Monday, September 22, 2014
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Premature Virtue

NEW YORK – The Obama administration’s insistence on fiscal rectitude is dictated not by financial necessity, but by political considerations. The United States is not one of Europe’s heavily indebted countries, which must pay hefty premiums over the price at which Germany can borrow. Interest rates on US government bonds have been falling and are near record lows, which means that financial markets anticipate deflation, not inflation.

Nevertheless, Obama is under political pressure. The US public is deeply troubled by the accumulation of public debt, and the Republican opposition has been extremely successful in blaming the Crash of 2008 – and the subsequent recession and high unemployment – on government ineptitude, as well as in claiming that the stimulus package was largely wasted.

There is an element of truth in this, but it is one-sided. The Crash of 2008 was primarily a market failure, for which US (and other) regulators should be faulted for failing to regulate.

But, without a bailout, the financial system would have remained paralyzed, making the subsequent recession much deeper and longer. True, the US stimulus package was largely wasted, but that was because most of it went to sustaining consumption rather than to correcting the underlying imbalances.

Where the Obama administration went wrong was in how it bailed out the banking system: it helped banks earn their way out of a hole by purchasing some of their bad assets and supplying them with cheap money. This, too, was guided by political considerations: it would have been more efficient to inject new equity into the banks, but Obama feared accusations of nationalization and socialism.

That decision backfired, with serious political repercussions. The public, facing a jump in credit card charges from 8% to nearly 30%, saw banks earning bumper profits and paying large bonuses. The Tea Party movement exploited this resentment, and Obama is now on the defensive. The Republicans campaign against any further stimulus, and the administration now pays lip service to fiscal rectitude, even if it recognizes that deficit reduction may be premature.

I believe that there is a strong case for further stimulus. Admittedly, consumption cannot be sustained indefinitely by running up the national debt; the imbalance between consumption and investment must be corrected. But to cut government spending at a time of large-scale unemployment would be to ignore the lessons of history.

The obvious solution is to distinguish between investments and current consumption, and increase the former while reducing the latter. But that seems politically untenable. Most Americans are convinced that government is incapable of efficiently managing investments aimed at improving the country’s physical and human capital.

Again, this belief is not without justification: a quarter-century of calling the government bad has resulted in bad government. But the argument that stimulus spending is inevitably wasted is patently false: the New Deal produced the Tennessee Valley Authority, the Triborough Bridge in New York, and many other public utilities still in use today.

Moreover, the simple truth is that the private sector is not employing available resources. Obama has been very friendly to business, and corporations are operating very profitably. But, instead of investing, they are building up liquidity. Perhaps a Republican victory will boost their confidence, but in the meantime investment and employment require fiscal stimulus (monetary stimulus, by contrast, would be more likely to stimulate corporations to devour each other than to hire workers).

How much government debt is too much is an open question, because tolerance for public debt is highly dependent on prevailing perceptions. The risk premium attached to the interest rate is the critical variable: once it starts rising, the existing rate of deficit financing becomes unsustainable. But the tipping point is indeterminate.

Consider Japan, with a debt-to-GDP ratio approaching 200% – one of the highest in the world. Yet ten-year bonds yield little more than 1%. Japan once had a high savings rate, but its current savings rate is about the same as in the US, thanks to an aging and shrinking population. The big difference – that Japan has a trade surplus and the US has a deficit – is not important as long as China’s currency policy obliges it to accumulate dollar assets in one form or another.

The real reason why Japanese interest rates are so low is that Japan’s private sector has little appetite for investing abroad and prefers ten-year government bonds at 1% to cash at 0%. With the price level falling and the population aging, the Japanese consider the real return attractive. As long as US banks can borrow at near zero and buy government bonds without having to commit equity, and the dollar does not depreciate against the renminbi, interest rates on US government bonds may well be heading in the same direction.

That does not mean that the US should maintain the discount rate close to zero and run up government debt indefinitely. Once the economy starts growing again, interest rates will rise – perhaps precipitously, if the accumulated debt is too large. But, while that would choke off the recovery, premature fiscal tightening would do so sooner.

The right policy is to reduce imbalances as quickly as possible while minimizing the increase in the debt burden. This can be done in several ways, but the Obama administration’s stated goal – halving the budget deficit by 2013 while the economy is operating far below capacity – is not one of them. Investing in infrastructure and education makes more sense. So does engineering a moderate rate of inflation by depreciating the dollar against the renminbi.

What stands in the way of this agenda is not economics, but misconceptions about budget deficits that are being exploited for partisan and ideological purposes.

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