Monday, November 24, 2014

The Dangers of Deficit Reduction

NEW YORK – A wave of fiscal austerity is rushing over Europe and America. The magnitude of budget deficits – like the magnitude of the downturn – has taken many by surprise. But despite protests by the yesterday’s proponents of deregulation, who would like the government to remain passive, most economists believe that government spending has made a difference, helping to avert another Great Depression.

Most economists also agree that it is a mistake to look at only one side of a balance sheet (whether for the public or private sector). One has to look not only at what a country or firm owes, but also at its assets. This should help answer those financial sector hawks who are raising alarms about government spending. After all, even deficit hawks acknowledge that we should be focusing not on today’s deficit, but on the long-term national debt. Spending, especially on investments in education, technology, and infrastructure, can actually lead to lower long-term deficits. Banks’ short-sightedness helped create the crisis; we cannot let government short-sightedness – prodded by the financial sector – prolong it.

Faster growth and returns on public investment yield higher tax revenues, and a 5 to 6% return is more than enough to offset temporary increases in the national debt. A social cost-benefit analysis (taking into account impacts other than on the budget) makes such expenditures, even when debt-financed, even more attractive.

Finally, most economists agree that, apart from these considerations, the appropriate size of a deficit depends in part on the state of the economy. A weaker economy calls for a larger deficit, and the appropriate size of the deficit in the face of a recession depends on the precise circumstances.

It is here that economists disagree. Forecasting is always difficult, but especially so in troubled times. What has happened is (fortunately) not an everyday occurrence; it would be foolish to look at past recoveries to predict this one.

In America, for instance, bad debt and foreclosures are at levels not seen for three-quarters of a century; the decline in credit in 2009 was the largest since 1942. Comparisons to the Great Depression are also deceptive, because the economy today is so different in so many ways. And nearly all so-called experts have proven highly fallible – witness the United States Federal Reserve’s dismal forecasting record before the crisis.

Yet, even with large deficits, economic growth in the US and Europe is anemic, and forecasts of private-sector growth suggest that in the absence of continued government support, there is risk of continued stagnation – of growth too weak to return unemployment to normal levels anytime soon.

The risks are asymmetric: if these forecasts are wrong, and there is a more robust recovery, then, of course, expenditures can be cut back and/or taxes increased. But if these forecasts are right, then a premature “exit” from deficit spending risks pushing the economy back into recession. This is one of the lessons we should have learned from America’s experience in the Great Depression; it is also one of the lessons to emerge from Japan’s experience in the late 1990’s.

These points are particularly germane for the hardest-hit economies. The United Kingdom, for example, has had a harder time than other countries for an obvious reason: it had a real-estate bubble (though of less consequence than in Spain), and finance, which was at the epicenter of the crisis, played a more important role in its economy than it does in other countries.

The UK’s weaker performance is not the result of worse policies; indeed, compared to the US, its bank bailouts and labor-market policies were, in many ways, far better. It avoided the massive waste of human resources associated with high unemployment in America, where almost one out of five people who would like a full-time job cannot find one.

As the global economy returns to growth, governments should, of course, have plans on the drawing board to raise taxes and cut expenditures. The right balance will inevitably be a subject of dispute. Principles like “it is better to tax bad things than good things” might suggest imposing environmental taxes.

The financial sector has imposed huge externalities on the rest of society. America’s financial industry polluted the world with toxic mortgages, and, in line with the well established “polluter pays” principle, taxes should be imposed on it. Besides, well-designed taxes on the financial sector might help alleviate problems caused by excessive leverage and banks that are too big to fail. Taxes on speculative activity might encourage banks to focus greater attention on performing their key societal role of providing credit.

Over the longer term, most economists agree that governments, especially in advanced industrial countries with aging populations, should be concerned about the sustainability of their policies. But we must be wary of deficit fetishism. Deficits to finance wars or give-aways to the financial sector (as happened on a massive scale in the US) lead to liabilities without corresponding assets, imposing a burden on future generations. But high-return public investments that more than pay for themselves can actually improve the well-being of future generations, and it would be doubly foolish to burden them with debts from unproductive spending and then cut back on productive investments.

These are questions for a later day – at least in many countries, prospects of a robust recovery are, at best, a year or two away. For now, the economics is clear: reducing government spending is a risk not worth taking.

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    1. CommentedCarol Maczinsky

      I think we ought to follow the example of Frederick William I of Prussia and reduce our spending, be functional and focussed. Good governance is the trick. Prussian Prudence, not anglosaxon austerity. Don't forget the USSR bankrupted because of its excessive military spending. The US could be next given that they seem unable to reduce their military budget and adjust it to international security realities. Relying on "Debt" sounds immoral and dishonourable to me.

    2. Commentedphilip meguire

      I agree that debt issued to finance long lived infrastructure should not count as part of the conventional deficit, as long as governmental accounting is scrupulously honest about the distinction between the current and capital budgets.

      I also agree that in nations where the tax / GDP ratio is under, say, 35%, tax increases have an important role to play in deficit reduction. I advocate 250-350B of cuts in Federal expenditure, combined with at least a 200B increase in personal taxes, and a 150B increase in corporate income taxes. This should reduce the Federal deficit to about 3% of GDP. I would welcome a further orderly reduction of the deficit.

      Stiglitz seems to think that current level of the Federal deficit and its rate of growth are not problematic. They do not seem problematic only because interest rates are artificially low. If the ex post real interest rate on Federal borrowing returned to 1%/year, the Federal budget would be in a major crisis.

      Finally, it is wrong to focus on unemployment as a measure of how subpar the American economy is. The trouble is that the distinction between being unemployed and being out of the labour force is mostly subjective. The unemployment rate does not do justice to people employed part time who wish they were employed full time. The employment-population ratio is much more operational, but it harder to interpret because it is not a stationary time series. The BLS does not report the employment-population ratio I would prefer to focus on, namely that for persons between the 25th and 62nd birthdays, broken down by gender.

      The employment-population ratio hit its all-time high in 2000. The current level of that ratio is about what it was in 1977-78, then seen as normal years. The 1980s and 90s witnessed a massive shift of married women into employed status. This century has witnessed a substantial decline in manufacturing employment. These and related data can be found on the FRED database run by the St. Louis Fed.

      The trouble with offsetting the national debt with the public sector's assets, is that those assets seldom have an objective market valuation. Hence there is an irresistible temptation to overvalue those assets in order to engage in profligate fiscal policy. Greece may soon discover that its public assets cannot find buyers at anything like the price it hoped to get for them.

      Continental Europe is a different kettle of fish. Recent events have shown that there is a real risk that debt markets will not buy the sovereign debt of many European nations unless they agree to pay punitive interest rates of a kind that make further deficits unaffordable.

      Europe fell into its current crisis having much higher levels of taxation and expenditure (scaled by GDP) than was the case in the USA. Hence there is much less scope for tax increases, and spending cuts will be more painful. In much of Europe, there is no way forward that does not involve significant reductions in the generosity of their welfare states, and in labour market regulations that make job separations very costly. Difficult separations make for reluctant employers.

        CommentedJohn Brian Shannon

        Hi Philip Meguire,

        What a great comment, I wish I had written it.

        One thing though, regarding your statement;

        "Stiglitz seems to think that current level of the Federal deficit and its rate of growth are not problematic."

        If you or I, or the neighbor down the street, say "The current level of the Federal Deficit and its rate of growth ARE problematic." -- the market will NOT go into a roller-coaster ride for a week.

        Whilst someone like Joseph E Stiglitz, or Paul Krugman saying that WOULD cause market turmoil, not to mention angry phone calls and a threat of legal action. (Not quite, but almost! We are headed in that direction these days)

        Best regards, JBS