Why Arenʼt We Running Bigger Deficits Right Now? J. Bradford DeLong June 1, 2010
This is still an exceptional time—a time in which many of the normal rules of the Dismal Science are changed and transformed. It is a time for not normal economics but rather “depression economics.” The terms on which the U.S. government can borrow now are exceptionally advantageous. And because of high unemployment the benefits of boosting government purchases or (I would say and) cutting taxes right now are exceptionally large. The result is that the normal benefits and costs of borrow-and-spend policies by the government are overturned for the short run—for as long as the current economic crisis of high unemployment lasts, which may well mean that the short run is not very short. In normal times a boost to government purchases or a cut in taxes • produces a limited increase in production and employment; • is associated with a substantial increase in national debt, • which raises interest rates, • and so crowds out productivity-increasing private investment spending and leaves us poorer after the effect of the stimulus ebbs; and which then must be financed at a significant interest rate, • • and thus paid for with higher taxes, • which reduce incomes by increasing the wedge between the private rewards and the social benefits of expanded production.
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Right now, as best as we can tell, an increase in federal spending or a cut in taxes has in the short run: • no increasing effect whatsoever on interest rates, • hence no crowding-out of productivity-increasing private investment, • indeed, government spending that adds to firms’ current cash flow may well boost private investment and so leave us richer after the effect of the stimulus ebbs; • can be financed at extremely low interest rates—1.83% per year if financed via 30-year TIPS, and less in expected real interest if financed for a shorter horizon. In normal times only government spending initiatives or tax cuts that promise a high value for the dollar are worth undertaking. Now, however, things are very different. Let’s run through the arithmetic.
Normal Economic Arithmetic Consider a $100 billion boost to government purchases or cut in taxes in some calendar year financed by borrowing from abroad. First the benefits: a normal year the Federal Reserve will worry about inflation, and raise interest rates somewhat to offset the inflationary impact of the fiscal boost. The multiplier will thus be something like 0.4—we will spend $100 billion on government purchases or tax cuts and gain perhaps $40 billion in extra production and associated employment out of it. Next, the costs. First, the added national debt. The national debt will not rise by the full $100 billion: those who earn that extra $40 billion will pay taxes—perhaps $16 billion. Thus the net impact on the government debt will be that by spending an extra $100 billion we will have added some $84 billion to the national debt. That debt must then be amortized. At a 4% per year long-run real rate of interest on government bonds, amortizing that debt will cost Americans $3.4 billion a year.
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Second, the higher tax rates needed to raise the extra $3.4 billion will themselves exert a cooling supply-side effect on economic activity. If each dollar of taxes raised imposes a supply-side excess burden of ⅓ of a dollar, we then have to add to the cost an additional $1.1 billion shortfall in production each year Third, there is another effect. The Federal Reserve’s fight against inflation and increase in interest rates will have reduced investment: because of the $100 billion in government purchases perhaps $40 billion of private investment that would have been made won’t be made—it will be crowded out. As a result of the lower capital stock, some $4 billion a year of income that would have been earned won’t be. Thus the net cost will be a reduction in Americans’ disposable incomes of $7.4 billion per year. That is not a terribly attractive bargain: we purchase $40 billion of extra production and income this year at the cost of a reduction in incomes of $11.9—call it $12—billion in every year in the future. That is a usurious annual real interest rate of 30%. No sane economist would recommend a policy with such costs and benefits: expansionary deficit-boosting fiscal policy is, or ought to be, simply a non-starter in normal times.
Depression Economic Arithmetic But right now we don’t have normal economic arithmetic. We have depression economic arithmetic. And in depression economic arithmetic things are very different. First, more government spending does not lead the Federal Reserve to raise interest rates to fight inflation—the Federal Reserve has pushed interest rates to the floor right now and wishes it could push them negative, to –5% per year or so. Thus the multiplier is not 0.4 but more like 1.5. We do not get $40 billion of additional production and employment, but rather $150 billion. And there is no crowding out but rather there is likely to be crowding in: if a fifth of the extra production flows through to corporate profits, and if a half of those extra corporate
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profits are then invested in projects paying a pretax net real rate of return of 10% per year, then future productivity is boosted to the tune of $1.5 billion a year. Second, that boost to production creates a substantial reflow in taxes that makes the spending program lunch not free but cheaper: $150 billion of added production leads to $60 billion of additional tax revenue, leading to only $40 billion in increased debt. Third, the financial crisis has created a configuration of interest rates that means that the government can borrow at uniquely favorable terms: suppose not 1.83% but to make the numbers round 2% per year in real terms for the next thirty years. Amortizing the $40 billion of additional government debt requires only $0.8 billion a year in additional interest payments and taxes. With our ⅓ excess burden we are up to $1.07 billion a year in amortization costs. Now net all these out. The increased cash flows to businesses boost future private-sector incomes by $1.5 billion a year. The costs of amortization reduce them by $1.07 billion a year. The net cost? There is no net cost t society as a whole: we get an extra $150 billion in production, spending, and income this year; and we get an extra $0.43 billion—$430 million—in extra after-tax private sector incomes each year in the future. Using expansionary fiscal policy to boost output today is worth doing, period. There are no tradeoffs. It is a free lunch. Note that this is not a “Laffer Curve” argument. Government spending does not pay for itself: the boost to productivity is not enough that additional taxes automatically cover the amortization of the debt. Taxes do need to go up in order to pay off the debt. But the amount that taxes go up each year in the future is less than the amount by which the policy boosts America’s future productive capacity and thus future incomes.
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The Limits of Depression Economics Thus it is a no-brainer that we in America ought to be doing more fiscal stimulus—especially so, since each dollar of missing production and each unemployed worker right now is much, much more painful to the country and a much greater loss to human welfare than a dollar of missed production and an unemployed worker in normal times. How much more in the way of expansionary fiscal policy—extra spending or (I would say and) tax cuts? Well, the argument for more is airtight as long as the arithmetic holds out. That is, until: • further increases in the deficit lead to rising expectations of inflation, leading the Federal Reserve to raise short-term interest rates and so crowd-out private-sector investment spending, or • further increases in the deficit lead to the beginning of pressure on the federal government’s debt capacity, so that we can no longer finance additional federal government debt at such extraordinarily advantageous interest rates. Back in December 2008 the incoming Obama National Economic Council feared that an increase in the proposed size of the Obama deficit-spending program, the ARRA, from $800 billion to $1.2 trillion would start to bring these factors into play. It is now clear that they were overly pessimistic, in large part because they were overly optimistic about the state of the economy. It is long past time not just for another Obama stimulus package, but for stimulus package number 3. June 1, 2010: 1480 words
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