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Moving the Policy Conversation Forward

Some interesting articles on the state and direction of economic policy:

David Frum challenges fellow conservatives to come up with compelling policy alternatives to Paul Krugman's recommendations:

 ...if Krugman’s direct government expenditure is not a very good policy answer, his dire economic warning remains a haunting policy question. What can we do to accelerate economic growth and job creation? For those of us on the free-market side of the debate, the question is even more haunting: What’s our countervailing idea? And if our countervailing idea is tax cuts, what is our reply to the obvious rebuttal that the Bush tax cuts have been in effect through the whole of this crisis, seemingly without effect?

Marshall Auerback outlines a bevy of progressive policies in response:

...Professor James K. Galbraith sets out some useful criteria for good stimulus:

1. Open-ended support for the current operations of state and local governments...

2. Comprehensive foreclosure relief...

3. Increased Social Security benefits...and a cut in the eligibility age of Medicare...

4. A payroll tax holiday to restore effectively the purchasing power of working families. By setting the payroll tax rate at zero (and letting the government write a check to the Social Security Trust Fund for the uncollected sums), tax relief can be delivered at large scale and with immediate effect...

...And finally deploy government spending in a way which REDUCES unemployment, rather than arises as a consequence of it. We therefore suggest a new approach: a Job Guarantee Program. The U.S. Government can proceed directly to zero unemployment by hiring all of the labor that cannot find private sector employment. Furthermore, by fixing the wage paid under this ELR program at a level that does not disrupt existing labor markets, i.e., a wage level close to the existing minimum wage, substantive price stability can be expected...As we have argued before, the Job Guarantee program should remain a permanent feature of our economy, in effect acting as a buffer stock to put a floor under unemployment, whilst maintaining price stability whereby government offers a fixed wage which does not “outbid” the private sector, but simply creates a stabilizing floor and thereby prevents deflation. [Many on the right might reflexively think of such a program as socialism run amok, but as we've pointed out more than once, an employer-of-last-resort program has been proposed on the right by Nobel economist Ned Phelps. The idea is definitely worth a closer bipartisan look.]

There are good ideas out there, but there is a distinct failure of political imagination and courage to implement them. With any hope Frum’s provocative article will spur a healthy discussion on the possible solutions, rather than a retreat to tired, discredited economic shibboleths.

But Brad DeLong gives little hope that Auerback's feared retreat can be avoided:

...Congress is balking. Republican legislators from states with double-digit unemployment have put party above country. Blue Dog Democrats, who think that they can marginally improve their chance of gaining more terms in office if they publicly worry about the deficit to the exclusion of all else, have put self above country and party. And, significantly, the Obama Administration has never offered a grand bargain for tax increases and entitlement caps in the future in return for more spending now to restore full employment.

We'll toss a few cents into the discussion in an attempt to show that we can and should overcome irrational deficit phobia (yes, there are sometimes rational reasons to fear government deficits). Until we do, we're likely to make little progress towards ensuring a strong and durable economic recovery. And ironically, we're likely to end up in a worse public debt position as a result. 

On Frum's question, Randy Wray has pointed out (pdf) that an accelerating pace of federal government tax receipts followed the Bush tax cuts and recovery, and may have contributed to the intersectoral strains that eventually resulted in financial collapse (emphasis added):

Every recession since World War II was preceded by a government surplus or a declining deficit-to-GDP ratio, including the recession following the Clinton surpluses. Recovery from that recession resulted from renewed domestic private sector deficits, although growth was also fueled by government budget deficits that grew to 4 percent of GDP. However...the Bush recovery caused tax revenues to grow so fast that the budget deficit fell through 2007, setting up the conditions for yet another economic collapse...

In 2005, tax revenues were growing at an accelerated rate of 15 percent per year—far above the GDP growth rate (hence, reducing nongovernment sector income) and above the government spending growth rate (5 percent)...this fiscal tightening was followed by a downturn—which automatically slowed growth of tax revenue.

Thus, conservatives might not be painted into as severe a policy corner as Frum fears. But that's true only if they can let go of their (newfound, circa 2006?) deficit phobia and escape the intellectual tyranny of Ricardian equivalence. If they can't, then Auerback's austerian liquidation is the only choice left for them. We think the right can escape it -- it's certainly done so in the past -- but there are two basic concepts that need to be framed out before the policy conversation can make any significant headway.

First, we need to frame our modern financial economy as Knut Wicksell did over 100 years ago. There are two 'interest rates' at work, one on the credit (financial) side, and one on the real (economy) side. The financial rate (in reality, there are many of them) is determined in large part by the cost of a marginal unit of money. The economic rate (in reality there are many of these too) is determined by the expected return on a marginal unit of investment.

When the financial rate is below the economic rate, the result is inflation (greater expected returns on investment lead to increased demand for credit, and money eventually becomes less valuable relative to real goods and services). When it's above the economic rate, the result is deflation (negative expected net returns on investment lead to decreased demand for credit and increased demand for saving; money thus becomes more valuable relative to real goods and services).

Wicksell's original thesis has been tweaked to acknowledge that inflation and deflation are unlikely to persist indefinitely. We also need to incorporate the idea of leverage. Low systemic leverage (the amount of credit relative to money) implies a higher cost of credit and lower inflationary pressures. When there's a high degree of leverage, inflationary swings can be exaggerated, and can turn sharply and suddenly into deflation (Minsky's "Ponzi finance" or Austrian's "crack up boom", of which 2008-2009 was a prime example).

Second, we need to get a better grasp of money -- what it is, where it comes from, and how it works. 

Under any type of gold standard, gold is essentially money, and over the long run, gold's real value is a function of its supply relative to all other goods, services, and assets (gold's flexibility, durability, and steady long term accumulation rate give it its monetary properties). As long as money is defined as a fixed weight of gold, the value of money will closely track the value of gold. Thus, under a gold standard, the financial rate of interest is determined in large part by developments in the gold industry relative to the rest of the economy (as an aside, Ricardian equivalence might have some merit in that type of system).

However, in a fiat currency system like the U.S. has had (officially) since 1973, money is just money, which the government sector creates at minimal cost (currently the money creation process is controlled by the Federal Reserve through its interactions with member banks and primary dealers). Thus, the financial rate on fiat money is more easily attuned to the economic rate, thereby helping to mitigate the cycles of inflation and deflation that occurred regularly under classical gold (that was Wicksell's stated intent when he first outlined his monetary theory). Granted, it's taken policymakers and markets several decades to learn how to run such a system effectively, and there's still plenty of room for improvement, but that's to be expected with any large scale innovation.

A key takeaway is that the federal government creates the money used in private sector transactions, satisfaction of tax and other liabilities to the public sector, and demand for goods and services by the public sector. Thus, saving or spending desires of the private sector can only be accomodated by the federal government (leaving aside export income), while under a gold standard, they could only be accomodated (with some qualifications) by the available supply of gold.

In other words, despite the widespread belief that they are subject to the same constraints, the federal government's budget is nothing like households' or businesses' budgets, and in fact, in some key respects it is the inverse -- just as under a gold standard, the gold industry would need to "dis-save" gold in order to satisfy the desire for saving in other sectors of the economy.

Today, if households, businesses, and state and local governments want to run a surplus, then the federal government must by definition (again ignoring exports) run a deficit. That's not an ideological statement, it's a simple operational fact, which is why (we think) it opens up a lot of common ground for policy.

So what role do federal deficits play in our economy?

Depending on how they come about, they can raise the expected rate of economic return (by increasing aggregate demand or investment), lower the financial rate (by increasing the supply of money), or both (by financing its demand for real goods and services or its investments with new rather than borrowed money).

Conversely, a budget surplus (or a smaller deficit) can lower expected economic returns, and can also impact the financial rate (under our Wicksellian framework, if money becomes more scarce, then the prevailing nominal interest rate becomes tighter, all else equal).

In certain environments (e.g., Japan 1990's thru 2000's, U.S. 2000's thru 2020), expanded deficits make sense, while in others (e.g., Japan 1970's thru 1980's, U.S. 1980's thru 1990's), smaller deficits or even surpluses might make sense -- albeit with this caveat from Wray:

...the United States has also experienced six periods of depression that began in 1819, 1837, 1857, 1873, 1893, and 1929. Comparing these dates with the periods of budget surpluses, one finds that every significant reduction of the outstanding debt, with the exception of the Clinton surpluses, has been followed by a depression, and that every depression has been preceded by significant debt reduction. The Clinton surpluses were followed by the Bush recession that was ended by a speculative, private debt–fueled euphoria, and was followed in turn by our current economic collapse. The jury is still out on whether we might yet suffer another Great Depression. While we cannot rule out coincidences, seven periods of surplus followed by six and a half depressions (with some possibility for making it a perfect seven) should raise eyebrows...our less serious downturns in the postwar period have almost always been preceded by reductions of federal budget deficits.

[Note that all six depressions Wray lists occurred under a gold standard of some kind, so their relevance today may be muted. In fact, we could even question the direction of causation. For example, if gold were in short supply, as it often was in the 19th century, the federal government might not have had the ability to roll its debt over. Could gold shortages have been a common factor in austerity and depression in some of those cases? The Jackson administration's debt retirement and subsequent depression clearly originated on the policy side, so the question can't be anwered without a closer historical examination of each period.]

Where are we today?

U.S. demographic composition (pdf) implies a relatively pessimistic outlook for productivity, saving, and investment, possibly until the end of this decade. Large swaths of the private sector -- notably households, but also some state and local governments -- are in desperate need of repairing their balance sheets. Many corporations are flush with cash but apparently reluctant to invest it in human or physical capital. In other words, the demand for saving in the private sector remains high, and probably will for some time. 

What's the proper response?

For households, some combination of fiscal support (e.g., extended payroll tax holiday, financed by money creation if need be) and financial relief (e.g., cleaning up the mortgage mess in as fair and transparent a way as possible, possibly with greater commitment from the federal government, as opposed to the private sector incentives and public-private partnerships experimented with to date) should help.

For state and local governments, direct budget assistance, again financed with new dollars if necessary (which is essentially how it's now done, except that primary dealer and other banks get to hold Treasury paper for "financing" the federal deficit and earn the spread over the fed funds rate).

For the corporate sector, expanded public sector demand (e.g., maintenance and productivity enhancing infrastructure improvements, R&D into promising areas like energy and health care, etc) and perhaps most importantly, tax and regulatory assurances that will decrease the level of political uncertainty that businesses now face.

All of these would mean higher deficits in the short run, but if we're right about the underlying state of the economy for the next decade, they will mean lower future debt and deficits than would otherwise occur (unless liquidationists and entitlement cutters were to win in drastic fashion, but in that improbable case the net costs would be much greater than any savings implied by a smaller federal debt).

It's also important to point out to the Tea Party types that, as Jamie Galbraith and many other economists have noted, only a small percentage of the rise in federal deficit and debt to GDP ratios was driven by increased discretionary outlays by the Democrats. Almost all of the rise is simply a function of counter cyclical measures like unemployment insurance in the numerator and lower GDP in the denominator.

However it turns out, the federal government is not "broke" and never can be. The only true constraint on federal deficits is inflation, and there simply aren't any signs of elevated inflation risk  today -- although USD exchange rate depreciation is a meaningful risk, depending upon the relative movements of fiscal, trade, and monetary policies in different countries and regions. As Wray observes (emphasis added):

...there is no financial constraint on the ability of a sovereign nation to deficit spend. This doesn’t mean that there are no real resource constraints on government spending, but these constraints, not financial constraints, should be the real concern. If government spending pushes the economy beyond full capacity, then there is inflation. Inflation can also result before full employment if there are bottlenecks or if firms have monopoly pricing power. Government spending can also increase current account deficits, especially if the marginal propensity to import is high. This could affect exchange rates, which could generate pass-through inflation. [Viewed in this light, the Obama administration's export initiative might be a wise idea.]

The alternative would be to use fiscal austerity and try to keep the economy sufficiently depressed in order to eliminate the pressure on prices or exchange rates. While we believe that this would be a mistake—the economic losses due to operating below full employment are almost certainly much higher than the losses due to inflation or currency depreciation—it is an entirely separate matter from financial constraints or insolvency, which are problems sovereign governments do not face.

We openly admit that:

  • While some of the measures we've outlined could be easily implemented, others are much easier said than done.
  • All of them are subject to severe agency and other risks. But that's true for most things in life, not just politics!
  • Many of the distortions and perverse incentives that got us here still need to be corrected.
  • Many voters may fear -- perhaps justifiably, judging by some of the rhetoric on the left -- that deficits do indeed imply higher future taxes and should thus be avoided.
We also admit that under certain conditions, fiscal austerity (via higher taxes and/or lower spending) may indeed be supportive of growth. But we do not think those conditions are in play today in most developed nations.

The bottom line is that no meaningful, bipartisan measures capable of supporting of economic growth at a reasonably healthy level can be crafted until we've moved beyond irrational deficit hysteria. And that requires a broader and deeper understanding of how modern money and financial economies work.


Disclosure: N/A