Is The Deficit A Threat To A Future Recovery?

Jamie Galbraith responds to the question posed by the National Journal, “Is the deficit a threat to future recovery?”

James K. Galbraith, National Journal:  No. The question is grossly misconceived. Right now and for the immediate future, the budget deficit is the only source of demand that can fuel a recovery. Our present problem is not that it is too big, but that it is too small. Far too small.

In principle, economic growth can come from household consumption, business investment, government spending, or exports. This is a tautology, indisputable and known to everyone who has ever opened a textbook….

[T]he entire private sector, across the entire country and indeed the world, is pulling the economy downward at the present time. … [A]s consumption, investment and exports decline, so will tax revenues. The government budget deficit is destined to rise, by a lot, on this account alone. This is helpful: a falling tax burden in a progressive tax structure keeps money in private pockets. But it is a weak device to promote expansion, since tax savings will be used first to try to pay down debt… A major tax cut, focused on working Americans such as by remitting the payroll tax, would help sustain after-tax incomes and provide funds to pay mortgages and buy cars. But even these effects are uncertain in a debt deflation.

In these conditions, only government spending can pull the economy out of the ditch. Government must spend. It must do so by as much as necessary in order to maintain a high level of employment. Aid to states and localities, an infrastructure fund, increased social security benefits, foreclosure relief, loans or grants to industry, a green jobs program — all can be useful in coping with the crisis. All will, of course, add to the public budget deficit.

There is no harm in seeking out wasteful or unnecessary programs to cut as the President-elect proposes. The war in Iraq is a huge waste of money with minor benefits to employment. Missile defense is a vast waste of construction, engineering and scientific resources with no benefit to security. Bridges to nowhere and roads to the wilderness add nothing to the value of the national capital stock. But the point of cutting waste and boondoggles is not to reduce the deficit, but to release real resources for better uses. The obligation to use those resources, and to deploy the public funds necessary to ensure that they are used, remains.

Will the projected future deficit “crowd out” future private investment as so many claim? This is absolutely improbable. To the contrary, a successful program of public expenditure will create profit opportunities that will encourage private businesses, many of which will otherwise close, to stay open and eventually to expand. A general improvement of economic conditions can only lower, not raise, the presently prohibitive risk premiums on interest rates being charged private borrowers! There is no way that present or future public spending, even in very large volumes, would under these conditions raise long term interest rates generally by enough to offset the positive effects of an increase in activity and a reduction of risk. Quite the contrary! Public spending will crowd in, not crowd out, private investment.

Whether they know it or not, those who argue a “crowding out” model are working from a mental construct under which the economy is always operating at or near full employment, and under which there is a fixed supply of credit resources, a pool which government and the private sector must share. This is not the case! We are far below full use of available resources now and will certainly fall very much farther in the months ahead… And there is no fixed pool of credit! The entire purpose of the capitalist banking system under the Federal Reserve Act, ever since 1913, has been to create an “elastic currency” not subject to fixed limits to the supply of finance. With due respect to those who continue to have reservations about “crowding out”, please stop. This is a moment when an unfamiliarity with the most basic economic and financial facts can be very dangerous to national well-being.

Finally, there are those who have argued, in times past, that projected future deficits might have a psychological or other effect, detectable in statistical data, on long term interest rates and therefore on private business investment. But whatever the merits of the statistical case, there is no risk under present conditions that something so remote and ethereal as a psychological fear of deficits in the distant future is going to drive up the long-term interest on public debt. We are in a full- fledged flight to safety! That is a flight to cash and to Treasury bonds and bills…, as witnessed by the rising dollar. Right now and for the foreseeable future Uncle Sam can borrow, for whatever term, on whatever scale, for practically nothing. In fact, he has suddenly become a creditor to much of the world — notably the European Central Bank — because of a worldwide shortage of dollar assets!

Finally, there is the question of whether it is possible to go too far. The answer is yes. Maybe my diagnosis is wrong. Maybe private credit will recover faster than I think likely. But even allowing for this possibility, action now should be on a grand scale. It is far easier to trim back tax relief in an expansion, than it will be to repeat the political effort of passing a large expansion package if the first one is too small. For this reason, the conditions call for error on the side of action, not of caution. “Wait-and-see,” in an emergency, is the worst possible advice. …

In these circumstance, large budget deficits are essential, and preoccupation with budget balance is counterproductive. … Those who hang on to simple views of economic virtue in present times need to rethink: time is short and action is needed.

On the crowding out issue, two conditions are required for this effect to be significant. First, an increase in the supply of bonds to finance a larger deficit must cause interest rates to increase. But in a liquidity trap, or near one, changing the supply of bonds has little if any impact on interest rates (this also makes it hard for monetary authorities to reduce interest rates). But even if interest rates do change, a second step is required for crowding out to occur. Investment must be sensitive to changes in the interest rate. However, in a recession this sensitivity is very low (and again, this makes monetary policy ineffective since it relies upon investment responding to lower interest rates). As noted above, near full employment things are different, but crowding out is not a worry in big recessions.

On the question of what if the stimulus is too large, we’ve heard for years how sensitive upper income households are to variations in the tax rate. If these claims are correct, then a way to slow down an overheated economy is available. In any case, as Jamie says, scaling down is easier than scaling up, and that asymmetry points to more aggressive action.


Originally published at the Economist’s Viewand reproduced here with the author’s permission.

6 Responses to "Is The Deficit A Threat To A Future Recovery?"

  1. Timone   December 4, 2008 at 9:26 am

    The chief problems associated with such Keyesian policies are time lag and increases in the national debt. Neither is addressed by the author in his recitation of “most basic economic and financial facts.” Giant public works projects takes years to come on line, in which case even the most severe recessions are over. At that point such policies are inflationary and would require tax increases when the economy was trying to grow. Secondly, all is deficit spending increases the national debt, which then requires more of the federal discretionary budget to service, and at the same time that Baby Boomers are retiring and demanding bigger entitlements. Large public works projects only increase productivity if specifically aimed at the most promising productive areas. Building roads, bridges and courthouses will no nothing if simply left to Congressional pork barrel distribution. These demand-siders never learn.

  2. Guest   December 4, 2008 at 9:54 am

    So there is a free lunch after all…

  3. Anonymous   December 4, 2008 at 9:16 pm

    Consider:Encouraging Baby Boomers to retire NOW — with better government sponsored retirements.This would immediately add money to the economy using it to address a known coming problem anyway.It also opens up more job opportunities for the young.

  4. Anonymous   December 5, 2008 at 5:57 am

    I’m getting pretty tired of hearing people talk about “solutions” to this problem that sound a damned lot like the activities that got us into it. It is not good for people to take on more debt. Debt is a drag on people’s real spending power because they eventually have to pay it off in addition to usurious interest. How is this good for anyone but the greedy banks?The only solution is the one that actually solves something. That is, reduce debt, reduce consumption to within our means even if it means our life styles have to come down 2 notches for years to come. This is FAAAAAR better than the eventual ruination of the currency, of everyone’s savings including those who are not gambling in the stock and bond markets right now. Hyperinflation could lead to the breakup of the USA into smaller countries. Yes, it really is that bad. The gov’t needs to get the heck out of the way of the free markets and stop meddling and chosing winners and losers immediately. Let the markets work it out. Austrians, unite and be heard on this matter before the Keynesians ruin everything and wipe out the middle class with their money tricks.

    • maxclover   December 17, 2008 at 8:16 am

      “Austrians, unite and be heard on this matter before the Keynesians ruin everything and wipe out the middle class with their money tricks. “I’m not Austrian–maybe things are different there but from where I stand (Canada), it looks like this mess began in the USA, and Bush’s deregulation and lack of oversight has been a big part of the problem. Bush is no Keynesian–Friedman has been the economy guru for eight long years.I’m reading a number of blogs at the moment and one of the truly frightening things is that most people agree that the problems are huge, complex, and growing, and that strong action is needed, but everyone wants to charge off in a different direction–bail-out, let-em-fail, stimulus, deficit, infrastructure, free-market….I don’t have solutions, but Keynes seems worth listening to, he provided the underpinnings to the New Deal in the 30s. Much more so than Friedman, whose disciples have wrought havoc all over, notably in Argentina in the 70s, and in the US under the Bush crowd.

  5. Aaron   December 10, 2008 at 1:51 pm

    This is not a repeat of the recession of the 1970’s. We are in the midst of a liquidity trap. Hyperinflation is not a concern right now unless commodity prices shoot up again for some reason.Our economy is in danger of being trapped in a downward spin and there is no reason to believe that markets will correct themselves any time soon on their own. Just as booms can last decades if left on their own, so can busts.The carburetor needs to be primed and that priming isn’t going to come from either the private sector or the fed. It’s time to turn back to demand-side fiscal policy.