TSLF: Is the government taking a risk?

In one of the latest blogospheric analyses of the Fed’s plans to accept private-label mortgage backed securities as collateral, James Hamilton concludes that the government is taking on a definite risk (specifically, although the Fed is the agent, it is really the Treasury’s risk, since the Fed’s profits are received by the Treasury) but that the risk is not a very large one. I wonder, though, if it’s appropriate to view the risk characteristics of the specific transactions in isolation without considering how they influence the Treasury’s other risks.

Modern portfolio theory teaches us that an asset that looks risky in isolation can actually decrease the risk of a portfolio. For example, if you have a portfolio that consists entirely of government bonds, and you take out some of the bonds and replace them with stocks, you have replaced a safer asset with a riskier one, and yet your portfolio overall is now less risky. In that context it is the correlation (or rather, lack thereof) between asset returns that is the issue, but in the case of the government itself, a more important issue is how transactions in one set of assets affect the value of other assets and liabilities.

In particular, the government’s most important asset, in real economic terms, is the expectation of tax revenues. Tax revenues depend mostly on incomes. In particular, revenues depend not on potential incomes but on actual incomes, so any expected gap between the two reduces the value of the government’s most important asset. The government’s most important liabilities are the securities it issues, most of which are denominated in nominal dollars and most of which do not contain a call provision. A worst case scenario for the government is a Japanese-style deflationary depression, in which the value of the government’s liabilities rises in real terms, while the value of its most important asset is eroded by an ongoing output gap.

Deflation might not have seemed like an issue before Friday’s CPI report, but now the risk cannot be so easily dismissed. Most of the positive inflation in recent months appears to be the result of rapidly rising commodity prices, which are volatile and could easily reverse direction. Meanwhile, the US labor market is weak, and the financial system – what’s left of it – is fragile. If, by taking on certain (relatively small, in the grand scheme of things) financial risks, the government is able to materially reduce the risk of a financial collapse and thereby reduce the risk of a deflationary depression, there is probably a net decline in the government’s total risk.

To put it a little differently, as James Hamilton says, “you don’t get something for nothing,” but, it seems to me, if the something that you get is clearly worth more to you than the something that you gave up, you kind of do get something for nothing. Don’t you?

What is the purpose of a fiscal stimulus?

In the course of thinking about my last post, I have come to a striking realization: the (primary) purpose of a fiscal stimulus is not, as commonly believed, to stimulate aggregate demand and thereby increase economic activity; the purpose is to prevent interest rates from going down.

If the purpose of a fiscal stimulus were to stimulate aggregate demand and thereby increase economic activity, then a fiscal stimulus would almost never be a good idea. Typically, when a fiscal stimulus is proposed, one will hear arguments against it from various economists, typically of the more conservative-leaning variety (as, for example, Andrew Samwick here). These arguments rest on the premise that the conventional reason for a fiscal stimulus is the true reason. They argue (in my opinion) convincingly that that reason is not a good one, and they conclude that a fiscal stimulus is a bad idea. Essentially, anything that fiscal policy can do, monetary policy can do better. And monetary policy will do it, because that’s the job of central bankers. And if you disagree with the central bank about whether we need a stimulus, it will do you no good to try to use fiscal policy unilaterally, because the central bank will act to offset the effect with higher interest rates.

There is one exception – one case where monetary policy (maybe) just doesn’t work: that is the case where the interest rate is zero. In that case, there is no opportunity for the central bank to stimulate the economy by reducing interest rates. And if the central bank tries to stimulate the economy just by increasing bank reserves, this may be ineffective, because banks, having obtained the funds at zero cost, will feel little pressure to make loans; they may simply hold all the extra reserves as free insurance against the prospect of unexpected cash needs. And moreover, their creditworthy customers may not be willing to borrow, even at extremely low interest rates, if they can’t think of anything good to do with the money. This may or may not have happened in Japan; it’s still controversial whether the Bank of Japan’s policy of “quantitative easing” had a major impact. Anyhow, it’s something to worry about.

But in the US, for example, the interest rate has not been zero since 1938. So this one exception does not apply. If you’re worried (like Paul Krugman) that the exception might apply at some point in the not too distant future, then your argument about today is not that the exception does apply, but that we need to take action to avoid the situation in which the exception would apply. In other words, you don’t want interest rates to go too far down. You want a fiscal stimulus to prevent interest rates from going down.

Alternatively, let’s say that you were calling for a fiscal stimulus (or perhaps a larger or better directed one than what we actually got) in 2001 and 2002 and that you had the foresight to see that a monetary stimulus would affect the economy by producing an excessive and ultimately destructive housing boom. If your foresight were that good, you would probably have seen also that the monetary stimulus would succeed in getting the economy going and getting the unemployment rate down. So you couldn’t advocate a fiscal stimulus for that purpose, which would already be served. Rather, you would advocate a fiscal stimulus to avoid an excessive housing boom – by preventing interest rates from going down.

Today it would be hard to argue that a monetary stimulus could spark another excessive housing boom. (It might, I think, spark some kind of a boom, but the boom will be more orderly and rational, given the “once bitten” status of the housing market, as well as the elimination of many of the prospects for creative financing.) But a monetary stimulus could have another bad effect – rising import prices due to sudden drop in the dollar. The way to avoid that effect is to keep US interest rates high enough to attract capital from abroad, which will prop up the dollar. And the way to do that is with fiscal policy – a policy to produce a demand for that capital, so that someone in the US will be willing to pay those interest rates. Again, the purpose of a fiscal stimulus is to prevent interest rates from going down.


[Update: pgl's response at Angry Bear makes me realize that my reference to "another bad effect – rising import prices" was misleading. Rising import prices are a good thing, in my opinion, in that they would help reduce the international imbalance (the large net inflow of goods to the US from Asia), but on balance, only a good thing if the prices rise slowly enough to avoid a dramatic deterioration of the output-inflation tradeoff (i.e. stagflation, or something like it). The argument for using a fiscal stimulus, and therefore having relatively higher interest rates, today is that higher rates would let the dollar fall gradually, thereby avoiding the shock from a sudden deterioration in the terms of trade. It would also avoid a sudden contractionary shock to the rest of the world's economy.]

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.]

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.

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.

Don’t Just Float the Yuan

My earliest posts in this blog (see the archives from April and early May 2006) dealt largely with the subject of China’s artificially weak currency. The general thrust was that the weak-RMB policy was inefficient from a global point of view, contrary to China’s interest, and probably contrary to US interest as well despite the benefit to US consumers. Upon further thought, it seems to me that those posts stand in a somewhat ironic relation to my KNZN screen name. From a Keynesian point of view, if we take China’s other policies as given, allowing the yuan to appreciate seems like a distinctly bad idea for China and not necessarily a good one for the US.

By most accounts, the pace of capital investment in China is already so rapid as to be unhealthy. Meanwhile, despite some concerns about overheating, the inflation rate remains tame. So what would happen if China were to allow the yuan to appreciate? In terms of the components of national output, net exports would fall. There is no reason to expect a change in either consumption or government purchases. This means that China’s monetary authorities would face a choice: either push easy money to encourage increased private investment, or let national income fall (relative to its path under the current regime). If national income were to fall, standard Phillips curve theory suggests that the inflation rate would fall as well, possibly pushing China into an unpleasant deflation. Those possibilities don’t sound particularly pleasant.

There is also the possibility that “standard” Phillips curve theory doesn’t apply in this case. That is, China’s Phillips curve may be flat in its current range, so the result of an appreciation would be lower output at the same inflation rate. A flat Phillips curve is essentially a free lunch, so by advising China to allow appreciation without encouraging more rapid investment, we would be advising them to pass up the free lunch. Alternatively, maybe the Phillips curve is vertical, in which case deflation becomes the only alternative to more rapid investment in the case of an appreciation.

The US, on the other hand, is by most accounts (though not by mine) already near (if not at or above) full employment. By increasing net exports (which is to say, decreasing net imports), a stronger yuan would force the Fed to raise interest rates to discourage private investment, which is already not as strong as one might hope. (I’m assuming that the Fed agrees with the consensus and not with me, and since the US Phillips curve seems to be fairly flat right now, it will be a long time before the Fed – and the consensus – realizes its error. Alternatively, you can just assume that the consensus is right.)

So a good Keynesian ought not to advocate a mere floating of the yuan (unless of course that good Keynesian disagrees with the consensus that investment in China is currently too rapid). For China, a good Keynesian ought primarily to advocate a fiscal stimulus – lower taxes or more government spending, perhaps a publicly financed health insurance system that would reduce the need for precautionary saving by individuals. Once the fiscal stimulus is a done deal, it will hopefully be obvious to the Chinese that the currency needs to appreciate.

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.

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.”

In the Red, White, and Blue

My economic intuition tells me that the budget deficit is bad and that we should make every effort to reduce it as much as possible, as soon as possible. That’s what all sensible economists think, isn’t it? The only economists who disagree are silly economists. (Politically, they are found on the right, the left, and the center, but they have silliness in common.) Yet when I think about this topic logically, I’m in serious danger of turning into a silly economist.

The US deficit clearly helped the world economy during the first half of this decade. What would have happened if the US hadn’t run a fiscal deficit from 2001 to 2005? The Asian countries, presumably, would still have bid the dollar up aggressively in order to ensure adequate demand; indeed, they would have had to do so even more aggressively to offset the weaker demand at any given exchange rate. Or possibly they would have given up, the Japanese economy would still be stagnating, and it would be joined in deflation by China. With the meager US demand going to keep the Asian countries out of severe deflation, there would be little left over for Europe and the rest of the world. The ECB would have brought rates down to zero, and Europe would be in a serious depression. Without a fiscal stimulus, a greater monetary stimulus would have been required to keep the US economy afloat: rates here would have gone to zero, and log cabins without indoor plumbing would be selling for seven digits. Ben Bernanke might well even have occasion to fuel up his helicopter.

The US deficit may still be helping the world economy. What will happen, then, if the US deficit disappears in the immediate future? If we’re lucky, the self-sustaining upward trends in private sector demand in the US, Europe, China, Japan, and elsewhere will continue. But there’s good reason to think we may not be so lucky. In the US, the end of the housing boom – if accompanied by a fiscal contraction – could send the economy back into recession, and we could end up in a position similar to where we were a few years ago. Hopefully, the Fed could succeed in replacing the stimulus, but the result would be a weaker dollar, wreaking havoc with the economies of those nations – such as our major trading partner, the UK – whose currencies trade freely against the dollar. Without the US eager to absorb it, Asia’s surplus of savings would be forced down the world’s throat, possibly inducing a worldwide recession and an international liquidity trap.

Running a (larger) deficit now is cheaper in the long run than not running one. It is often objected that our children will have to pay for today’s deficit. But in fact, it will be easier for them to pay than for us to pay now. The reason is that the US economy is growing at a rate greater than the interest rate the government pays on its debt. Therefore, for any marginal increase in the deficit from (or up to) today’s level, the tax rate increase necessary to pay it off in the future will be less than the tax rate increase necessary to eliminate it today.

Even if it weren’t cheaper, running a deficit would be economically efficient. Even if the government’s interest rate were higher than the growth rate, it would still almost certainly be lower than the marginal subjective discount rate for the average American. Given that many Americans are willing to borrow money at credit card interest rates, it seems likely that most would be willing to borrow even more if they could pay what the government pays. In fact, this behavior would seem to be a rational response to the income growth profiles expected by younger people. Aren’t they better off if the government borrows on their behalf at a very low interest rate, cuts their taxes today, and promises to raise their taxes, if necessary, later, when they can afford to repay?

This isn’t exactly “opposite day,” because I’m not quite ready to declare that my alter ego (author of the last 4 paragraphs) is definitely wrong. I still think he’s probably wrong, but there’s a real challenge here for sensible economists. Anybody want to take up the challenge?