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.

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.