the deficit, let’s say by canceling a bunch of bridges to nowhere? If I were in a hurry, I would say, “The government will borrow less, easing demand on credit markets and causing interest rates to fall.” But that statement is misleading. Short-term interest rates are determined by Fed policy, and long-term interest rates are determined largely by anticipation of future Fed policy. The deficit affects interest rates because it affects Fed policy. So what would really happen? First, many of the people who were supposed to build those bridges to nowhere would lose their jobs, or would not be hired in the first place. The Fed, being a forward-looking institution, would attempt offset the decline in employment by stimulating new employment, which it would do by cutting interest rates.

What happens when US interest rates go down? Among other things, the dollar becomes a less attractive currency, because it offers less interest. Consequently, investors try to exchange their dollars for other currencies. These attempts to exchange dollars present different problems for different countries, depending on whether their currencies are pegged to the dollar.

Consider first a pegged country, China. China will have three options, none of which it will be very happy with. First, it can cut its own interest rates so as to reduce the incentive to hold yuan and stem the tide of dollar exchanges. The problem with this option is that it would further encourage Chinese investment, which by most accounts is already too high, and it would run the risk of causing the Chinese economy to overheat and generate inflation. Second, it can simply accommodate the demand for yuan by increasing its own holding of dollars. The problem with this option is that the People’s Bank of China already has more dollars than it could possibly want. At some point it’s going to start worrying about the risk it takes by holding ever increasing numbers of dollars. The final option is to revalue the yuan. It’s probably not as likely as the other options, but if we want to put pressure on China to revalue, cutting the budget deficit is a good way to do it.

Now consider an unpegged country – well, not a country but a union – the EU. Since the EU doesn’t normally intervene in the foreign exchange market, it will initially allow the market to handle the dollar exodus by letting the value of the dollar drop against the euro. The drop in the dollar will decrease demand for European products relative to US products, and the ECB will attempt to offset this decrease in demand by cutting interest rates. But how far will it go? Will it go all the way and cut interest rates to the point where the dollar rises back to its initial level? Consider what would happen if it did. Europe’s trade balance would be the same as before, but its interest rate would be lower. Since the lower interest rate stimulates demand domestically, the overall level of demand would be higher, and the ECB would worry about inflation. Consequently, it will not allow this situation to occur. It will cut interest rates somewhat, but not enough to fully offset the effect of the US deficit cut on the exchange rate. Thus, in the end, because the budget deficit declined, the dollar falls against the euro.

Notice that any US “weak dollar policy” or “strong dollar policy” has no effect on these outcomes (unless such a policy means that the Fed is willing to override its employment and inflation objectives). In principle, it can’t. If the US as a nation is going to borrow less, then it must run a smaller trade deficit, and the only way to do so (aside from having a recession) is to drop the value of the dollar to make US goods and services more attractive. If the government reduces its borrowing, unless this decline is offset by an increase in private borrowing (or unless the Fed allows a recession to happen), the dollar must fall, regardless of whether the US has a “strong dollar policy.”