WILLIAM GALSTON JUNE 9, 2010
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As several recent surveys make clear, concern about deficits and debt is rising sharply. An NBC/Wall Street Journal survey conducted in early May showed that the share of individuals rating “the deficit and government spending” as the top priority for the federal government to address has jumped since January from 13 to 20 percent—second only to job creation and economic growth. According to Gallup, “federal government debt” now ties with terrorism for the top spot in perceived threats to our future well-being. It is entirely possible that we are reaching an inflection point in public attitudes that will force the political system to change course.
Indeed, as Janet Hook shows in a well-reported piece in Monday’s Los Angeles Times, concerns about the deficit are already forcing congressional Democrats to scale back ambitious plans for continuing stimulus. Hook quotes Mark Mellman, a pollster who has long worked with Democrats, as saying that “there’s no question that people are almost as concerned about the deficit and government spending as about jobs. It is not just about the actual dollars—it is a metaphor for wasted money and lack of discipline and long-term economic decline.” A near-identical complex of concerns created an opening for a third-party presidential movement that garnered 19 percent of the vote in 1992 and strengthened the case for the policy of fiscal restraint Bill Clinton adopted in 1993.
All of this raises the question of whether public sentiment coincides with sound economics. A pretty good case can be made that it did in the 1990s, although it’s also possible to argue that the U.S. economy got a special boost during that decade from information technology and the winding-down of the Cold War. Today, many economists fear that we may be headed for a replay of Japan’s “lost decade” of slow growth, which in our case would condemn us to historically high levels of long-term unemployment.
That raises another question: What can the United States learn from the Japanese experience that should shape our own policy choices during this decade? This is more than an academic question, and the discussion cannot be confined to professional economists. After all, how to deal effectively with the twin challenges of economic growth and fiscal sustainability will be this decade’s dominant domestic policy debate.
It was in that context that I waded (some would say blundered) into a public colloquy with Paul Krugman and his legions of supporters. In the process, I discovered that Japan’s lost decade is surprisingly difficult to decode and that much of the data doesn’t mean what it appears to. Because Adam Posen of the Peterson Institute for International Economics seems to be the generally acknowledged guru of Japanese economics studies, I turned to a lecture he delivered at LSE last month. Posen argues that when the Japanese employed traditional Keynesian stimulus, it worked in the ways that conventional theory would predict and that the recovery faltered when the government unwisely pulled back from stimulative policies. (In that respect, Japanese policies in the late 1990s were akin to FDR’s turn toward restraint after 1936, which halted the recovery and renewed the decline.) Posen sums up as follows:
“Note, however, that this assessment is not a blank check for unlimited fiscal stimulus at every time, everywhere. Japan in the 1990s was where fiscal activism should have worked the best, being closed, with passive highly home-biased savers, and a large economy with essentially no foreign indebtedness. Having a low government share in GDP and a low tax base also means the distortions incurred by sustained fiscal expansions are of relatively low cost. Looking at today’s world, only the U.S. shares these attributes with Japan, and can thus afford to engage in ongoing fiscal stimulus in a protracted recession—and the lesser passivity of U.S. savers and increasing American foreign indebtedness suggest some limit will be reached.” [Italics mine]
In short, the United States can go down Japan’s road, but not as far. In that respect, the U.S. stands between Japan and the UK, whose economy is far less closed than Japan’s and whose public sector is much larger. (To judge from the important speech Prime Minister David Cameron gave on June 7, he agrees with Posen’s assessment and has decided to attack public spending frontally.)
To get a better handle on how far the U.S. can venture down the road of sustained fiscal stimulus, I turned next to an important survey, “Activist Fiscal Policy to Stabilize Economic Activity,” written by two macroeconomists, Berkeley’s Alan J. Auerbach and my Brookings colleague William Gale. In a key section of their paper, titled “Short-Term Stimulus with Long-Term Deficits,” they state that “there are many reasons to think fiscal policies would have different effects if they are adopted during a period of fiscal stress than they would otherwise. ... [F]iscal consolidations have less contractionary effects when adopted under fiscal stress, as measured by high debt and projected government spending relative to GDP.”
In plain English: the higher spending and public debt go, the stronger the economic case for fiscal restraint. At some point, serious deficit reduction ceases to be a green eye-shade exercise and becomes essential for sustainable economic growth. But when? After summarizing the grim prognosis for U.S. deficits and debt during this decade and beyond, Auerbach and Gale formulate the choice as follows:
“[P]olicy makers will need to decide when to cut off stimulus and start imposing fiscal discipline. Cutting off stimulus too soon could plunge the economy into a new downturn, as happened to the United States in 1937 and Japan in 1997. Letting stimulus run for too long could ignite investors’ fears and create a ‘hard landing’ scenario.”
In retrospect, Keynesians agree that U.S. and Japanese policymakers underprovided fiscal stimulus, given the length and severity of the crises they faced. If we were sure that we are now up against a comparable crisis, then the case for continued stimulus would be compelling. But the problem is that we aren’t sure, and we do know that as public spending and deficits continue to rise, the risks that come with excessive debt accumulation increase significantly.
I draw a few rules of thumb from this ensemble of theory, data, and prudential argument.
· First, the economic case for terminating key safety-net programs such as extended unemployment insurance is very weak, and the human case for continuing them is very strong. (Large, permanent programs affect the taxes and revenues that define our fiscal future—not modest cyclical programs that shrink as the economy improves.) It seems wrong-headed to allow valid concerns about deficits and debt to trump the good that we can do for our fellow citizens at modest cost during times of stress.
· Second, setting aside political constraints, it is not easy to decide whether we need another round of major economic stimulus to get the economy to the point of self-sustaining growth. It is facile to argue that all the risks lie on the side of inadequate stimulus. As we are learning from the European case, the global financial crisis has left investors very jittery—so much so that the budget woes of one small country (Greece) have been enough to trigger not only fears about excessive public debt in many other countries, but also a destabilizing flight from the Euro. This suggests that any additional stimulus should be linked explicitly to fiscal restraint down the road.
· What matters most is making a credible commitment—through binding legislation that changes both programs and budget procedures—to alter our long-term fiscal course before our debt enters the red zone (where federal debt closes in on GDP). I can only hope that the report of the president’s fiscal commission, due out in December, sets the stage for the national discussion we have evaded for far too long. This discussion will test our capacity to govern ourselves wisely, and the whole world will be watching. History makes one thing clear: In the long run, no country is too big to fail.
21 comments
Your ignorance doesn't really matter. At the end of this year the stimulus is gone, the Bush tax cuts expire, and Europe's coming fiscal cuts kick in. To varying degrees all of these are contractionary. We'll probably enter the 2nd dip in this recession. If we're lucky maybe we'll get away with low growth. In the meantime the skills of the masses of unemployed will continue to erode, and we'll continue to run deficits large enough to keep us stagnant, but too small to actually move us into positive growth.
- vips73
June 9, 2010 at 1:21am
An open mind is a beautiful thing for all to see. Galston gets it right this time. It's not that fiscal stimulus isn't without risk, but rather comparing that risk to the risk of no (or too little) fiscal stimulus, and then adopting measures (including monetary as well as fiscal) that will result in the least possible overall risk. And in making that assessment, we must also acknowledge that the relative risks aren't the same for everybody, as someone with a high net worth invested in bonds is more attuned to the risk of too much (or any) fiscal stimulus, whereas someone with little savings and who is un(under)employed is more attuned to the risk of too little fiscal stimulus. And it's this difference, that not everybody is on the same side of the equation (for risk), that makes this issue, and writing about this issue, so difficult.
- rayward
June 9, 2010 at 7:19am
The US needs government spending reform. China owns 2.5 trillion dollars of US debt; as of now, they are helping to keep the US afloat–it is rumored that they will step in and help the European financial crisis (specifically, the PIG nations). The debt to GDP ratio may be nearing a "red zone," but the tipping point to look out for is when the US's is unable to borrow money in dollars.
- jonrosse
June 9, 2010 at 10:28am
It's incredible to see an entire article about this topic without any discussion of tax policy and how it has changed since FDR and in particular how it changed in 1980 when deficit spending truly began in earnest under Republican administrations. These are devolutionary Keynesian policies. The Republicans do believe in Keynes in a massive way. The Democrats are more timid. I do not think comparing the US to Japan is particularly interesting. We have decaying and underdeveloped infrastructure in many areas. If it were sufficiently developed we would not benefit in the same way. Also we have an energy crisis that needs to be addressed. It is critical for our economy, our health, and our safety. And we have the skill and creativity to address these things. That could change as key people leave for the countries that are addressing these issues. That is the part that concerns me. The Republican media outlets make deficits a point of concern when Democrats are in office and change the subject when they are out of office. That is why white men in particular are now concerned about the deficit. There is very little rationale for it.
- keepin_on
June 9, 2010 at 10:45am
Somebody help me here, I'm basically an economic ignoramus and there's something I truly don't understand. I don't want to sound flippant, but if US sovreign debt becomes regarded as "too risky", and investors flee, just what is it that they will buy instead? If the US totally goes down the crapper, what market goes up as we go down? Do people really just buy bigger mattresses?
- gwcross
June 9, 2010 at 10:59am
One little focused on reason for Japans "lost" decade (and considering how unemployment stayed low and exports high, we should be so lost) is their slow to negative population growth rate and their aging population of less productive workers. The US doesn't face this problem, and would face this problem even less if it allowed far more skilled productive workers here from the rest of the world (they come in pre-educated and grown up so we don't have to waste resources on that end) and many retire to their home countries so on the back end we save as well, and they go right about paying taxes.
- blackton
June 9, 2010 at 11:21am
gwcross, You aren't an ignoramus. That fact that you ask that question puts you miles ahead of Mr. Galston here. They can't buy anything else, that's the point. They have dollars, the only place dollars can end up is in Treasury debt or mattresses, and debt pays interest. If they choose to spend their dollars, good, demand will increase, and whoever receives the dollars will have the same two choices, Treasury debt or mattress. There is no funding issue for sovereign countries which control their own fiat currencies. That's why it's called a fiat currency.
- vips73
June 9, 2010 at 12:34pm
The biggest risk comes not from domestically held Treasuries but from foreign holdings. Those are 100 percent due to trade deficits. We must get beyond the free-trade Kool-aid and start managing our trade to eliminate these deficits, both to increase domestic labor demand and to limit our exposure to foreign debt holders. We would have much more room for maneuver on domestic fiscal and monetary policy if we did this.
- roidubouloi
June 9, 2010 at 1:43pm
I think our problem is that 8 thin cows (2000 - 2008) ate up 8 healthy cows (1992 - 2000) in the form of tax cuts.
- Nusholtz
June 9, 2010 at 1:45pm
Spot on. Structural deficits under full employment are a huge mistake.
- roidubouloi
June 9, 2010 at 2:00pm
We don't call it that, but are we not in the second "Great Depression?"
- skahn
June 9, 2010 at 6:00pm
Once again, days before Galston's column, Krugman addressed the issue. Does no one at tnr-- editors or readers--check with well-regarded Keynsian economists on such issues before publishing on Keynsian questions?? June 6, 2010, 3:00 AM Lost Decade, Here We Come The deficit hawks have taken over the G20: “Those countries with serious fiscal challenges need to accelerate the pace of consolidation,” it added. “We welcome the recent announcements by some countries to reduce their deficits in 2010 and strengthen their fiscal frameworks and institutions”. These words were in marked contrast to the G20’s previous communiqué from late April, which called for fiscal support to “be maintained until the recovery is firmly driven by the private sector and becomes more entrenched”. It’s basically incredible that this is happening with unemployment in the euro area still rising, and only slight labor market progress in the US. But don’t we need to worry about government debt? Yes — but slashing spending while the economy is still deeply depressed is both an extremely costly and quite ineffective way to reduce future debt. Costly, because it depresses the economy further; ineffective, because by depressing the economy, fiscal contraction now reduces tax receipts. A rough estimate right now is that cutting spending by 1 percent of GDP raises the unemployment rate by .75 percent compared with what it would otherwise be, yet reduces future debt by less than 0.5 percent of GDP. The right thing, overwhelmingly, is to do things that will reduce spending and/or raise revenue after the economy has recovered — specifically, wait until after the economy is strong enough that monetary policy can offset the contractionary effects of fiscal austerity. But no: the deficit hawks want their cuts while unemployment rates are still at near-record highs and monetary policy is still hard up against the zero bound. But what about Greece and all that? Look, right now sovereign debt problems are taking place in countries with a very specific problem: they’re part of the euro zone, AND they’re badly overvalued thanks to huge capital inflows in the good years; as a result they’re facing years of grinding deflation. Countries not in that situation are not facing any pressure from the markets for immediate cuts; as of this morning, 10-year bonds were yielding 3.51 in Britain, 3.21 in the US, 1.27 in Japan. Yet the conventional wisdom now is that these countries must nonetheless cut — not because the markets are currently demanding it, not because it will make any noticeable difference to their long-run fiscal prospects, but because we think that the markets might demand it (even though they shouldn’t) sometime in the future. Utter folly posing as wisdom. Incredible.
- drofnats1
June 9, 2010 at 9:57pm
malahat, That is a common belief, but it is wrong. Foreign debtholders only obtain the dollars with which to buy Treasuries because we run trade deficits. The foreign debt represents the cumulative trade deficit less any equity investments made in the US. On the other hand, the budget deficits do fuel the trade deficits by giving foreign dollar holders an alternative use for their dollars than using them to buy our goods which would balance our trade. In financial terms, the budget deficits help to keep the dollar from falling to the level that would balance our trade by soaking up offshore dollars. However, if we do not start managing our trade, we would likely have trade deficits even with a balanced government budget because there are so many assets in the US to buy. Based on the algebra, economics speak of this flow of dollars into US assets as "investment." That is a terrible misnomer as it is actually our disinvestment -- selling assets to pay for consumption -- even though it is net investment for foreigners.
- roidubouloi
June 10, 2010 at 12:54am
drofnats1: " Does no one at tnr-- editors or readers--check with well-regarded Keynsian economists on such issues before publishing on Keynsian questions??" How can you know their position for sure? Krugman is against deficits under republican presidents, and for them under democrats. http://www.realclearpolitics.com/articles/2010/02/11/krugman_bushs_deficit_bad_obamas_deficit_good_100258.html But don't worry, the guy would never use his knowledge to manipulate you.
- seattleeng
June 10, 2010 at 3:59pm
There is a difference between structural deficits under full-employment and with a slack economy. In the former case, you want surpluses, in the latter deficits. The exact opposite of Bush-Reaganomics.
- roidubouloi
June 10, 2010 at 5:15pm
seattle. I have noted and grant that that you are immune from manipulation by knowledge or facts.
- drofnats1
June 10, 2010 at 9:27pm
Malahat, It is not even really true that we depend on foreigners for financing. If we weren't running trade deficits, we would have a larger domestic output and tax rates that would give us a budget in surplus, as we did under Clinton. There is enough output capacity in the US to pay for our government.
- roidubouloi
June 10, 2010 at 10:25pm
To put it another way, our budget deficits are a cause of our trade deficits. The trade deficits do not ameliorate our budget deficits.
- roidubouloi
June 10, 2010 at 10:26pm
Yes, we might have a trade surplus due to a recession, but that is hardly what you want. Yes, sufficient depreciation in the exchange rate would get us into balance and that's what orthodox economics says will happen. But the US is an exception in this regard because investment in our government securities or in assets here is more attractive than most anywhere else. The budget deficits exacerbate the problem by soaking up the dollars sent abroad to pay for imports and thus keeping the dollar from falling. I don't think that the whole thing is self-correcting. We need to raise taxes. But if we had full output and employment, we are certainly wealthy enough to pay for our government and our capital needs without net imports. Along the way, we would be very smart gradually to replace employment taxes with carbon taxes, reducing the cost of what we want more of, employment, and increasing the cost of what we want less of, carbon emissions. Our problem is 99% one of political will in a political environment where the Republicans are insane -- believing in fiscal and tax fairy tales -- and they have created an environment since Reagan where a large part of the public believes in the craziness along with them. This makes it very hard to do the sensible and doable things we need to do.
- roidubouloi
June 11, 2010 at 7:33am
I don't disagree, malahat, but we have the crises, in every sphere, and are still unable to muster much of a response. We are suffering a grave political illness. It is called the Republican party.
- roidubouloi
June 11, 2010 at 5:09pm
To you too.
- roidubouloi
June 11, 2010 at 6:15pm