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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