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Deficits and the Future

By Paul Krugman

Right now there’s intense debate about how aggressive the United States government should be in its attempts to turn the economy around. Many economists, myself included, are calling for a very large fiscal expansion to keep the economy from going into free fall.

Sounds good.

Others, however, worry about the burden that large budget deficits will place on future generations.

OK.

But the deficit worriers have it all wrong. Under current conditions, there’s no trade-off between what’s good in the short run and what’s good for the long run; strong fiscal expansion would actually enhance the economy’s long-run prospects.

No, under any conditions coincident with a shortage of aggregate demand.

The claim that budget deficits make the economy poorer in the long run is based on the belief that government borrowing “crowds out” private investment — that the government, by issuing lots of debt, drives up interest rates, which makes businesses unwilling to spend on new plant and equipment, and that this in turn reduces the economy’s long-run rate of growth. Under normal circumstances there’s a lot to this argument.

Not true. There is never anything to this argument.

But circumstances right now are anything but normal. Consider what would happen next year if the Obama administration gave in to the deficit hawks and scaled back its fiscal plans.

Would this lead to lower interest rates? It certainly wouldn’t lead to a reduction in short-term interest rates, which are more or less controlled by the Federal Reserve. The Fed is already keeping those rates as low as it can — virtually at zero — and won’t change that policy unless it sees signs that the economy is threatening to overheat. And that doesn’t seem like a realistic prospect any time soon.

What about longer-term rates? These rates, which are already at a half-century low, mainly reflect expected future short-term rates. Fiscal austerity could push them even lower — but only by creating expectations that the economy would remain deeply depressed for a long time, which would reduce, not increase, private investment.

Both true.

The idea that tight fiscal policy when the economy is depressed actually reduces private investment isn’t just a hypothetical argument: it’s exactly what happened in two important episodes in history.

The first took place in 1937, when Franklin Roosevelt mistakenly heeded the advice of his own era’s deficit worriers. He sharply reduced government spending, among other things cutting the Works Progress Administration in half, and also raised taxes. The result was a severe recession, and a steep fall in private investment.

Yes, taxes were raised to pay for the new social security program and kept off budget. After the immediate economic setback they changed the accounting and put social security taxes on budget where they remain today. The lesson of public accounting for the government was and is that it best serves public purpose when it’s on a ‘cash basis’.

The second episode took place 60 years later, in Japan. In 1996-97 the Japanese government tried to balance its budget, cutting spending and raising taxes. And again the recession that followed led to a steep fall in private investment.

Yes, they kept pushing consumption taxes that set them back.

Just to be clear, I’m not arguing that trying to reduce the budget deficit is always bad for private investment. You can make a reasonable case that Bill Clinton’s fiscal restraint in the 1990s helped fuel the great U.S. investment boom of that decade, which in turn helped cause a resurgence in productivity growth.

No you can’t. The deficits of the early 90’s recession fueled the subsequent expansion, and the resulting surplus killed it, and we are still feeling the effects of those surplus years today.

What made fiscal austerity such a bad idea both in Roosevelt’s America and in 1990s Japan.

And the US in the late 90s- he conveniently bypasses that one?

were special circumstances:

No, fiscal austerity necessarily reduces aggregate demand.

in both cases the government pulled back in the face of a liquidity trap, a situation in which the monetary authority had cut interest rates as far as it could, yet the economy was still operating far below capacity.

Yes, because monetary policy- changing interest rates- doesn’t actually work as theorized by the mainstream.

And note that in the last year interest for savers has come down about 4% while interest charges for borrowers are about unchanged, or, in many cases, higher, as the spreads widened as the Fed cut rates. And in any case the non government is a net saver/net receiver of interest payments to the tune of the government’s outstanding treasury securities. So the largest consequence of last year’s rate cuts has been a cut in private sector interest income.

And we’re in the same kind of trap today — which is why deficit worries are misplaced.

At least he gets to the right place, even if it is via faulty logic.

One more thing: Fiscal expansion will be even better for America’s future if a large part of the expansion takes the form of public investment — of building roads, repairing bridges and developing new technologies, all of which make the nation richer in the long run.

Yes.

Should the government have a permanent policy of running large budget deficits? Of course not.

Why not, if demand is chronically weak, which it has been for a long time.

Although public debt isn’t as bad a thing as many people believe —

True!

it’s basically money we owe to ourselves —

Wrong reason :(

in the long run the government, like private individuals, has to match its spending to its income.

Wrong. He misses the difference between issuers of non convertible currencies with uses of those currencies.

The funds for us to pay taxes to come from government spending (or government lending). So government is best thought of as spending first and then collecting taxes or borrowing.

And every dollar of cash in circulation has to be from government deficit spending- funds spent but not yet collected for payment of taxes.

Etc.

Rookie mistake for a Nobel Prize winner not to see the difference between issuer and user of anything.

But right now we have a fundamental shortfall in private spending: consumers are rediscovering the virtues of saving at the same moment that businesses, burned by past excesses and hamstrung by the troubles of the financial system, are cutting back on investment.

Yes!

That gap will eventually close,

Not without sufficient deficit spending.

but until it does, government spending must take up the slack. Otherwise, private investment, and the economy as a whole, will plunge even more.

Yes!

How about a payroll tax holiday where the treasury makes the FICA payments for employees and employers, along with maybe $300 billion to the states for operations and infrastructure projects?

he bottom line, then, is that people who think that fiscal expansion today is bad for future generations have got it exactly wrong. The best course of action, both for today’s workers and for their children, is to do whatever it takes to get this economy on the road to recovery.

And keep it there.

Doesn’t he know about the ongoing ‘demand leakages’ taught in the text books? Tax advantaged pension funds, IRAs. insurance, and other corp reserves, etc. That grow geometrically (most years)?

And that’s why the full employment deficit is something like 5% of GDP, etc?

(If anyone knows Professor Krugman feel free to email this to him, thanks)

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