On Volcker and Peterson's debt problem

In their recent NYTimes op-ed Paul Volcker and Peter Peterson say:

Yes, this country can handle the nearly $600 billion federal deficit estimated for 2016. But the deficit has grown sharply this year, and will keep the national debt at about 75 percent of the gross domestic product, a ratio not seen since 1950, after the budget ballooned during World War II.

The practical consequence of large deficits and debts, according to them is that:

Our current debt may be manageable at a time of unprecedentedly low interest rates. But if we let our debt grow, and interest rates normalize, the interest burden alone would choke our budget and squeeze out other essential spending. There would be no room for the infrastructure programs and the defense rebuilding that today have wide support. 

It’s not just federal spending that would be squeezed. The projected rise in federal deficits would compete for funds in our capital markets and far outrun the private sector’s capacity to save, to finance industry and home purchases, and to invest abroad.

In other words, large deficits and debt will compete with funds for other activities, the savings glut which a good chunk of the profession thinks causes low interest rates will vanish, and this, in turn, will increase interest rates, which not only will increase the interest rate burden, but also will reduce the fiscal space to spend on things we agree are fine, like infrastructure.

What should we do according to them? No surprise here, cut social spending. In their words: "A realistic approach toward the major entitlement programs is required, given that they are projected to account for all of the growth of future noninterest spending." They fall short of asking for privatization of Social Security, but you can bet that this is what they are going to push for in a Clinton administration. To finish the work they started in the previous Clintocracy (the system of government in which a Clinton holds power).

I discussed fiscal issues several times here, and the problem in their argument is with basic principles really. Below Gross Federal Debt, which stands at slightly more than 100% of GDP, and once the amounts of public held by the Fed and in the Social Security Trust Fund and other government accounts are accounted for, then this leaves us with the Net debt of about the size reported by Volcker and Peterson in their piece.

Looking at the figure you might be alarmed. It has increased significantly after the last crisis. However, there are important elements that suggest that the increase in public debt is not problematic. First of all, as noted by Dean Baker, the burden of debt service (interest payments) is tiny. And will most likely remain low, since the space for normalization of interest rates is much smaller than what Volcker and Peterson suggest. The idea that government spending will grow out of line with the ability to finance it (which has little to do with the "private's sector capacity to save," btw) is difficult to believe too. Note that government spending has been subdued as the graph below shows.

Government spending in real terms remains below the pre-crisis level, and after the fiscal package, Obama has essentially followed the Clintonomics rule book of fiscal conservatism. If anything spending is kind of small, for the needs of the economy (I would say spending, and not deficits, since the result is endogenous, but I agree in general terms with the argument here). There is no problem of runaway government spending, and certainly no danger, as Volcker and Peterson suggest that "we would risk returning with a vengeance to stagflation — the ugly combination of inflation and economic stagnation that we tasted in the 1970s" if we do not cut social spending. This is the old trick of creating fear of a fake fiscal crisis to force cuts on spending for social programs.

My fear is that Volcker and Peterson, and others like them, will have an outsized influence on a Clinton administration. The danger is not the high inflation of the 1970s, but the completion of the neoliberal project of the 1990s.

Crowding out: what's the evidence?

Before the publication of Keynes' General Theory, most marginalist economists were against expansionary fiscal policy. It was believed that an increase in government spending would reduce by the same amount private spending, and, hence, it would have no effect on output and employment. Keynes referred to this as the Treasury View, since bureaucrats at the Treasury were prone to believe it. This has been known as crowding-out in more recent times.The evidence is not particularly forthcoming, as far as I can tell.

Amazingly, given the relevance of the topic for conservative ideas, and the fact that this is still the reason why the fear of deficits and debt is so pervasive, there is not much research on the effects of deficits on interest rates. Robert Murphy, on the Instructor's Resources for Mankiw's manual (funny that is NOT in the manual) says:

"Economists worry, therefore, that high deficits imply low levels of investment, leading ultimately to a lower capital stock and so lower living standards. It is, therefore, important to see if this prediction that high deficits lead to high interest rates is supported by the data. Like many empirical questions in economics, this one is difficult to answer unequivocally. Figure 1 shows a scatterplot of the real government deficit and the ex post real interest rate between 1960 and 2000. While there is some evidence of a positive association, it is not strong."

The graph below.

Updating the graph for 1962 to 2014, with CPI for deflating the rate of interest, I've got the following graph:

 

There is a very weak, and statistically insignificant relation between deficits and the real rate of interest (note that in mine deficits are negative). In my view, this suggests that there is no clear relation. Deficits do not seem to impact the rate of interest, and crowding out is not empirically relevant. There are plenty theoretical reasons for not believing in it too. And Ricardian Equivalence is NOT one of those. But that would be material for another post.

PS: The weak correlation remains even if one adjusts for outliers, by the way. So no there is nothing there, and that's why there isn't much in the mainstream published on this.

On Paul Krugman and his call to stop listening to paranoid inflationists

From Alternet:

It’s been nearly six years since the demise of Lehman Brothers “ushered in the worst economic crisis since the 1930s,” and New York Times columnist Paul Krugman would like to move on. But he can’t, and by extension we can’t, because recovery is nowhere near complete. And going for the wrong policies at this moment of fragile improvement but enduring “economic weakness” would spell disaster, and possibly “permanent depression,” according to Krugman. The years since the start of the crisis have been largely defined by two camps, the “too-muchers” and “not-enoughers,” The too-muchers have warned incessantly that the things governments and central banks are doing to limit the depth of the slump are setting the stage for something even worse. Deficit spending, they suggested, could provoke a Greek-style crisis any day now —  within two years, declared Alan Simpson and Erskine Bowles some three and a half years ago. Asset purchases by the Federal Reserve would “risk currency debasement and inflation,” declared a who’s who economists, investors, and pundits in a 2010 open letter to Ben Bernanke.

Read rest here.

CEPR | Stimulus and Fiscal Consolidation: The Evidence and Implications

In a previous post, see here, Matias provided a graph that displayed the fiscal results for the US as a share of GDP from 1993-2014, along with a discussion of the misconception that democrats are nothing but tax/spend liberals. I thought it would be pertinent to post this paper by Dean Baker and David Rosnick providing conclusive evidence on the effects of stimulus packages and fiscal consolidation during the recent economic crisis.

From the abstract:

The first part deals with the most important literature on the subject, the consensus in the research of the past decade attests a clear counter-cyclical effect of stimulus packages during a prolonged recession. The second part deals with the impact of changes in government consumption and investment to growth. For this data for developed countries in 1980 are analyzed. Consistent with much of the previous literature have increased government spending during a crisis has a positive effect on economic growth. In addition, the period is simulated after the crisis, the multiplier effect is around 1.5. The third part focuses on the production potential, which has declined sharply due to the economic crisis. This would have to include a comprehensive model that analyzes the effects of an economic stimulus package with, since the effect could turn out relative to the size of the stimulus package as significant.

Read rest here.

Jamie Galbraith: Government Doesn’t Have to Borrow to Spend

When the Treasury writes a check, a bank credits an account. That's money creation. Treasury bonds absorb money, but aren't needed.

Jamie Galbraith on endogenous money and US Debt in NYTimes:

The debt ceiling was enacted in 1917 for one purpose: to fool the rubes back home. Just as Congress started running up debts to pay for the war, they voted in the ceiling to pretend otherwise. And that is why whenever reached, it must be raised.

The debt ceiling is also an anachronism. It is based on the idea that the government must raise money from elsewhere, before it spends. That was true in the days of gold. It hasn't been true, for this country, since at least the creation of the Federal Reserve back in 1913.

In the modern world, when the Treasury writes you a check, your bank credits your account. That's how money creation works. The Treasury then issues bonds to absorb that money. Banks like this because bonds pay more interest than reserves. But there is nothing economically necessary about the bonds. This is obvious since the Federal Reserve buys back many of them, leaving the public with the cash it would have had in the first place.

Read rest here.

The Barriers to Full Employment are Political, Not Economic

By Malcolm Sawyer

In “Political Aspects of Full Employment,” a still widely cited article from 1943, Michal Kalecki raised many questions about the ability of a capitalist economy to maintain prolonged full employment — even though in light of the understanding of tools for stimulating aggregate demand and the use of fiscal policy brought about by the Keynesian ‘revolution.’ In a series of papers, Kalecki showed that the arguments against the use of budget deficits to secure full employment were invalid. Among these arguments, and their rebuttals, were that:

• deficits add to government debt, which is a burden on future generations (rather, the government debt is bonds owned by individuals, pension funds etc.);
• deficits crowd out investment (rather, they allow savings to take place and enable investment); and
• deficits cause higher interest rates (the current situation makes the rebuttal to this clear).

Yet those arguments are still trotted out.

Read the rest here.

Galbraith on Summers and deficit spending

Letter to the Financial Times published today as 'Dr Summers performs a medical miracle.'

From Prof James K. Galbraith

Sir, Whence comes Lawrence Summers’ medical knowledge? He writes of palliatives, of misdiagnosis, and states that “treating symptoms rather than causes is usually a good way to make a patient worse” (“Growth not austerity is the best remedy for Europe”, April 30).

As to cures, Prof Summers writes of “a need to raise retirement ages, reform sclerosis-inducing regulations and restructure benefit programmes”. Yet he presents no evidence that these matters caused our troubles, and of course they didn’t – unsupervised bankers and ambitious economists did. Blaming the elderly and poor is just a prejudice, common to people who have easy jobs and private means. Bleeding them (gradually, of course) is a medieval practice.

And yet, on the main point, Prof Summers gets it right. He does this by mistaking a symptom (recession) for a cause, and then prescribing a palliative (deficit spending). A minor medical miracle, perhaps!

The irony is that a real doctor would likely approve. After all, fever-reducers and pain relievers, from aspirin to morphine, are in widespread medical use and have been for many years.

So “Dr” Summers is on the right track for now, but as his methods show, he is still very dangerous to the sick.

Originally published here.

Debt dynamics for dummies

Krugman again does a great job showing that the risks of explosive debt are way overblown.  As he says:

"So even with substantial deficits, the pace of long-term budget worsening is very slow."

It is not difficult to understand debt dynamics.  The ratio of debt to income (GDP) is a measure of the capacity to repay debt.  If the economy grows faster than debt, the debt-to-GDP ratio falls.  GDP grows with demand expansion, and debt grows at the pace of the interest on the debt.  In other words, if the economy grows faster than the rate of interest, then the debt-to-GDP ratio will fall even if the government runs deficits.

The graph below shows the growth rate and the real rate of interest on government bonds for the US since 1990.  As it can be seen, since 2003, with the exception of the Great Recession, the rate of interest has been below the rate of growth.

The debt-to-GDP ratio has only increased (see graph below), because the crisis has caused significant deficits to accumulate.  Note that in the 1990s, a combination of lower interest rates, higher growth and fiscal surpluses had stabilized debt, which starting growing in the Reagan years.

Finally, note the growing deficits in the figure below have reversed with a very mild recovery in 2010. Interest will remain low. What is needed is a stronger recovery to get growth going and that would increase revenue (allow for reduced spending on several things like unemployment insurance) and eventually lead to a lower debt-to-GDP ratio.

The way out of the fiscal problems is growing!  Even dummies should get this right.