The Importance of Deficit Cutting to Liberal Economists, pre-Crisis Edition.

A lot of people seem surprised the Democrats have implicitly prioritized deficit cutting over job creation and full employment. It’s an explicit goal for Republicans, so that isn’t a surprise. But why are Democratic, liberal types not worried enough about the demand shortfall and so much more worried about deficits?

It might be helpful to see what a prominent, liberal macroeconomist would say about the state of the world going into the recession. This might look like a cheap shot but I hope you don’t read it this way – I think it’s important to remind ourselves what the baseline looks like before the world economy was shoved off a cliff.

Which prominent economist gave the following speech, Macroeconomic Policy in the 1960s: The Causes and Consequences of a Mistaken Revolution, in 2007? (My bold):

One of the most striking facts about macropolicy is that we have progressed amazingly. … In my opinion, better policy, particularly on the part of the Federal Reserve, is directly responsible for the low inflation and the virtual disappearance of the business cycle in the last 25 years…

The 1960s represented the beginning of a long dark period for macroeconomic policy…. [But] since 1985, inflation has been below 4% every single year and has averaged just 2.5%. Real short-run macroeconomic performance has been similarly splendid. … As someone who started her career saying there had not been a stabilization of the postwar economy, I now have to admit there most certainly has been – it just started in 1985, not 1947….

What stops this story from being a good morality play is that good hasn’t triumphed entirely. At the same time that we have seen a glorious counterrevolution in the ideas and conduct of short-run stabilization policy, we have seen a remarkable lack of progress in long-run fiscal policy. In this area, the legacy of 1960s beliefs is still very much with us and may threaten the long-run stability of the American economy. … The revolutionary idea of the 1960s concerning long-run fiscal policy was that it was not important to balance the budget even over a period of several years. Rather, persistent budget deficits could actually be desirable because they would lower unemployment and move the economy toward a more desirable path for real output….

The consequences of persistent deficits may only be felt over a very long horizon…It is also possible that the effects of persistent deficits are highly nonlinear. Perhaps over a wide range, deficits and the cumulative public debt really do have little impact on the economy. But, at some point, the debt burden reaches a level that threatens the confidence of investors. Such a meltdown and a sudden stop of lending would unquestionably have enormous real consequences….

The fact that the effects of deficits may be very slow to reveal themselves or highly nonlinear may have allowed policymakers to put off learning in a way that they could not with short-run stabilization policy…There was indeed a fiscal revolution in America in the 1960s, and we are still trying to recover from it more than forty years later.

This argument is what people who think the government should “do more” face from the center.  The low inflation achieved post 1980s was a hard-won achievement. We are down to a 2.5% average, well under the 4% of the mid-Reagan years, which is part of a “glorious counterrevolution” in macroeconomic policy thinking. The business cycle has largely been tamed, so presumably we need to look elsewhere, to skills and job polarization and mobility, to explain unemployment.

But for all the good news there’s still one piece of bad news obvious to macroeconomists in 2007 – though its not inequality, the pending financial crisis, or the large leveraging of Americans based on flimsy, rigid, Frankenstein-style financial contracts. It’s that politicians don’t take budget deficits seriously, and it’s the goal of a proper macroeconomist to convince politician to start.  The evidence for why large deficits matter isn’t clear, but it isn’t worth the risks.  By the time they show up, it’ll be too late.

(Advanced readers might catch the “nonlinearity” of the effects of deficits, a mathematical way of saying that bond vigilantes are in fact actually invisible, or at least well camouflaged.)

Who gave this speech in 2007? Christina Romer. You may know Christina Romer as the strong liberal pushing for a larger stimulus over Larry Summers, who just wanted an insurance policy against a Depression. As a person who has worked to get the government to do more in regards to the unemployed.  All the while, Romer has still emphasized long-term deficit reduction while putting short-term stimulus and job creation front and center (see this interview with Ezra Klein).

This speech was caught by JW Mason, who offers arguments for why this proves that there needs to be more heterodox voices in macroeconomics. Regardless of that debate, I’m more interested in the turnaround.

I’m guessing Romer, a student of the Great Depression, understood that what had happened was a major event and required a new playbook, if only for the immediate future. If you don’t think the Great Recession was a barely-avoided Great Depression, you probably think other things – that our labor force is too weak and soft, that incumbent businesses need more gimmies, that high-end tax cuts should be extended, that this is the result of pressures on the financial system, etc.

Or to put it a different way, people have priorities over the things that should be done, and they change their emphasis as the conditions change.  Lots of liberals think that long-term fiscal deficits is one of the biggest problems in the economy.  The economy hitting the largest downturn since the Great Depression has moved some of those liberals to worry a lot more about the short-term jobs situation for the time being, and the weak recovery has kept them worrying about it.  Those who don’t believe that, or are so anxious to get back to their previous worries they have forgotten the words “full employment”, need to be reminded we still have a jobs crisis.

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22 Responses to The Importance of Deficit Cutting to Liberal Economists, pre-Crisis Edition.

  1. SIMON says:

    Nice post, thank you. Something I am confused about, however, is what the worst case scenario is from doing nothing. I understand the worst case scenario of increasing our debt (well, kind of) but if additional stimulus is not applied to the economy right now what will happen to major measurements (GDP, Unemployment etc) in the long run. Will they eventually recover or…

  2. coin says:

    I give you…Ben Bernanke, ladies and gentlemen, dancing in a bikini:

  3. foosion says:

    @Simon, even if major measurements improve in the long run, there will be much unnecessary suffering the in short run.

  4. JW Mason says:

    You’re more charitable to Romer than I was. Which is fine.

    But, I don’t think that worrying about deficits made sense even in 2007. First of all, it’s pretty clear that one of the drivers of the housing bubble was that reserve accumulation by the rest of the world (especially Asian countries) was crowding less return-insensitive purchasers out of Treasuries. The demand this created for assets with (supposedly) similar liquidity and risk characteristics drove a lot of the mortgage securitization. So it seems pretty clear that the big problem in the 2000s was that we didn’t have enough federal debt, not that we had too much. But of course mainstream macroeconomics, whose workhorse models are strictly nonmonetary, ignores the liquidity demand that federal debt meets.

    More broadly, while it sounds superficially reasonable to say that we need a bigger deficit now but smaller deficits in the future, I think it’s a tricky position to hold consistently.

    First, because it asks for more agility and better judgment than is reasonable to expect from our political system. For a benevolent dictator, maybe, but our fundamentally adversarial political system doesn’t pivot that way. I think you have to kind of pick a side and stick with it.

    More fundamentally, I’m not sure the deficits now, surpluses later position is intellectually coherent. Of course you can rationalize anything, but I think it’s pretty clear that most economic worlds in which budget surpluses are really important for long-term growth, are worlds in which fiscal policy is not very important for short-run output, and vice versa. So altho you can reconcile the two in some ad hoc way, there’s always going to be a strong temptation to simplify things by choosing one or the other.

    The Phillips curve is the flipside of this. The consensus view is that it is sloped in the short run but vertical in the long run. But as the New Classicals always said, there was no good story for why the short-run and long-run relationship should be qualitatively different, or how long the relevant long run is. If you’re strongly committed to the view that the long-run curve is vertical (as both wings of the mainstream are), it’s more logical to assume it’s vertical in the short run too.

    • Matthew says:

      @JW Mason: “It seems pretty clear” must be code for “It helps my argument to claim” in your parlance. Or your sarcasm escapes me.

      “it’s pretty clear that one of the drivers of the housing bubble was that reserve accumulation by the rest of the world (especially Asian countries) was crowding less return-insensitive purchasers out of Treasuries.”
      “So it seems pretty clear that the big problem in the 2000s was that we didn’t have enough federal debt, not that we had too much.”

      I can’t help but think of tax cuts and new medicare plans that turned a federal surplus into an increasing debt during the last decade. Perhaps it was low interest rates and a lot of false assumptions that drove individuals towards mortgate backed securities. And why would the treasury be buying US debt if there is a lack of supply? Just like housing prices could never go down, US debt may not alway be the zero risk investment it is today.

      To me, the deficits now, surpluses later position is the view that the economy should be self sufficient, that there is some “sweet spot” level of debt that should be maintained. For a permanent deficit position to be at all rational, the economy would have to grow faster that the debt. Maybe if you elaborate, I can better understand your positions.

      • JW Mason says:

        “It seems pretty clear” must be code for “It helps my argument to claim” in your parlance. Or your sarcasm escapes me.

        No, I think it is pretty clear. Not definitely true, but likely. For instance, here is Daniel Gros:

        the increased demand for US government debt by emerging economy central banks led to lower yields, thus forcing those savers in the OECD countries which would normally have held government assets to frantically “search for returns”. But this was a search for yield on safe (and liquid) assets. The AAA tranches on securitised US mortgages (and other debt) seemed to provide the safety plus a “yield pick up” without any risk … This analysis implies that the current (smaller but still sizeable) US current account deficit should not lead to similar asset supply and demand mismatches since … it is the US government which is running the deficit, thus supplying exactly the kind of assets needed by emerging economy central banks.

        In other words, it was the excess demand for government debt that drove mortgage securitization; if the US government had supplied additional debt to match the increasing demand for it as an asset, it is unlikely there would have been a housing bubble. Of course the fact that Gros says it doesn’t prove it’s true, but it does prove it’s not just crazy commies like me who believe it. More to the point here, this is the kind of question that the “new consensus” macro that Romer extols is constitutionally incapable of asking.

        I can’t help but think of tax cuts and new medicare plans that turned a federal surplus into an increasing debt during the last decade.

        Indeed. As Jamie Galbraith, Wynne Godley, and many other Post Keynesians have pointed out, without the Bush deficits economic performance in the past decade would probably have been much worse. Of course it would have been better to use those deficits to finance public investment rather than handouts to rich people, but that’s a different question. Macroeconomically, the tax cuts were a good thing.

        To me, the deficits now, surpluses later position is the view that the economy should be self sufficient, that there is some “sweet spot” level of debt that should be maintained.

        Lots of people share this aesthetic preference. But I’m afraid it doesn’t work as economics. To begin with, the two goals you suggest — a budget that is balanced over the business cycle, and a stable debt-GDP ratio — are logically contradictory. If a given deficit-GDP ratio — call it d — is maintained over an extended period, the debt-GDP ratio converges to d/g, where g is the nominal growth rate of GDP. So if deficits are canceled out by surpluses over the long term, then the debt-GDP ratio falls asymptotically toward zero. Conversely, despite what you sometimes hear, there is *no* sustained level of deficit that causes the debt-GDP ratio to explode.

        So, you can argue — reasonably enough IMO — that there is a “sweet spot” of debt, and deficits should average out to the appropriate (positive) level to maintain that. Or you can argue, in the functional-finance vein, that the current fiscal balance should be as high as needed to absorb the excess of savings over private investment at full employment, with the debt-GDP ratio passively adjusting. You could even argue, if you take the loanable-funds view seriously, that the government should always seek to achieve the lowest deficit, or highest surplus, possible. What you cannot argue is that there is something particularly beneficial about a budget balance of exactly zero. Or at least you can’t argue it economically — it is, as I say, a widely held aesthetic preference.

        And needless to say, one of the key lessons of the Great Recession is, or should be, that the economy *cannot* be relied on to be self-sufficient.

        Keynes, I’ll note in passing, did not believe in fiscal policy as we understand it. Rather, he believed that the state should become society’s “entrepreneur in chief,” carrying out (or at least directing) the large majority of investment.

        For a permanent deficit position to be at all rational, the economy would have to grow faster that the debt.

        What I think you mean here is that for a permanent primary deficit (i.e. deficit exclusive of interest payments) to be sustainable, GDP growth must be above the after-tax interest rate on government debt. This condition is certainly satisfied for the United States; I believe it is for most other rich countries as well.

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  7. LosGatosCA says:

    Growth is first. Growth with jobs is second. Inflation is third. Deficit reduction is fourth.

    It’s the Maskow hierarchy of economic needs.

    Food. Shelter. Comfort. Money in the bank for the future.

    Can’t save for tomorrow if people are starving today. Unless you don’t give a shit – then it makes sense.

  8. LosGatosCA says:

    Maslow

  9. Matthew says:

    @JW Mason

    I would argue that people bought mortgage backed securities because they were rubber stamped AAA and provided higher yields than treasuries. If you take away the fraud that led to AAA ratings, the bubble never would have happened. If there were higher returns on Treasuries, mortgage backed securities still would have existed. Do you propose that the government should create debt to compete with other AAA rated assets? That the US gov’t itself could not be a bubble just like the housing market? That the US will always pay back it’s debt? So long as those assumptions hold true, everyone can keep on dancing. But as we saw with housing prices, as we’re seeing in European countries, once the music stops you lose a generation of wealth.

    So I agree, so long as US debt remains the safest asset to hold in the world, it is perfectly reasonable to argue that more gov’t debt is a good thing. As long as I pay my credit card each month, I should buy whatever I want. But you have to concede there is a limit to the amount of debt the gov’t should create, right?

    Regarding my sweet spot comment, assuming GDP is constant, there should be deficits and surpluses based on the business cycle. I agree that you can have continued deficits so long as the economy grows faster.

    We have had negative (or at least level) GDP growth. How does that reconcile with this:
    What I think you mean here is that for a permanent primary deficit (i.e. deficit exclusive of interest payments) to be sustainable, GDP growth must be above the after-tax interest rate on government debt. This condition is certainly satisfied for the United States; I believe it is for most other rich countries as well.

    The key lesson from the Great Recession was that the banks need not worry about being self sufficient (at least if you aren’t called Bear Stearns).

    • Andy Harless says:

      “If you take away the fraud that led to AAA ratings, the bubble never would have happened.”

      Exactly. The bubble would not have happened, and instead there would have been an excess demand for safe assets. And what happens when there’s an excess demand for safe assets? (Clue: Look at what has been happening for the past 3 years.)

      The federal funds rate was down to 1% in 2003. It didn’t go any lower, because that 1% was low enough to spark a housing boom and get the recovery going. But as you say, that boom would not have happened without “the fraud that led to AAA ratings.” (I’m interpreting the word “fraud” loosely.) If risk perceptions had been accurate, the housing boom would not have happened, the recovery would not have happened, and the federal funds rate would have gone to zero, probably still without sparking a recovery. Or if it had sparked a recovery, it would only have been with the indispensable aid of an easy fiscal policy — the wars, tax cuts, and deficit spending that the left so often decries.

      • Matthew says:

        I meant fraud in the sense of people falsely stating income, investment banks falsely representing the quality of MBS, etc.

        I don’t understand what you mean by excess demand. In a market economy, supply and demand are equated by price. Naturally people are going to buy high yielding AAA assets before they buy a BBB asset at the same interest rate.

        I disagree that there would have been no recovery w/out the housing boom or more government intervention. The money chasing mortgages still would have existed. I could only speculate to which industry/business/emerging gov’t could have achieved a higher return. And even if we never had a recovery, we’d been in the same spot we are today without the stress caused by the collapse with a few million more jobs.

        I agree that growth requires investment. I disagree with the approach of using gov’t as the money manager. They can cause bubbles, too (see Europe).

      • JW Mason says:

        Exactly! Somebody gets it….

  10. JW Mason says:

    Do you propose that the government should create debt to compete with other AAA rated assets?

    Yes. That is what I propose. The financial system requires a stock of highly liquid assets. The government has a comparative advantage in providing those assets, in the form of its own liabilities. If the government fails to provide enough, private actors will step in to fill the gap. But the liquidity of private assets can change unexpectedly. So up to some level — a level that we can’t know a priori, but depends on the liquidity needs of the financial system — a higher government debt is stabilizing rather than destabilizing, and will increase rather than decrease the supply of credit available to private borrowers.

    as we’re seeing in European countries, once the music stops you lose a generation of wealth.

    No. That is not what we saw in Europe. Ireland had one of the lowest debt-GDP ratios in Europe prior to the crisis. They were a model of responsible fiscal policy. Now they have one of the highest debt-GDP ratios, thanks to the assumption by the state of the liabilities of the banking system. I’m not defending that decision. But what Ireland shows is that it is not the case that running a government surplus in good times protects from a fiscal crisis in bad times. Indeed, it’s quite possible that if the Irish government had borrowed more in the 2000s, its debt would be lower today, because the financial inflows from Germany would have gone into public debt instead of mortgages, and the housing bubble would have been less severe. OK, that last bit is a little speculative. But it is absolutely, categorically the case that the crisis in Europe is not the result of fiscal irresponsibility.

    you have to concede there is a limit to the amount of debt the gov’t should create, right?

    That there is, in principle, a debt-GDP ratio that is too high, is not informative as to whether the current ratio is too high, or too low.

    The key lesson from the Great Recession was that the banks need not worry about being self sufficient (at least if you aren’t called Bear Stearns).

    Right. Nw we get to the real sticking point.

    Keynesians like me would like a more active public sector; we want more economic decisions made through a democratic political process, and fewer in pursuit of private profit. But anyone with their eyes open sees that much of the time today, the public sector is just another vehicle for the pursuit of private profit — specifically the profits of the big financial institutions. That makes it hard to get excited about the idea of unencumbering government from traditional financing constraints, however compelling the arguments are in principle.

    How to solve this problem? I don’t know. There’s a certain sense in which Keyenesianism has never really worked except in the context of total war, because that’s the only time the state has sufficient autonomy & legitimacy. In the current context, certainly a first step would have been prosecutions of some high-profile financial figures. Whatever its other merits — and I would have paid goood money to watch those perp walks — that would at least have given some credibility to unconventional macroeconomic policy was something other than the blood funnel in disguise. There are smart liberals who recognize this, but, obviously the administration didn’t.

    The chance has probably been missed, for now. But for my part, I’m going to continue criticizing people like Romer. So that when we do have a government ready to “build our New Jerusalem out of the labour which in our former vain folly we were keeping unused and unhappy in enforced idleness,” they aren’t held back by irrational debt-phobia.

  11. JW Mason says:

    My “Somebody gets it” comment above was in response to Andy Harless, who formulates the problem exactly. (Sorry Matthew.)

    The problem is that given wealthholders’ current level liquidity preference, fixed investment needs a very high return high enough to convince them to part with cash. But there aren’t nearly enough actual investment opportunities with high enough returns, to get aggregate demand up to a full-employment level. So the US economy can avoid stagnation in only two ways:

    – A speculative bubble that leads to an overestimation, ex ante, of the returns available from fixed investment.

    – An increase in the supply of liquid assets from the government, i.e. an increase in the debt-GDP ratio.

    In theory, monetary policy is supposed to resolve this problem, but it can’t, for a variety of reasons I can’t go into here.

    In the long run there are other potential solutions:

    – A substantial increase in the profitability of new investment. This probably requires an epochal new technology, and while those do come along every so often, it’s not really something policy can control.

    – A reduction in the illiquidity premium paid by fixed investment. The simplest way to achieve this, I think, would be a return to the corporate governance practices of the pre-1980s era, when a much larger share of earnings were retained by firms. The hurdle rate on new investment is much lower when it is financed out of internal funds, than when it must be externally financed.

    But in the current context, the point is just as Andy says. Over the 2000s (and before), the private sector wanted more liquid (AAA) assets than the government was supplying. So securitized mortgages were developed as substitutes, and as long as they functioned as such, the demand for liquid assets could be satisfied at something like full employment. But if those securities had not been forthcoming, or had been (correctly) perceived as poor substitutes for government debt, then we simply would have been in the same place as in 2008 five years earlier.

    As long as those who control our collective wealth are very desirous of keeping their claims in liquid form, and businesses can’t provide returns high enough to get them accept more illiquid claims, we’re going to have this dilemma.

  12. Andy Harless says:

    Matthew,

    There can be excess demand for safe assets, because one of those assets is money, and the market for money, traded against goods and services, is not continuously clearing. (In fact, it’s usually not clearing at all: it almost always easier to purchase goods and services with money than to sell goods and services for money.) Ordinarily, when the risk-free rate is positive, money is, on the margin, more-or-less dominated by other safe assets, and it is only used for transaction purposes, and under those circumstances you can say that “supply and demand are equated by price” because the relevant price is the interest rate, and money only represents a standard of value and a convenience for transactions. But when the risk-free rate is zero — which happens when the demand for safe assets gets sufficiently high — money becomes just like other safe assets. Money is no longer just a standard of value and a convenience for transactions; it is an asset like any other. And in that case, there is an excess demand for safe assets. The only way to cure that excess demand is for the general price level (i.e. the price of goods and services traded against safe assets) to fall, but prices (and, probably more importantly, wages) are sticky. So the price level doesn’t fall, and you get a depression instead.

    • Matthew says:

      If I am understanding your argument correctly, you believe that the government (specifically US) should create debt to satisfy investor demand for safe assets. At a high level, it makes sense. But the devil is in the details and that’s what I’m trying to get a better understanding of. Here are some questions that I’m having trouble answering.

      Why, in a time of low interest rates, did the treasury need to become a buyer safe assets via QE 1 and 2?

      Wasn’t the gov’t involved in creating the mortgage bubble through fannie may/ freddie mac? Is it not possible that the gov’t could have issued more debt and used the funds to create the bubble in the same way as CDOs (and the same way surplus EU countries created debt problems in deficit EU countries).

      The US sets the interest rate at near zero because there is a lack of liquidity. Wealth holders should keep their assets in cash because safe asset interest rates are low but we’ve seen the price of commodities and the S&P move inversely to value of the USD. IE, investors have moved their money from cash to other assets besides US debt when the value of safe assets has fallen

      I agree that there are worthwhile reasons for gov’t debt (security, infrastructure and education). Still, they are speculating just like the private sector. If low risk, high reward investments exist, they will be purchased by investors. The wealthy can surely afford to invest over longer timelines, they just haven’t been forced to by the existence of surplus safe assets (maybe a stretch).

      The point I’m trying to make is that whether it’s through gov’t or private individuals, excess debt will create bubbles. Either you put your trust in the government to manage money or you put your trust in wall street. Unfortunately right now, I’d say there isn’t a huge difference between the two.

      • JW Mason says:

        I don’t mean this to sound rude, Matthew, but I’m afriad your confusion is not going to be cleared up in this comments thread. Just to begin with:

        Why, in a time of low interest rates, did the treasury need to become a buyer safe assets via QE 1 and 2?

        QE consisted of the Fed (not the Treasury) buying relatively *risky, illiquid* assets, and selling safer ones. The whole logic of unconventional monetary policy over the past three years has been that the government has been selling Treasuries, and buying other, more risky assets. These transactions, and not the financing of current government spending, account for a large majority of the increase over the crisis in federal debt held by the public. I don’t know where you got the idea that there have been interventions to support the price of Treasuries, but it’s exactly the opposite of what’s happened.

  13. Matthew says:

    I see no rudeness in your explanation, perhaps only that you make a point of one mistake and ignore the other questions I raise. Here is an article stating that the Fed (yes I wrote the Treasury by mistake) will buy US treasuries. Are these considered ill-liquid assets or is cnn-money wrong?

    “The central bank will buy $600 billion in long-term Treasuries over the next eight months, the Fed said Wednesday. The Fed also announced it will reinvest an additional $250 billion to $300 billion in Treasuries with the proceeds of its earlier investments.”

    http://money.cnn.com/2010/11/03/news/economy/fed_decision/index.htm

  14. JW Mason says:

    Buying long-term treasuries, selling short-term. The liquidity gap between them is small, which is why QEII did not have much effect. But the principle of selling relatively liquid and buying relatively illiquid assets is the same. In the earlier episodes, a much broader range of illiquid assets was purchased.

    You can see this very clearly in the Fed’s balance sheet (Table L.108 in the Flow of Funds: Up through 2007, the Fed’s assets consisted overwhelmingly of US government debt — $800 billion or so, out of $900 billion in total assets. But starting in 2008 the Fed acquired over $1.5 trillion in private financial assets, while significantly reducing its holding of Treasuries. The flipside of this was that the financial system was able to get rid of a bunch of private debt it didn’t want, and replace it with the newly created federal liabilities — over 2008, federal debt (Treasuries plus reserves) went from about 1.5% of banking-system assets to nearly 8%. That transformation of bad private debt into good government debt is, in essence, how the Fed saved the financial system.

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