As the disappointing May job numbers confirm, this is still an exceptional time—a time in which many of the normal rules of the Dismal Science are changed and transformed. It is a time for not normal economics but rather “depression economics.” The terms on which the U.S. government can borrow now are exceptionally advantageous. And because of high unemployment the benefits of boosting government purchases and cutting taxes right now are exceptionally large.
The result is that the costs of borrow-and-spend policies are overturned for the short run—indeed, for as long as the current economic crisis of high unemployment lasts, which may well mean that the short run is not very short.
In normal times, a boost to government purchases or a cut in taxes produces a limited increase in production and employment while adding a substantial increase to the national debt. The increase in debt raises interest rates, which crowds out productivity-increasing private investment spending and, dollar for dollar, leaves us poorer after the effect of the stimulus ebbs.
The borrowing must then must be financed at a significant interest rate, and thus paid for with higher taxes, which reduce incomes by increasing the wedge between the private rewards and the social benefits of expanded production.
It's nasty business.
Normally, only government spending initiatives or tax cuts that promise a high value for the dollar are worth undertaking, but things are different now.
However, right now, as best we can tell, an increase in federal spending or a cut in taxes will produce (in the short run) no increase in interest rates and hence no crowding-out of productivity-increasing private investment. Indeed, government spending that adds to firms’ current cash flow may well boost private investment and so leave us, dollar for dollar, richer after the effect of the stimulus ebbs.
Why?
Because our debt today can be financed at extremely low interest rates—1.83 percent if financed via 30-year TIPS, and even less in expected real interest if financed over a shorter horizon.
In normal times, only government spending initiatives or tax cuts that promise a high value for the dollar are worth undertaking. Now, however, things are very different. Let’s run through the arithmetic.
Normal Economic Arithmetic:
Consider a $100 billion boost to government purchases or cut in taxes financed by borrowing from abroad. In a normal year, the Federal Reserve will worry about inflation, and raise interest rates somewhat to offset the inflationary impact of the fiscal boost. The multiplier will thus be something like 0.4—we will spend $100 billion on government purchases or tax cuts and gain perhaps $40 billion in extra production and associated employment out of it.
But there are costs. First, the added national debt. The national debt will not rise by the full $100 billion: Those who earn that extra $40 billion will pay taxes—perhaps $16 billion. Thus the net impact on the government debt will be that by spending an extra $100 billion we will have added some $84 billion to the national debt. That debt must then be amortized. At a 4 percent per year long-run real rate of interest on government bonds, amortizing that debt will cost Americans $3.4 billion a year.
Second, the higher tax rates needed to raise the extra $3.4 billion will also exert a cooling supply-side effect on economic activity. With higher tax rates, people will have greater incentive to spend time and energy dodging their taxes rather than doing useful work. If this effect amounts to roughly one-third of the revenue raised, then we have to add to the total cost an additional $1.1 billion shortfall from the time and energy that would have been used to produce stuff but that will instead be devoted to dodging taxes.
Third, there is another effect. The Federal Reserve’s fight against inflation, which demands an increase in interest rates, will have reduced investment. Due to the $100 billion in government purchases, perhaps $40 billion of private investment that would have been made won’t be made—it will be crowded out. As a result of the lower capital stock, some $4 billion a year of income that would have been earned won’t be. Thus the net cost of the $100 billion in government spending will be a reduction in Americans’ disposable incomes of $7.4 billion per year.
That’s an unattractive bargain. It would allow us to purchase $40 billion of extra production and income this year at the cost of a reduction in incomes of $11.9 billion—call it $12 billion—in every year in the future. That is a usurious annual real interest rate of 30 percent. No sane economist would recommend a policy with such high costs and meager benefits. Expansionary deficit-boosting fiscal policy is, or ought to be, simply a non-starter in normal times.
Depression Economic Arithmetic:
But right now that arithmetic doesn’t apply. We have instead depression economic arithmetic. And in depression economic arithmetic things are very different.
First, more government spending does not lead the Federal Reserve to raise interest rates to fight inflation. The Federal Reserve has pushed interest rates to the floor and wishes it could drive them into the basement—to –5 percent per year or so. Thus the multiplier on the government’s spending is not 0.4 but more like 1.5. We do not get $40 billion of additional production and employment for $100 billion; we get something closer to $150 billion. And there is no crowding out of private investment; on the contrary, there is likely to be crowding in. If one-third of the extra production flows through to corporate profits, and if one-quarter of those extra corporate profits are then invested in projects paying a pretax net real rate of return of 8 percent per year, then future productivity is boosted to the tune of $1 billion a year.
Second, that boost to production creates a substantial reflow in taxes that makes the spending program a bargain. We get $150 billion of added production leading to $60 billion of additional tax revenue, leading to only $40 billion in increased debt.
Third, the financial crisis has created a configuration of interest rates that means that the government can borrow at uniquely favorable terms. Suppose we borrow at 1.83 percent – we’ll round it to 2 percent — per year in real terms for the next 30 years. On those terms, amortizing the $40 billion of additional government debt requires only $0.8 billion a year in additional interest payments and taxes. Even adding in our one-third excess burden brings us only to $1.07 billion a year in amortization costs.
Now, net all this out.
The increased cash flows to businesses boost future private-sector incomes by $1 billion a year. The costs of amortization reduce them by $1.07 billion a year. The net cost? $70 million per year. So to gain $150 billion of increased production and incomes this year we incur a $70 million a year cost going forward. That means that using expansionary fiscal policy to boost output today is an investment worth doing at any interest rate greater than 0.05 percent per year.
That is not quite a free lunch—they take away my union card as an economist if I start claiming that free lunches exist. But it is certainly a value meal. We are getting more income and employment now—when we really need it—in return for sacrificing only a tiny bit of production each year in the future, when we believe that we will be richer and will mind the reduction significantly less.
The Limits of Depression Economics:
Thus it is a no-brainer that we ought to be doing more fiscal stimulus. Each dollar of missing production and each unemployed worker right now is much, much more painful to the country and a much greater loss to human welfare than a dollar of missed production and an unemployed worker in normal times.
The argument for more spending is airtight as long as the arithmetic holds out. That is, until:
- further increases in the deficit lead to rising expectations of inflation, leading the Federal Reserve to raise short-term interest rates, which then crowds out private-sector investment spending;
or:
- further increases in the deficit lead to pressure on the federal government’s debt capacity, so that we can no longer finance additional federal government debt at such extraordinarily advantageous interest rates.
Back in December 2008 the incoming Obama National Economic Council feared that an increase in the proposed size of the Obama stimulus program, the ARRA, from $800 billion to $1.2 trillion would bring these factors into play. It is now clear that they were overly pessimistic, in large part because they were overly optimistic about the state of the economy.
Right now, bad politics is undermining good policy, hurting the American economy and legions of unemployed workers. It is long past time for another stimulus package.
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