Saturday, November 22, 2014

Debt-Friendly Stimulus

NEW HAVEN – With much of the global economy apparently trapped in a long and painful austerity-induced slump, it is time to admit that the trap is entirely of our own making. We have constructed it from unfortunate habits of thought about how to handle spiraling public debt.

People developed these habits on the basis of the experiences of their families and friends: when in debt trouble, one must cut spending and pass through a period of austerity until the burden (debt relative to income) is reduced. That means no meals out for a while, no new cars, and no new clothes. It seems like common sense – even moral virtue – to respond this way.

But, while that approach to debt works well for a single household in trouble, it does not work well for an entire economy, for the spending cuts only worsen the problem. This is the paradox of thrift: belt-tightening causes people to lose their jobs, because other people are not buying what they produce, so their debt burden rises rather than falls.

There is a way out of this trap, but only if we tilt the discussion about how to lower the debt/GDP ratio away from austerity – higher taxes and lower spending – toward debt-friendly stimulus: increasing taxes even more and raising government expenditure in the same proportion. That way, the debt/GDP ratio declines because the denominator (economic output) increases, not because the numerator (the total the government has borrowed) declines.

This kind of enlightened stimulus runs into strong prejudices. For starters, people tend to think of taxes as a loathsome infringement on their freedom, as if petty bureaucrats will inevitably squander the increased revenue on useless and ineffective government employees and programs. But the additional work done does not necessarily involve only government employees, and citizens can have some voice in how the expenditure is directed.

People also believe that tax increases cannot realistically be purely temporary expedients in an economic crisis, and that they must be regarded as an opening wedge that should be avoided at all costs. History shows, however, that tax increases, if expressly designated as temporary, are indeed reversed later. That is what happens after major wars, for example.

We need to consider such issues in trying to understand why, for example, Italian voters last month rejected the sober economist Mario Monti, who forced austerity on them, notably by raising property taxes. Italians are in the habit of thinking that tax increases necessarily go only to paying off rich investors, rather than to paying for government services like better roads and schools.

Keynesian stimulus policy is habitually described as deficit spending, not tax-financed spending. Stimulus by tax cuts might almost seem to be built on deception, for its effect on consumption and investment expenditure seems to require individuals to forget that they will be taxed later for public spending today, when the government repays the debt with interest. If individuals were rational and well informed, they might conclude that they should not spend more, despite tax cuts, since the cuts are not real.

We do not need to rely on such tricks to stimulate the economy and reduce the ratio of debt to income. The fundamental economic problem that currently troubles much of the world is insufficient demand. Businesses are not investing enough in new plants and equipment, or adding jobs, largely because people are not spending enough – or are not expected to spend enough in the future – to keep the economy going at full tilt.

Debt-friendly stimulus might be regarded as nothing more than a collective decision by all of us to spend more to jump-start the economy. It has nothing to do with taking on debt or tricking people about future taxes. If left to individual decisions, people would not spend more on consumption, but maybe we can vote for a government that will compel us all to do that collectively, thereby creating enough demand to put the economy on an even keel in short order.

Simply put, Keynesian stimulus does not necessarily entail more government debt, as popular discourse seems continually to assume. Rather, stimulus is about collective decisions to get aggregate spending back on track. Because it is a collective decision, the spending naturally involves different kinds of consumption than we would make individually – say, better highways, rather than more dinners out. But that should be okay, especially if we all have jobs.

Balanced-budget stimulus was first advocated in the early 1940’s by William Salant, an economist in President Franklin Roosevelt’s administration, and by Paul Samuelson, then a young economics professor at the Massachusetts Institute of Technology. They argued that, because any government stimulus implies higher taxes sooner or later, the increase might as well come immediately. For the average person, the higher taxes do not mean lower after-tax income, because the stimulus will have the immediate effect of raising incomes. And no one is deceived.

Many believe that balanced-budget stimulus – tax increases at a time of economic distress – is politically impossible. After all, French President François Hollande retreated under immense political pressure from his campaign promises to implement debt-friendly stimulus. But, given the shortage of good alternatives, we must not assume that bad habits of thought can never be broken, and we should keep the possibility of more enlightened policy constantly in mind.

Some form of debt-friendly stimulus might ultimately appeal to voters if they could be convinced that raising taxes does not necessarily mean hardship or increased centralization of decision-making. If and when people understand that it means the same average level of take-home pay after taxes, plus the benefits of more jobs and of the products of additional government expenditure (such as new highways), they may well wonder why they ever tried stimulus any other way.

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    1. CommentedJoshua Ioji Konov

      The idea to use QE for targeted stimulus seems the most credible in any ways the whole idea of QE is expand the money pool, however the US economy has not been performing for the last 20-25 years not because of lacking capital: but because of the economy's transmission-ability under the new Globalization and rising Productivity, the China and the Internet that developments require newer approaches in economics, The not working US economy accumulates debt however capital is injected, so logically the reasons for such weakness should be changed along with targeted capital injections.

    2. CommentedJulio Huato

      What Keynes wrote about nominal wages applies (mutatis mutandis) to nominal taxes. Spend and then use (moderate) inflation to tax the rich. Some transfers may be required to assist widows, retirees, and other innocent bystanders affected by inflation. But Schumpeterian forced saving works. Inflation can be kept moderate, but the very powerful vested interest that promote austerity have convinced a large portion of the public, that once it sets in, inflation tends to get out of control. Not necessarily.

    3. CommentedArmen Papazian

      Our economic and financial imagination is at the heart of all the self inflicted challenges we face. Starting from debt itself, and money mechanics. Indeed, we must transform QE3 in such a way so that we inject the money without debt and as income first!! Currently QE3 conditions further expansion on bank credit because the banks are the ones getting the 85 billion a month since september 2012. We need instruments that are equity like, and inject the newly created money as investment capital. More here:

    4. CommentedMichael Cohen

      If you raise taxes at the same rate as you are increasing government spending. Aren't you just moving spending from the private sector to the government unless the taxes result in less savings in the private sector?

      It seems to increase aggregate demand, the government needs to go into debt to "prime the pump" and then pay off the debt through increased revenue due to economic growth and some increased taxes as required.

        CommentedJeremy Majerovitz

        If you raise government spending and taxes by one dollar each, then you have increased spending by one dollar (through the government spending), but you have decreased spending by less than one dollar, because some of the money that you took from the private sector through taxes is money that would have been saved anyway.

        CommentedJeremy Majerovitz

        If you raise government spending and taxes by one dollar each, then you have increased spending by one dollar (through the government spending), but you have decreased spending by less than one dollar, because some of the money that you took from the private sector through taxes is money that would have been saved anyway.

        CommentedJeremy Majerovitz

        If you raise government spending and taxes by one dollar each, then you have increased spending by one dollar (through the government spending), but you have decreased spending by less than one dollar, because some of the money that you took from the private sector through taxes is money that would have been saved anyway.

    5. Commentedgurmit bhatia

      Very Insightful article. Robert J. Shiller along with Dambisa Moyo are two Brilliant Individuals.

    6. CommentedPedro Dudiuk

      Dear Professor Shiller, Could you say why you have not used the Haavelmo theorem in his argument?

    7. CommentedLee Hubbard

      Prof Shiller's position rests on this premise: "That way, the debt/GDP ratio declines because the denominator (economic output) increases, not because the numerator (the total the government has borrowed) declines."
      Where is the evidence that this is the case?

        CommentedRock Steady

        The United States in the 1990's, for one. Post-WWII United States, to name another. The evidence abounds.

        CommentedRock Steady

        Lee Hubbard,
        The United States in the 1990's, for one. Post-WWII United States, to name another. The evidence abounds.

    8. CommentedG. A. Pakela

      If the debt and Fed accomodation-based stimulus has failed to jump start the economy, why would anyone think that increasing government spending using the so-called balanced budget multiplier would work any better?

      A better way of to remove austerity is to cut taxes permanently and then make a commitment to hold government spending increases to a minimum. In Europe, this can be accomplished on the demand-side by drastically slashing the VAT, and on the supply-side in both Europe and the U.S. by reducing marginal income tax rates and lowering the after-tax cost of capital.

      In the U.S., the major tax cuts have never failed to pay for themselves within a few years, and this fact can be ascertained by simply looking at a table of the percentage of tax revenue to GDP.

    9. CommentedJoe Dunn

      Nonsense on stilts!
      To wit: The author states the following: "History shows, however, that tax increases, if expressly designated as temporary, are indeed reversed later."
      On what planet?
      In 1898, the US instituted a excise tax of 3% on telephone service specifically to pay for the Spanish American War, nothing else. In 1906, a full 108 years later, they finally, after much weeping and
      gnashing of teeth, rescinded a PORTION of that tax.
      Apparently, a teaching position at Yale does not insulate one from the silly.

        CommentedThomas Haynie

        One instance from one country does not a significant argument or outcome make.

        In general I see the Liberatopians and debt hawks come from the wood work.

        last I checked. . . Nordic countries had a MUCH higher overall standard of living than the U.S. despite the "tax and spend" mind set... they must get more for their money than we do.

        Also, last I checked the recovery in the most austere countries has been among the slowest. There is considerable history to support Keynesian policies in an updated and modified form.

    10. CommentedFred Cripe

      If Dr. Shiller's policy recommendations were correct, one might expect Denmark and Sweden, which have been following his policy nonstop for the past two decades (and have the highest tax and spending to GDP ratios in the developed world) would have much higher GDP growth than the US. They don't. Sweden's growth is virtually identical to the US over the past 20 years and Denmark's growth rate is a bit over half of the US growth rate during that period.

    11. CommentedFrank Aten

      I'm not totally buying the argument. There is only conjecture that stimulus works to ignite sustainable aggregate demand and there is no evidence that it works when real wages have been stagnant, current debt (both private and public are at high levels and total wealth depleted). Stimulus (another word for creating more debt in the public sector) in fact only makes things worse as it creates additional stress at both the private and public levels. What we are witnessing is not even a natural event but an event brought on by very poor public policies that were developed to enrich a select few at the expense of total social welfare. One must correct the policies before embarking on the long road back to economic growth and normal business cycles again. I'm not encouraged that will happen in what most would consider a reasonable time frame.

    12. CommentedRoman Bleifer

      Nature of the problems are not in stimulating consumption, and in the absence of the necessary investment in the economy ( ). The Obama administration has come essentially from the Keynesian principle that increasing demand through fiscal expansion can compensate for lack of inveatitsy in the economy. This idea gets the economy to a standstill. Creates the problem of sovereign debt and inflate dangerous financial bubbles. And they inevitably burst, bringing down the stock markets.

    13. CommentedProcyon Mukherjee

      It is very clear that there are limits to corporate investments in an economy where the general public is not spending; how would they if wage is stagnant? So we have a spiral, which cannot be ignored.

      Price and wage stickiness being what they are and government spending is doing precious little to stimulate demand, we cannot simply hope that debt driven policies would take us to salvation.

      While we have been referring to debt/GDP ratios, it would be prudent to look at Government debt to Government revenue ratio and it would be clear how this has been growing over the last decade.

    14. CommentedAlan Ortiz

      I believe the fundamental problem is that labor's skills are not yet adjusted to the developments in technology for the past 20-years. Automation, digital data keeping, among other things replaced the need for certain skills (and degrees), and especially large companies in developed nations are reaping the benefits (explaining the current highs in profits), without redistributing the wealth to the workforce. Typically, businesses in developed countries prioritize capital expenditure in machines and technology, over increasing their workforce. This is complicated by globalization and international competition.

      While I think the professor's proposal will help in the short-term, I do not think it will improve the structural unemployment-- what I call a "labor-trap", in the long run.

    15. CommentedMukesh Adenwala

      Such a stimulus can work if either the economies are closed with no international trade or when all the countries in a globalized world adopt similar policy. What happens to the international competitiveness in a scenario prescribed by Professor Shiller? Higher domestic taxes reduces exports competitiveness, can be expected to suffer, which in itself can be unaffordable.

      Nordic countries had this model of high taxes, high income (and high welfare) but they had to dismantle the same because of international competition.

        CommentedRalph Musgrave

        Obvious exports and imports involve leakages. But that does not render the polices proposed by Shiller totally ineffective.

    16. CommentedMukesh Adenwala

      Such a stimulus can work if either the economies are closed with no international trade or when all the countries ina globalized world adopt similar policy. What happens to the international competitiveness in such a scenario? Because of higher taxes the exports can be expected to suffer, which in itself will be a big minus. Nordic countries had this model of high taxes, high income and high welfare but they too have been dismantling the same because of international competition.

    17. CommentedC. Jayant Praharaj

      Mr. Shiller's neat little argument that the denominator ( GDP ) in the debt/GDP ratio will increase due to what he calls "debt-friendly" stimulus needs to be justified. Why will the denominator increase ? Mr. Shiller needs to answer sophomore economics questions like - what happens to private consumption, private investment, availability of credit, availability of savings etc. Without this exercise in sophomore economics, Mr. Shiller's arguments will fail to convince. Do things add up the way they need to in order that Mr. Shiller's claim about what will happen to the GDP following his " debt-friendly " measures holds true ? The argument involving what happens to all the production parameters in the economy and what happens to all the cash-flow components in the economy needs to be laid out in detail. If Mr. Shiller goes through this exercise in sophomore economics, he will probably find that his denominator doesn't budge much once all the cash flow considerations and all the production parameters have been considered.

      Countries sometimes have to follow fiscal austerity policies, not because its economists don't understand the difference between household finance and public finance, not because its economists don't understand the difference between an individual and an economy, but because of very germane and unavoidable factors having to do with economies with a large number of people. Where did Mr. Shiller get the idea that the economists in charge of government finance ministries do not understand what fallacies of composition are ? We don't need lectures about how fallacies of composition affect economies. Those are understood well enough after two hundred years or so of modern economics. Mr. Shiller needs to rest assured that the people involved in debt negotiations and the ministers and bureaucrats in charge of public finances of countries consider far more details than Mr. Shiller's article considers. And no, economists and finance ministers are not in the habit of managing national economies as if they were individuals or households. It seems Mr. Shiller has given free rein to his imgaination when it comes to judging how economic policies are framed and executed. He has engaged in what can be called a superficial kind of psychoanalysis that is not borne out by the empirical evidence or by common-sense.

    18. Commentedjack lasersohn

      The idea that temporary increases in government spending will stimulate the economy is wrong for the same reason that temporary tax cuts are not stimulative. People know the demand created by temporary spending is temporary and will not make the investment in permanent new capacity to move the economy to a new equilibrium. In addition, if the spending is financed by tax increases on the 'wealthy', they will be even less inclined to make the investments in expanded capacity.
      A temporary stimulus might have the capacity to produce a sustainable increase in demand under very unusual circumstances. WW ll led to a new higher demand equilibrium point because it enforced an extended period of deprivation and rationing creating both 'pent up demand' and savings, forced investment in new productive capacity, and created an artificial rapid population increase in the baby boom.
      The classic Keynesian stimulus of having everybody dig and then fill in ditches, might produce temporary hot dog stands and sleeping tent villages along the route of the ditch, but not much else. It will also wear out a lot of useful shovels and many able bodied workers.
      The stimulus idea relies on a version of the 'money illusion' hypothesis that explains why labor will accept 3% inflation for 3 years but not a 9% pay cut. Stimulus assumes that entrepreneurs will see more money/demand in the economy and simply respond with increased supply/hiring. But entrepreneurs are not as easily fooled as labor and will be much more skeptical about whether the demand is real and sustainable before investing(particularly if you increase their taxes at the same time). I think it is completely obvious that is why the massive existing stimulus is not really working.
      Give the deleveraging cycle a chance to work. Or if you want to be really clever, print money to pay off household debt, and rely on the money illusion to trick consumers into thinking they are permanently wealthier.

    19. CommentedZsolt Hermann

      Last week I found this interesting article:
      Basically it says that even if we are in a position, state, action we do not believe in, which does not make any sense or logic, but if start defending, promoting that state, action, we ourselves start to believe in it, and then live in it like a bubble disconnected from reality.
      The stance political, leaders, economists and other experts adopted regarding the global crisis and regarding "solutions" is a real life example of this.
      All the field data, daily events, and even up to date scientific research is proving that the present constant quantitative growth economic model is unsustainable, moreover it has become self-destructive.
      But these people keep on coming up with "solutions", adjustments which will guide us back to growth, upturn, basically they try to prove we can resuscitate the horse that is already dead.
      Until we are brave enough to look into the mirror, and take honest stock of the dead end we arrived into, and how our inherent selfish, greedy nature brought us here, how we disconnected from our natural foundations ignoring that we still exist within a natural system, we will never find a solution.
      We have to burst all our bubbles, leave our illusions behind and come down to earth and adapt to the natural system we are part of.
      The demand/provision couple cannot be dictated by the excessive demand side in a closed and finite natural system. Only the demand can be adjusted to the given and finite provisions.

    20. CommentedMark Pitts

      The professor ignores the fact that not “all of us” pay income taxes; only about half do. Furthermore, among those who pay any taxes, the rate (income tax), and the maximum level for deductions (SS and Medicare) varies enormously. Thus, “debt-friendly stimulus” ends up being all about income and wealth redistribution.

      Even spending that is nominally “investment” goes primarily to teachers and the unions involved in infrastructure projects. This is political payback and helps the general population only very indirectly.

      There are big winners and big losers in the suggested scheme. We’re not, in fact, “all in it together.”

    21. CommentedJens Kolhammar

      Very Interesting. However, seeing all the new research about austerity being self-defeating, would it not be better, economically speaking, to at least have a couple of years of debt financed stimulus before you raise taxes.

      In the long run, one or two more years of deficit does not really contribute that much to the debt of a state and a stimulus that is not offset by raised taxes should be even more effective at creating demand.

    22. CommentedJ St. Clair

      "NEW" highways....where would that be in USA.....where would that be in all already developed countries..........

        CommentedMichael Cohen

        They don't have to be New highways. We have 3 Trillion dollars in deferred maintenance to take care of. Timely maintenance is generally a better policy than waiting for things to fall down.

        And isn't now the best time to build them with high unemployment, low borrowing costs, relatively, low resource costs and wages ?

        If we put off the maintenance we will pay more later when we ought to be paying down the debt.

    23. CommentedShane Beck

      The major problem is Democracy itself. The politicians won't make the hard decisions. Austerity itself is not bad- during the boom time when a surplus can accumulate to pump prime the slump- a point that Keynes made. The problem with building a surplus is trying to stop politicians from squandering it in the boom period on vote buying schemes such as tax cuts, government programs, a war or two. The other hard decisions that the politicians flubbed was the bailout of the Western financial institutions. Not only did this create a moral hazard toward risk taking but it socialized the private debt into public debt adding to amount of public pain through austerity. Time and time again we see the voters and therefore the politicians in places like Greece, Italy and recently Cyprus reject the EU solution. Part of the reason is that they believe that the solution is inequitable- the burden of the austerity measures falls upon the lower to middle classes and not the elite- you could point to evictions in Spain, the haircut on savings in Cyprus, the rampant tax evasion in Greece etc. Another part of the problem with Democracy is that the politicians will always give the voters what they want- and inevitably the voters want welfare and tax cuts even if the costs are pushed further down the road, even onto succeeding generations. Witness the furor of such a thing as chained CPI. And the politicians are quite happy to go along with it and push the cost onto succeeding generations. Look at the Debt as a percentage of GDP and you will find the worst offenders.

        Commentedradek tanski

        Thanks for saying that Shane.

        I similarly believe that majority democratic entitlements are only made possible through the accumulation of capital and the past resultant good times. Our latest energy boom from steam and oil have made such surplus possible. People have in result bred till the limits of their new energy limitations, and consequently no more surplus exists. And I'm sure this pattern has repeated itself for all humanities history, if not that of all of life.
        But this cycle of entitlement democracy will soon come to an end, if it already hasn't.

        Austerity is just a way of inducing the entitled hangers on, who consume instead of produce, into sufficient discomfort to get creative and create. There is no alternative to austerity, which is why it puzzles me that popular writers keep denouncing it. It's like they get a salary from appealing to the entitled hangers on.

    24. CommentedRalph Witherell

      What a crock. You said it right though, "petty bureaucrats will inevitably squander the increased revenue on useless and ineffective government employees and programs."

      Look at what an unwieldy beast our federal govt has become for proof.