Noted for March 28, 2013
Liveblogging World War II: March 28, 1943

The Live Arguments for Austerity Right Now: A Bestiary

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Arguments that looser monetary policy right now would be too risky:

The Jeremy Stein argument: At very low interest rates, banks will gamble not quite for resurrection but for (apparent) profitability, because bank executives who report losses tend to lose their jobs. Thus it is very important that the central bank keep nominal interest rates on loans banks can safely make above 3%/year in order to prevent the impact of the lower bound on deposits from generating unwise reaching for yield, and consequent systemic vulnerability.

The Gavyn Davies argument: Central banks won't dare unwind because politicians won't like it when central banks report losses. Therefore central bankers dare not adopt policies that have a chance of incurring losses because they will not be able to execute such policies.

Arguments that looser fiscal policy right now would be contractionary:

The investment crowding-out argument: Looser fiscal policy right now would be taken as a sign of much larger deficits in the future and hence much lower corporate bond prices as the future Treasury floods the market. Thus looser fiscal policy right now would generate sharply higher long-term interest rates right now, which would discourage interest-sensitive spending of all kinds. This fall would more than offset the direct stimulative effect of higher spending.

The future-tax crowding-out argument: Looser fiscal policy right now would be taken as a sign of much higher taxes imposed on businesses in the future. Fear of such taxes would discourage business investment committees and lower stock prices. Thus fear of higher business taxes would lead to a fall in private investment. This fall would more than offset the direct stimulative effect of higher spending.

The future inflation argument: Looser fiscal policy right now would be taken as a sign of much higher money-printing and hence higher inflation in the future. Higher expected inflation would lead sticky-price businesses and workers to start raising prices more rapidly now in order to avoid falling behind. Consequently, the Federal Reserve would have to reduce output below potential and raise unemployment above the natural rate in order to keep inflation at its target.

The Alesina argument: Spending increases diminish output even without increases in interest rates or in the real value of the currency--never mind the channel.

The Reinhart-Rogoff argument: Spending leads to higher debt accumulations, and higher debt accumulations lead to reduced economic growth even without any increases in interest rates--never mind the channel.

Arguments that looser fiscal policy right now would be too risky:

Interest rates will normalize very soon: And when interest rates do normalize, debt at 80% of annual GDP implies a 4% of GDP interest cost to the government at 2% inflation. That is a high cost which the government cannot easily cover either by taxes or by spending cuts, and it would put us on a trajectory with a rising debt-to-annual-GDP ratio just as entitlement spending begins to climb much more steeply.

  • One counterargument is that at an 80% debt-to-annual GDP ratio with 2.5%/year inflation and 2.5%/year real growth, even financing none of the interest cost but merely balancing the primary budget leads only to a stable and not to an explosive debt-to-annual GDP ratio.

  • A second counterargument is that the government (within limits) chooses the interest rate it pays on its debts via the reserve and capital requirements it imposes on the banking sector. You can call this "financial repression" and condemn it as not-ideal--as an inefficient allocation of taxes putting too large a weight on finance. But because the government can and will resort to financial repression if necessary, interest rate normalization does not create an emergency: financial repression can be gradually removed as additional revenue sources come on line.

  • A third counterargument is that countries that get into trouble do so because they find themselves with lots of harder-currency debt--so inflation and devaluation do not boost tax collections and exports and so fail to be the powerful stabilizing forces controlling the debt that they are in countries with no harder-currency debt, and such countries can get into trouble only if they have truly dysfunctional politics.

  • A fourth counterargument is that if America's politics are truly dysfunctional in the 2030s, spending $3 trillion less in the teens to keep the national debt from rising will not help us at all. (a) Right now fiscal policy is self-financing--increasing spending eases the burden of the debt-to-annual-GDP twenty years from now when interest rates normalize and entitlements rise further. (b) Even if fiscal policy is not self-financing, spending an extra $3 trillion now--20% of a year's GDP--for a net additional rise in the debt-to-annual-GDP ratio of 6 percentage points