Deficits always matter
By Scott Sumner
Paul Krugman has a new post entitled “Deficits Matter Again”:
Not long ago prominent Republicans like Paul Ryan, the speaker of the House, liked to warn in apocalyptic terms about the dangers of budget deficits, declaring that a Greek-style crisis was just around the corner. But now, suddenly, those very same politicians are perfectly happy with the prospect of deficits swollen by tax cuts; the budget resolution they’re considering would, according to their own estimates, add $9 trillion in debt over the next decade. Hey, no problem.
He’s right about the GOP hypocrisy, but I can’t help noticing that the GOP is not the only group that changed their tune after the election.
Unlike Krugman, I’ve consistently argued that deficits are not a good way of stimulating the economy, and that monetary policy should be used to assure the appropriate level of aggregate spending.
Those apocalyptic warnings are still foolish: America, which borrows in its own currency and therefore can’t run out of cash, isn’t at all like Greece. But running big deficits is no longer harmless, let alone desirable.
The way it was: Eight years ago, with the economy in free fall, I wrote that we had entered an era of “depression economics,” in which the usual rules of economic policy no longer applied, in which virtue was vice and prudence was folly. In particular, deficit spending was essential to support the economy, and attempts to balance the budget would be destructive.
This diagnosis — shared by most professional economists — didn’t come out of thin air; it was based on well-established macroeconomic principles. Furthermore, the predictions that came out of those principles held up very well. In the depressed economy that prevailed for years after the financial crisis, government borrowing didn’t drive up interest rates, money creation by the Fed didn’t cause inflation, and nations that tried to slash budget deficits experienced severe recessions.
That last sentence is incorrect. If you look at the group of nations with independent monetary policy, there is no correlation between (cyclically-adjusted) deficit reduction and growth. At the beginning of 2013, a letter signed by 350 Keynesians warned that fiscal austerity risked pushing the US into recession. Instead the deficit fell by nearly half, and economic growth actually sped up in calendar year 2013 (Q4 to Q4). The reason is simple—monetary offset.
But these predictions were always conditional, applying only to an economy far from full employment. That was the kind of economy President Obama inherited; but the Trump-Putin administration will, instead, come into power at a time when full employment has been more or less restored.
How do we know that we’re close to full employment? The low official unemployment rate is just one indicator. What I find more compelling are two facts: Wages are finally rising reasonably fast, showing that workers have bargaining power again, and the rate at which workers are quitting their jobs, an indication of how confident they are of finding new jobs, is back to pre-crisis levels.
What changes once we’re close to full employment? Basically, government borrowing once again competes with the private sector for a limited amount of money. This means that deficit spending no longer provides much if any economic boost, because it drives up interest rates and “crowds out” private investment.
This isn’t really the issue. To the extent that the Keynesian model allows fiscal stimulus to work, it is based on the zero bound issue, not the economy being deeply depressed. Thus in 1982 the economy was deeply depressed, but nowhere near the zero bound. Fiscal stimulus would have been almost completely ineffective at boosting demand (even in the New Keynesian model) because Paul Volcker would have tightened monetary policy enough to keep the economy on track for his low inflation goals. (Of course, there may have been supply-side effects.)
One area where I do agree with Krugman is that economic slack is almost gone. In this recent MoneyIllusion post I also cited the acceleration in hourly wage growth. James Alexander contested this argument, pointing to more ambiguous data for weekly wage growth. But I like hourly wages best, because they are a particularly sticky variable. When the growth rate of hourly wages changes, it usually signals a disequilibrium in the labor market. (In fairness, James points to one case (2008) where they briefly gave a false signal. They probably are not the best forward looking indicator, but I do think they are one of the best indicators of the current condition of the labor market–perhaps with a slight lag.
Krugman links to an earlier post that provided one argument for stimulus, even without much economic slack:
Does this mean that the case for easy monetary and fiscal policies is over? No, but it’s subtler now: it hinges mainly on the precautionary motive. Right now the economy looks OK, but things may change. Of course they could get better, but they could also get worse — and the costs of weakness are much greater than those of unexpected strength, because we won’t have a good policy response if it happens.
What I mean is that because interest rates are still near zero, a bout of economic weakness can’t be met with strong monetary expansion; and discretionary fiscal stimulus is politically hard, especially given who’ll be running things. This strongly suggests that you want to build up some momentum, get further away from a lee shore, pick your metaphor; that means letting the economy build strength, inflation rise modestly.
In this post I criticized this view. The Fed may want to raise its inflation target (although I prefer other reforms) but it should not overshoot an unchanged inflation target to build up ammunition against a potential zero bound problem. Doing so would make inflation even more procyclical, and make another recession more likely. Indeed excessive monetary stimulus in 2006 was one of the causes of the 2008 recession. It pushed inflation above target, and a couple year slater the Fed tightened to reduce inflation at the worst possible time.
A better solution would be to switch to 4% NGDP level targeting. This would generate countercyclical inflation.