The Usual Suspect

BERKELEY – Across the Euro-Atlantic world, recovery from the recession of 2008-2009 remains sluggish and halting, turning what was readily curable cyclical unemployment into structural unemployment. And what was a brief hiccup in the process of capital accumulation has turned into a prolonged investment shortfall, which means a lower capital stock and a lower level of real GDP not just today, while the recovery is incomplete, but possibly for decades.

One legacy of Western Europe’s experience in the 1980’s is a rule of thumb: each year that lower labor-force attachment and reduced capital stock as a result of declining investment depresses production $100 billion below normal implies that productive potential at full employment in future years will be $10 billion below what would otherwise have been forecast.

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The fiscal implications of this are striking. Suppose that the United States or the Western European core economies boost their government purchases for next year by $100 billion. Suppose further that their central banks, while unwilling to extend themselves further in unconventional monetary policy, are also unwilling to stymie elected governments’ policies by offsetting their efforts to stimulate their economies. In that case, a simple constant-monetary-conditions multiplier indicates that we can expect roughly $150 billion of extra GDP. That boost, in turn, generates $50 billion of extra tax revenue, implying a net addition to the national debt of only $50 billion.

What is the real (inflation-adjusted) interest rate that the US or Western European core economies will have to pay on that extra $50 billion of debt? If it is 1%, boosting demand and production by $150 billion next year means that $500 million must be raised each year in the future to keep the debt from growing in real terms. If it is 3%, the required increase in annual tax revenues rises to $1.5 billion a year. If it is 5%, the government will need an additional $2.5 billion per year.

Assuming that continued subnormal output casts a 10% shadow on future potential output levels, that extra $150 billion of production means that in the future, when the economy has recovered, there will be an extra $15 billion of output – and an extra $5 billion of tax revenue. Governments will not have to raise taxes to finance extra debt taken on to fund fiscal boosts. Instead, the supply-side boost to potential output over the long run from expansionary fiscal policy would be highly likely not only to pay for the additional debt needed to finance the spending boost, but also to allow for additional future tax cuts while still balancing the budget.

Now this is, to say the least, a highly unusual situation. Normally, the multipliers applied to expansions in government purchases are much less than 1.5, because the central bank does not maintain constant monetary conditions as government spending expands, but rather acts to keep the economy on track to meet the monetary authority’s inflation target. A more usual multiplier is the monetary-policy offset multiplier of 0.5 or zero.

Moreover, in a normal situation, governments – even the US government and those in Western Europe – cannot run up the national debt and still pay a real interest rate of 1%, or even 3%. Normally, the math of increasing government purchases tells us that a small or dubious boost to output today brings a heavier financing burden in the future, which makes debt-financed fiscal expansion a bad idea.

But the situation today is not usual at all. Today the global economy is, as Ricardo Cabellero of MIT stresses, still desperately short of safe assets. Investors worldwide are willing to pay extraordinarily high prices for, and accept extraordinarily low interest rates on, core-economy debt, for they value as an extraordinary benefit having a safe asset that they can use as collateral.

Right now, investors’ preference for safety makes financing additional government debt abnormally cheap, while the long-run shadows cast by prolonged subnormal production and employment make the current sluggish recovery predictably costly. Given the need to mobilize idle resources in the short run in order to maintain productive potential in the long run, a larger national debt would be, as Alexander Hamilton, the first US treasury secretary, put it, a national blessing.

Read more from our "America's Precarious Recovery" Focal Point.