Can the economy handle a 20% fiscal contraction (at near zero interest rates?)
By Scott Sumner
Here’s Matt O’Brien:
Libertarian presidential candidate Gary Johnson is a friendly guy, seems pretty moderate. But he could tank the economy.
That’s what trying to balance the budget all at once would do. Which, of course, is what Johnson says he would. He wants to cut spending by 20 percent next year to get the government back in the black, and then veto any legislation that would make the red ink return.
This probably wouldn’t end well. The problem is the Federal Reserve might not be willing or able to really counteract this. In normal times, you see, the Fed cuts interest rates when the government cuts the deficit so that the private sector can pick up the slack for the public sector. But even eight years after the Great Recession, these are still not normal times. The Fed can’t cut interest rates right now, because they’re barely above zero. Now, it’s true that the Fed could print money instead — that’s how it stopped austerity from starting a recession in 2013 — but Johnson doesn’t want the Fed to do that. He’s said that quantitative easing, which is when the Fed buys bonds with newly created dollars, is just an attempt to “override the free market” that will only lead to “malinvestment, inflation, and prolonged unemployment.” And since he would not only get to pick two Fed members in 2017, but also a new Fed chair in 2018, what he thinks matters.
I mostly agree with this, but not entirely. I certainly agree that the Fed could offset fiscal austerity with a more expansionary monetary policy, just as they did in 2013. But it’s not quite right to say that the Fed cannot cut interest rates. The current rate of interest on reserves is 0.5%, and that rate could be cut by 100 basis points, to minus 0.5%. Nonetheless O’Brien is right that interest rate cuts might not be enough.
But I also think he slightly exaggerates how much we know about this issue. Let’s take the policy environment at the end of WWII. Here are some relevant facts:
1. There was massive austerity, as government spending fell by far more that 20%. We suddenly went from a deficit of 20% of GDP, to a surplus.
2. Several top Keynesian economists warned that this austerity would lead to another post-war depression.
3. Short term interest rates were very low, but slightly above zero (0.38% on T-bills, for instance.)
Sound familiar? Here’s what happened next. After WWII, the Fed did not cut rates at all to offset the fiscal austerity. Indeed after holding them at 0.38% for about 2 years, they began gradually raising them in mid-1947. Nor did they do any QE. And despite all that, the economy remained fine, with the unemployment rate fluctuating between 3% and 5% throughout 1946, 1947, and 1948, despite millions of men suddenly being discharged from the military. The Keynesian predictions did not come true.
I recognize that there are lots of differences between 1946 and today. But even so, it should give us all pause to consider that well-informed Keynesian economists got this wrong. Maybe there is something wrong with the model.
And let’s not forget that Johnson is also proposing many positive initiatives that would boost aggregate supply, such as tax reform.
This is not to say that I agree with everything Johnson is proposing. I disagree with him on the wisdom of balancing the budget so quickly, and I disagree with him on QE, at least as an option. Nonetheless, the post-WWII experience should make us all very cautious about predicting the impact of fiscal austerity.
PS. A few months back Trump proposed paying off the entire national debt in 8 years, which is an even more contractionary proposal. These sorts of proposals need to be taken with more than a grain of salt.
PPS. I recommend this David Beckworth interview of Jason Taylor, which touches on some of these issues. Taylor says that Keynesians predicted 25% to 35% unemployment if the government suddenly discharged 10 million soldiers, and also suddenly slashed massive military spending. The government did exactly that, and unemployment averaged 3.9% in 1946 and 1947. (The specific discussion occurs after the 47 minute mark.)