Tag: functional finance

The Politics of Pay-Fors: A Simple Framework

One of the central economic debates among progressives is over the necessity or desirability of accompanying new public spending with similar-sized tax increases. In recent years perhaps the most visible, or at least the most heated, instances of this debate have been around Modern Mone(tar)y Theory. But the debate itself is broader and older.

These debates are in part about economic questions — both what the constraints on issuing new public-sector liabilities (“borrowing”) are in principle, and of how close we are to those constraints in practice. But a second and arguably more important dimension of the debate is political: In a public or legislative debate, what are the advantages and disadvantages of linking proposals for public spending with proposals for increased taxes?

I think it’s useful to think of this second question in terms of the grid of possibilities below. Some of this may seem obvious, but I find it’s sometimes helpful to spell out even obvious points.

On the horizontal axis we have spending relative to the baseline, from less to more. This axis also describes the political priority of the new spending — if there is to be only a small increase in spending, it will presumably go to items that are deemed highest value by the budget authorities, while greater overall spending allows for lower value items. Assuming that we think the priorities of the political process at least somewhat reflect social value, points at the far right can be thought of as socially useless or “waste”.

The vertical axis shows tax increases relative to the baseline, from less to more. Again, this also has a qualitative dimension. Modest tax increases can be targeted, for instance on higher incomes or on socially undesirable products or activities (Pigouvian taxes). But in order to raise large amounts of revenue, broad-based taxes are needed.1 The upper left corner, then, represents the status quo; the diagonal line coming down from it represents proposals that are fully paid for, that leave the expected fiscal balanced unchanged. Points below the line represent shifts toward fiscal surpluses, while points above it represent shifts toward deficit. If you think that spending to some degree pays for itself through Keynesian and/or supply side effects, you can imagine the slope of the diagonal line being flatter.

Remember: This is just a conceptual diagram, useful for organizing the debate. It doesn’t imply any substantive claims about what particular forms of spending will be prioritized by the political process, or what particular taxes should be seen as desirable for their own sake. And “status quo” here just means the null, what will happen if nothing happens, which might or might not be a continuation of current spending and tax policies.

Since I want to focus on the political question here, let’s stipulate that the budget balance itself isn’t economically important. So we can assess our preferred spending and tax proposals independently. We will want whatever progressive and Pigouvian taxes are desirable for their own sake, indicated by the blue bar on the left of the figure. And we will want whatever level of spending is required to meet urgent social needs, indicated by the blue bar at the top of the figure. Both of these will be modified based on current macroeconomic conditions — unemployment calls for more spending and/or lower taxes, while sustained inflation calls for less spending and/or higher taxes. (That’s why they are ranges rathe than points.) Thus the social optimal mix of spending and taxes will fall in the region marked with blue dotted lines.2

The question is now, what is the effect of linking spending changes with revenue changes — of requiring that new spending be “paid for”?

In general, it is to shift the policy debate away from the upper right and toward the lower left. This is shown by the various red arrows in the the figure, all of which represent trajectories from budget deficit toward surplus. The different arrows reflect the extent to which the pay-for requirement is  felt more strongly on the expenditure side (the flatter arrow) or the tax side (the steeper arrow), and what kinds of proposals you think are likely to be put forward in the absence of such a requirement.

Independently of where you think the socially optimal region is located, your judgement about the desirability of pay-for requirements will depend on what mix of spending cuts and revenue increases you think will result from it; what outcome you expect in its absence; and how you prioritize getting close to the optimum on the expenditure side versus on the revenue side. The argument of this post is that where people fall on paying for public spending depends more on these political judgments than on disagreements about economics. 

Here are some cases, corresponding to the arrows in the picture:

Arrow a reflects a view that the main effect of pay-for requirements is to impose priorities on spending. In this view, the normal outcome of the legislative process when large spending increases are proposed is to increase them even further, with items of limited or negative social value. So the main effect of fiscal constraints, in this view, is to force the budget authorities to focus on higher-priority items.3 This is reflected in an arrow that moves mainly to the left out of the “waste” region, toward the social optimum. This, I think, captures the view of the Obama team in 2009 and of prominent Obamanauts still in public life.

Arrow b is even flatter, and starts further to the left. This reflects a similar judgement that the main effect of pay-for requirements is to limit spending, but also that the bias of the political system is toward too little spending and that tax increases are politically very difficult. In this view, the main effect of a pay-for requirement is to make it likely that socially valuable spending will not take place. This is the view of most people in the progressive macro space today, as far as I can tell. Here is a version of this argument from some of my colleagues at the Roosevelt Institute.

Arrow c is steeper, moving directly toward the balanced-budget line. This reflects a judgement that a pay-for requirement will result in a mix of spending cuts and tax increases. Unlike the first two lines, which clearly move toward and away from the social optimum, respectively, this one is ambiguous on that point. This arrow, I think, captures where a lot of people around the Biden administration are right now. There is a range of views about what kind of fiscal position is appropriate in current conditions, and no significant commitment to balanced budgets as such. But there is, or has been, a strong view that it’s not possible to pass further large deficit-financed spending increases through Congress, in which case it’s important to preemptively move the debate (in the terms of the diagram) towards the diagonal. There’s also a view — reflected in the position of the arrow — that even if a pay-for requirement means the loss of some useful spending, the revenue raisers it encourages may be socially desirable for their own sake.

Finally, arrow d is even steeper, and starts higher up. This reflects a judgement that the main effect of pay-for requirements is to create pressure for higher taxes, and that this is a good thing. In this view, the main effect of “Keynesian” deficit financing is to allow the rich to escape the burden of paying for public spending, spending which will take place one way or the other. This is a minority but not fringe position on the left. It’s especially pronounced among MMT critics who attribute the school’s prominence to the fact that rich people welcome an excuse not to be taxed.

Broadly then, we have views that pay-for requirements are: politically helpful, because they reduce wasteful spending; politically harmful, because they reduce valuable spending; an unfortunate necessity, because deficit increases are politically harder than raising revenue; and politically helpful, because they motivate taxes on the rich. 

Again, all of this may seem a bit obvious. But I think it’s worth spelling out, because there’s some avoidable confusion that comes from treating as economic disagreements what are actually differing judgements about the contours of political possibility.

Between the two “left” positions (b and d), for example, you could put it this way: If we’re looking at a big expansion of public spending, what’s the effect of adding a requirement that it be paid for? Relative to the case without the requirement, it is more likely that we will get both the spending and a progressive tax increase. But it is also more likely that we won’t get the spending at all, or get less of it. How you trade these off against each other depends not just on your assessment of the relative likelihood, but also the relative importance you assign to the two goals. If you think that income inequality and the political power of the rich is the existential problem of our times, and progressive taxes are the only tool to rein it in, it’s not unreasonable to, in effect, hold public spending hostage in order to win them. If you think that other problems or more important, or there are other tools, you’ll feel differently.

My purpose here is not to say that any of these views is right or wrong. I’m just trying to clarify what’s being argued about. 

That said, here is the news story that prompted me to finally sit down and write this post. It’s a Financial Times article with the eye-catching headline “‘A Humiliating Climbdown’”:

This week Richard Neal, a Massachusetts Democrat and the leading tax writer in the House of Representatives, released his plan for $2.9tn in tax increases to fund Biden’s $3.5tn package… Neal’s proposal includes an increase in the top individual income tax rate from 37 per cent to 39.6 per cent, yet shies away from more aggressively targeting taxes on capital gains, the source of a huge share of wealth for millionaires and billionaires.

… The changes to Biden’s tax plan proposed in the House highlight the extent of the backlash among Democratic donors, lobbyists and constituents who have balked at the president’s efforts to tax wealth — especially capital gains.

\The point is, in this case at least, the link to tax increases seems to be making House Dems less likely to vote for something that includes them, not more likely. And this is especially true for the progressive income and wealth taxes that are central to the progressive case for pay-fors.

Even more than to the intra-left debate I just mentioned, the article speaks to the pragmatic mainstream case for pay-fors. One sometimes hears people say, ok, you’re right, there isn’t any real economic argument for matching spending and revenue. With interest rates on public debt still well below anything seen in US history before 2020, it’s hard to argue with a straight face that financial markets limit the US government’s ability to borrow. But, they say, there are still political constraints — at some point Congress is not going to pass more spending financed with debt.

In the view in which pay-fors are politically helpful, the space of political possibility slopes downward from upper right to lower left. The less borrowing you ask people to vote for, the easier it is. By committing to fully paying for all new spending, you are more likely to end up with a package that can make it past all the various veto points. But things like the FT article suggests that this isn’t the case — that the gradient of political feasibility instead slopes from bottom to top. The less revenue you need, the easier. 

In Arjun Jayadev’s and my piece on MMT and mainstream economics, we argued that differences between the two schools mostly “involve practical judgement about policy execution rather than any fundamental difference about how policy works in principle.” We continued:

We suspect that most in the mainstream macroeconomic policy world reject a functional finance rule not because they believe that it would not work if followed, but because they believe it would not in fact be followed. There is a widely shared though not always explicitly theorized presumption in mainstream policy discussions that macroeconomic policy in democratic polities suffers from a systematic bias toward deficits and inflation… Conversely, many MMT advocates believe that policymakers operating under a conventional assignment consistently err in the direction of accepting unemployment higher than required to maintain stable prices. … These judgements about the most likely direction of policy error are quite important for evaluating alternative policy rules, but they do not depend on any difference in strictly economic analysis.

That still seems right to me.

So which, then, seems more plausible? “Congress can’t pass something that will raise the deficit, so we need to find revenues to offset our spending,” versus “Congress hates raising taxes, so we need to be ready to accept higher deficits if we want higher spending.” 

Or again, which seems more plausible? “In the absence of some kind of financial constraint — even an artificial or imaginary one — we’ll see a wave of wasteful or even socially harmful spending,” versus, “Even in the absence of financial constraints, any expansion of the public sector has to overcome all kinds of hurdles and resistance.”  

I am arguing against my own interest as an economist here. But I suspect that clarifying what we believe — and why — on these kinds of questions would at this point advance the conversation around paying for public spending more than more narrowly economic analysis would.

A Baker’s Dozen of Reasons Not to Worry about Government Debt

(EDIT: It’s not sufficiently clear in the original post, but I wrote this as a sort of compendium of arguments one might use in response to claims that the federal debt is a binding constraint on new spending. I’m not saying these are the best or only reasons to reject the idea that federal government cannot borrow more. I’m saying that these are arguments that seem to have some traction in the mainstream policy world, such that you could use them in a newspaper op-ed or conversation with a congress member’s staff. Also, a premise here is that there are urgent needs we want the public sector to spend more on. Apart from the last couple, these are not arguments for more public dbet as an end in itself.)

 

Why might larger budget deficits be ok?

There are a number of reasons why economists, policymakers and advocates believe that increased public borrowing is not something to be afraid of. As I’ll discuss below, the fundamental factor linking most of these reasons is the idea that the US economy is generally operating below capacity.

When we think about the fiscal balance – the difference between government spending and government revenue – we always have to keep in mind that it has two sides: the real side and the financial side. Whenever the government increases spending, it has two kinds of effects. First, all else equal, it increases the amount of government debt in circulation. And second, it increases demand for goods and services, both directly when the government buys them and indirectly as government spending creates incomes for private businesses and households. 

To put it another way, for government to successfully raise spending without raising taxes, two things have to be true. First, someone – banks, wealthy families, foreign countries – has to be willing to hold the additional debt that the government issues. And second, someone has to be prepared to sell whatever it is that the government is trying to buy. If we are asking what kinds of limits there might be to deficit spending, we have to think about both sides. A government’s spending may face financial constraints, if people are unwilling to hold more of its debt; or real constraints, if the economy cannot produce the additional goods and services it is trying to buy.

Some people who think higher deficits are not a problem – particularly those associated with Modern Monetary Theory – believe that the US federal government never faces financial constraints, so only the real constraints matter. Others believe that the federal government might in principle face financial constraints, but there are good reasons to think that they are not an issue today. For policy purposes, the difference between these positions may not be very important.

On the real constraint side, the essential question is how close the economy is to potential output, or full employment. (The two terms are used interchanegably.) In an economy operating at potential, government can only increase its spending f the private sector reduces its spending. This “crowding out” is the real cost of increased public spending. In an economy below potential, on the other hand, the goods and services purchased by increased public spending come from mobilizing unused productive capacity, so there is no crowding out. In. fact, if the fiscal multiplier is big enough (greater than one) then increased purchases of goods and services by the public sector will result in more goods and services being purchased by the private sector as well.

Below, I lay out a baker’s dozen of related arguments for why, from a macroeconomic perspective, we should welcome increased debt-financed public spending. Some people who believe in greater public borrowing would accept all of these arguments; some only some of them. 

Real-economy arguments for more public borrowing

1. The economy generally operates below potential. Over the past 30 years, there have been three recessions, each followed by a long period of weak growth and high unemployment. By official measures, in 10 of the past 30 years GDP has been at least two points below potential; there have been only six months when it was more than two points above potential. And there has been no periods of high inflation. This suggests that in general, the economy is not running at full capacity; there is additional productive potential that could be mobilized by higher public spending, without crowding out private spending. In that sense, there is no real cost to higher public spending, and no need top offset it with higher taxes. Even better, higher public spending will help close the output gap and raise private spending as well.

2. There are long run forces pushing down demand. Larry Summers famously reintroduced into the economic conversation the idea of secular stagnation – that there is a long-run tendency for private spending to fall short of the economy’s productive potential. There are many reasons we might expect private spending to be lower, relative to national income, in the future than in the past. Among these: increased monopoly power; the shift toward information-based rather than resource-intensive production; increased shareholder power; a more unequal distribution of income; slower population growth; and the satiation of demand for market consumption, in favor of leisure and nonmarket activities. (The first three of these factors tend to reduce investment spending, the last  three consumption spending.)  If this idea is correct, the demand shortfalls of the past thirty years are not an anomaly, and we should expect them to grow larger in the future.

3. Potential output is mismeasured; we are still well below it. Even by the conventional measures of unemployment and potential output, the US economy has spent far more time in recent decades below target than above it. But if the target is mismeasured, the problem may be even worse. There are good reasons to think that both productivity and laborforce growth over the past decade have been depressed by weak demand. If this is the case, the US economy even at the height of a supposed boom, may in fact be operating well below potential today. The fact that  even with measured unemployment below 4 percent wage growth has accelerated only modestly, and inflation has not accelerated at all, is important evidence for this view.

4. Recessions and jobless recoveries have occurred repeatedly in past, will occur again in the future. Whether or not the US economy is at potential today, the current expansion will not continue forever. Recessions have occurred in the past and will occur in the future. Many forecasts believe there is a high risk of recession is likely in the relatively near future; the fact that the Fed is moving toward cutting rates suggests that they share this view. When thinking about what fiscal balance is appropriate, we need to consider not just where the economy is today but where it is likely to be in coming years.

5. Monetary policy is not effective at maintaining full employment. In the past, weak demand and recessions weren’t considered an argument for more public spending because it was assumed that a central bank following the correct policy rule could quickly return the economy to full employment. But it is increasingly clear that central banks do not have the tools (and perhaps the willingness) to precent extended periods of weak demand. It is increasingly recognized that fiscal policy is also required to stabilize demand. In his July testimony before Congress, Fed chair Jerome Powell said explicitly that in the event of another deep recession, the Fed would need help from fiscal policy. One important reason for this is the problem of the zero lower bound – since the policy interest rate cannot be set below zero, there is a limit to how far the Fed can lower it in a recession.

6. It’s hard to ramp up public spending quickly in recession. Orthodox opinion has long been that fiscal policy is not as effective as monetary policy in a recession because it takes much longer to ramp up public spending than to cut interest rates. While the experience of the Great Recession undermined conventional wisdom on many points, it supported it on this one. The ARRA stimulus bill was supposed to direct spending to “shovel-ready” projects, but in fact the majority of the infrastructure spending funded by the bill came several years after it passed. There are many institutional obstacles to increasing public spending rapidly. This means that if we need higher public spending in a recession, the best thing is to have higher spending all the time. If that leads to an overheating economy in the boom, that is an easier problem for the Fed to solve then a deep recession.

7. The costs of getting demand wrong are not symmetrical. Traditionally policymakers have defined their goal as keeping output as close to potential as possible. But it is increasingly clear that the costs of demand falling short are greater than the costs of demand overshooting potential. One reason for this is the previous point – that conventional policy has an easier time reining in excessive demand than stimulating weak demand. (As the old saying has it, “you can’t push on a string.”) A second reason is that demand has effects that go beyond the level of output. In particular, strong demand and low unemployment redistribute income toward workers from owners, and toward lower-wage workers in particular. Periods of weak demand, conversely, reduce the share of income going to workers. If we think the upward redistribution of income over the past generation is a problem, we should prefer to let demand overshoot potential than fall short of it.

8. Weak demand may have permanent effects on potential output. Traditionally, economists saw the economy’s long-term growth as being completely independent of demand conditions. People spending more money might raise production and employment today, but the long-term growth of potential output depended on structural factors – demographics, technological change, and so on. More recently, however, there has been renewed interest in the idea that weak demand can reduce potential output, an effect known as hysteresis. high unemployment may lead more people to drop out of the laborforce, while low unemployment may lead more people to enter the laborforce (or immigrate from abroad.) Strong demand may also lead to faster productivity growth. If hysteresis is real, then demand shortfalls don’t reduce output and employment this year, but potentially many years in the future as well. This is another reason to be more worried about demand falling short than overshooting, hence another reason to prefer a more expansionary fiscal stance, which normally implies more public borrowing.

Financial arguments for more public borrowing

9. With low interest rates, debt does not snowball. Traditionally, concerns about the financing of government spending have focused on whether debt is “sustainable” – whether debt levels will stabilize as a fraction of GDP, or rise without limit. When interest rates are greater than GDP growth rates, this implies a hard limit to government borrowing – to keep the debt-GDP ratio on a stable path, a deficit in one year must be made up for by a larger surplus in a future year. Otherwise, the interest on the existing debt will imply more and more borrowing, with the debt-GDP ratio rising without limit. But when interest rates on government debt are below growth rates, as they have been for the past 25 years, the debt ratio will stabilize on its own – deficits do not have to be offset with surpluses. This makes much of the earlier concern with debt sustainability obsolete.

10. There is good reason to think interest rates will remain low. There are a number of reasons to think that interest rates on public debt are likely to remain low, even if debt ratios rise considerably higher. First, low interest rates reflect the conditions of chronic weak demand discussed above, for two reasons. First, low investment means less demand for borrowed funds. And second, weak demand means that the interest rate set by the central bank is likely to be low. A second reason to expect low interest rates to continue is that the past ten years have repeatedly falsified predictions of bond vigilantes driving up the rates on government debt. Prior to the financial crisis of 2007-2008, many observers expected a catastrophic flight by investors away from US government debt and the dollar, but in fact, the crisis saw a steep fall interest rates on government debt and a rise in the dollar, as investors all over the world rushed to the safety of Treasury debt. Similarly, in Europe, even in the worst crisis-hit countries like Greece, interest rates are at their lowest point in history. Similarly Japan, with one of the highest debt0-GDP ratios ever recorded (about triple that of the US) continues to borrow at very low rats. Third, the experience of the past ten years have made it clear that even if investors were to demand higher interest rates on government debt, modern central banks can easily overcome this. The most dramatic illustration of this came in the summer of 2012, when a public statement by European Central bank chief Mario Draghi “we will do whatever it takes, and believe me, it will be enough”) reversed the spike in interest rates in countries like Italy, Spain and Portugal practically overnight. Finally, the prices of bonds — with hardly any premium for 30 year bonds over 5 and 10 year maturities — show that private investors do not expect a rise in interest rates any time in the foreseeable future.

11. With hysteresis, higher public borrowing can pay for itself. Even if we are concerned about lowering the debt-GDP ratio, the existence of hysteresis (point 8 above) means that cutting public borrowing is necessarily the right way to get there. In a world where the long-term path of GDP depends on aggregate demand, austerity can be self-defeating even in its own narrow financial terms. If lower public spending reduces demand, then it can lead to lower GDP, potentially raising the debt to GDP ratio even if it succeeds in reducing debt. Greece offers a clear example of this – the fiscal surpluses between 2010 and 2015 succeeded in reducing government debt by 5 percent, but the deep austerity contributed to a fall in GDP of 25 percent. So the debt-GDP ratio actually rose. Similarly, if debt-financed public spending leads to faster growth, the debt-GDP ratio may end up lower than otherwise. 

12. Federal debt is an important asset for financial markets. The points up to now have been arguments for why higher public debt is acceptable. But there is also an argument that increased public debt would be a positive good. Financial markets depend on Treasury debt as a safe, liquid asset. Federal government debt offers an absolutely safe asset that can always be sold quickly and at a predictable price – something that is extremely valuable for banks and other financial institutions. There is a strong argument that the growth of the mortgage-backed security market in the 2000s was fundamentally driven by a scarcity of government debt – many financial institutions wanted (or were compelled by regulation) to hold a substantial amount of ultrasafe, liquid debt, and there was not enough government debt in circulation to meet this demand. So financial markets came up with mortgage-backed securities as a supposed alternative – with disastrous results. Similarly, after the recession, one argument for why the recovery was so slow was a “safe asset shortage” – financial institutions were unwilling to make risky loans without  holdings of ultrasafe assets to balance them. While these concerns have receded today, there is still good reason to expect a “flight to safety” toward Treasury debt in the event of a new crisis, and government debt remains important for settling many financial contracts and pricing other assets. So strange as it may sound, there is a serious argument – made by, among others, Nobel prize winner Jean Tirole in his book on financial liquidity — that increased government borrowing would make the financial system more stable and increase access to credit for other borrowers.

13. Federal debt is an important asset for the rest of the world. Federal debt is an important asset not just for the US financial system, but for the rest of the world. In today’s dollar-based international system, the great majority of international trade and investment is denominated in dollars, and most foreign-exchange transactions involve dollars. As a result, central banks (and private financial institutions) all over the world hold foreign-exchange reserves primarily in the form of dollars. These dollar reserves are mainly held in the form of Treasury debt. Close to half of federal debt is now held abroad, mainly as reserves by foreign governments. These holdings are essential for the stability of the international financial system – without adequate reserves, countries are vulnerable to sudden flows of “hot money” out of their countries. As Barry Eichengreen – perhaps the leading economic historian of the international financial system, — has noted, a deep market for government is an essential requirement for a currency to serve as the global reserve currency. If the US is going to be a responsible partner for the rest of the world — and continue reaping the benefits of being at the center of the global economy — it needs to provide an adequate supply of safe government debt for the rest of the world to hold as reserves.

 (I wrote this document for internal use at the Roosevelt Institute. Figured I might as well put it up here as well. Obviously it would benefit from links to supporting material, which I may add at some point.)

New Piece on MMT

Arjun Jayadev and I have a new piece up at the Institute for New Economic Thinking, trying to clarify the relationship between Modern Monetary Theory (MMT) and textbook macroeconomics. (There is also a pdf version here, which I think is a bit more readable.) I will have a blogpost summarizing the argument later today or tomorrow, but in the meantime here is the abstract:

An increasingly visible school of heterodox macroeconomics, Modern Monetary Theory (MMT), makes the case for functional finance—the view that governments should set their fiscal position at whatever level is consistent with price stability and full employment, regardless of current debt or deficits. Functional finance is widely understood, by both supporters and opponents, as a departure from orthodox macroeconomics. We argue that this perception is mistaken: While MMT’s policy proposals are unorthodox, the analysis underlying them is largely orthodox. A central bank able to control domestic interest rates is a sufficient condition to allow a government to freely pursue countercyclical fiscal policy with no danger of a runaway increase in the debt ratio. The difference between MMT and orthodox policy can be thought of as a different assignment of the two instruments of fiscal position and interest rate to the two targets of price stability and debt stability. As such, the debate between them hinges not on any fundamental difference of analysis, but rather on different practical judgements—in particular what kinds of errors are most likely from policymakers.

Read the rest here or here.

Five, Ten or Even Thirty Years

Neel Kashkari is clearly a very smart guy. He’s been an invaluable voice for sanity at the Fed these past few years. Doesn’t he see that something has gone very wrong here?

Kashkari:

When people borrow money to buy a house, or businesses take out a loan to build a new factory, they don’t really care about overnight interest rates. They care about what interest rates will be for the term of their loan: 5, 10 or even 30 years. [*] Similarly, when banks make loans to households and businesses, they also try to assess where interest rates will be over the length of the loan when they set the terms. Hence, expectations about future interest rates are enormously important to the economy. When the Fed wants to stimulate more economic activity, we do that by trying to lower the expected future path of interest rates. When we want to tap the brakes, we try to raise the expected future path of interest rates.

Here’s the problem: recession don’t last 5, 10 or even 30 years. Per the NBER, they last a year to 18 months.

Mainstream theory says we have a long run dictated by supply side — technology, demographics, etc. On average the output gap is zero, or at least, it’s at a stable level. On top of this are demand disturbances or shocks — changes in desired spending — which produce the businesses cycle, alternating periods of high unemployment and normal growth or rising inflation. The job of monetary policy is to smooth out these short-term fluctuations in demand; it absolves itself of responsibility for the longer-run growth path.

If policy responding to demand shortfalls lasting a year or two, how is that supposed to work if policy shifts have to be maintained for 5, 10 or even 30 years to be effective?

If the Fed is faced with rising inflation in 2005, is it supposed to respond by committing itself to keeping rates high even in 2010, when the economy is sliding into depression? Does anyone think that would have been a good idea? (I seriously doubt Kashkari thinks so.) And if it had made such a commitment in 2005, would anyone have worried about breaking it in 2010? But if the Fed can’t or shouldn’t make such a commitment, how is this vision of monetary policy supposed to work?

If monetary policy is only effective when sustained for 5, 10 or even 30 years, then monetary policy is not a suitable tool for managing the business cycle. Milton Friedman pointed this out long ago: It is impossible for countercyclical monetary policy to work unless the lags with which it takes effect are decidedly shorter than the frequency of the shocks it is supposed to respond to. The best you can do, in his view, is maintain a stable money supply growth that will ensure stable inflation over the long run.

Meanwhile, conventional monetary policy rules like the Taylor rule are defined based on current macroeconomic conditions — today’s inflation rate, today’s output gap, today’s unemployment rate. There’s no term in there for commitments the Fed made at some point in the past. The Taylor rule seems to describe the past two or three decades of monetary policy pretty well. Now, Kashkari says the Fed can influence real activity only insofar as it is setting policy over the next 5, 10 or even 30 year’s based on today’s conditions. But what the Fed actually will do, if the Taylor rule continues to be a reasonable guide, is to set monetary policy based on conditions over the next 5, 10 or even 30 years. So if Kashkari takes his argument seriously, he must believe that monetary policy as it is currently practiced is not effective at all.

In the abstract, we can imagine some kind of rule that sets policy today as some kind of weighted average of commitments made over the past 5, 10 or even 30 years. Of course neither economic theory nor official statements describe policy this way. Still, in the abstract, we can imagine it. But in practice? FOMC members come and go; Kashkari is there now, he’ll be gone next year. The chair and most members are appointed by presidents, who also come and go, sometimes in unpredictable ways. Whatever Kashkari thinks is the appropriate policy for 2022, 2027 or 2047, it’s highly unlikely he’ll be there to carry it out. Suppose that in 2019 Fed chair Kevin Warsh  looks at the state of the economy and says, “I think the most appropriate policy rate today is 4 percent”. Is it remotely plausible that that sentence continues “… but my predecessor made a commitment to keep rates low so I will vote for 2 percent instead”? If that’s the reed the Fed’s power over real activity rests on it, it’s an exceedingly thin one. Even leaving aside changes of personnel, the Fed has no institutional capacity to make commitments about future policy. Future FOMC members will make their choices based on their own preferred models of the economy plus the data on the state of the economy at the time. If monetary policy only works through expectations of policy 5, 10 or even 30 years from now, then monetary policy just doesn’t work.

There are a few ways you can respond to this.

One is to accept Kashkari’s premise — monetary policy is only effective if sustained over many years — and follow it to its logical conclusion: monetary policy is not useful for stabilizing demand over the business cycle. Two possible next steps: Friedman’s, which concludes that stabilizing demand at business cycle frequencies is not a realistic goal for policy, and the central bank should focus on the long-term price level; and Abba Lerner’s, which concludes that business cycles should be dealt with by fiscal policy instead.

The second response is to start from the fact — actual or assumed — that monetary policy is effective at smoothing out the business cycle, in which case Kashkari’s premise must be wrong. Evidently the effect of monetary policy on activity today does not depend on beliefs about what policy will be 5, 10 or even 30 years from now. This is not a hard case to make. We just have to remember that there is not “an” interest rate, but lots of different credit markets, with rationing as well as prices, with different institutions making different loans to different borrowers. Policy is effective because it targets some particular financial bottleneck. Perhaps stocks or inventories are typically financed short-term and changes in their financing conditions are also disproportionately likely to affect real activity; perhaps mortgage rates, for institutional reasons, are more closely linked to the policy rate than you would expect from “rational” lenders; perhaps banks become more careful in their lending standards as the policy rate rises. One way or another, these stories depend on widespread liquidity constraints and the lack of arbitrage between key markets. Generations of central bankers have told stories like these to explain the effectiveness of monetary policy. Remember Ben Bernanke? His article Inside the Black Box is a classic of this genre, and its starting point is precisely the inadequacy of Kashkari’s interest rate story to explain how monetary policy actually works. Somehow or other policy has to affect the volume of lending on a short timeframe than it can be expected to move long rates. Going back a bit further, the Fed’s leading economist of the 1950s, Richard Roosa, was vey clear that neither the direct effect of Fed policy shifts on longer rates, nor of interest rates on real activity, could be relied on. What mattered rather was the Fed’s ability to change the willingness of banks to make loans. This was the “availability doctrine” that guided monetary policy in the postwar years. [2] If you think monetary policy is generally an effective tool to moderate business cycles, you have to believe something like this.

Response three is to accept Kashkari’s premise, yet also to believe that monetary works. This means you need to adjust your view of what policy is supposed to be doing. Policy that has to be sustained for 5, 10 or even 30 years to be effective, is no good for responding to demand shortfalls that last only a year or two at most. It looks better if you think that demand may be lacking for longer periods, or indefinitely. If shifts in demand are permanent, it’s not such a problem that to be effective policy shifts must also be permanent, or close to it. And the inability to make commitments is less of a problem in this case; now if demand is weak today, theres a good chance it will be weak in 5, 10 or even 30 years too; so policy will be persistent even if it’s only based on current conditions. Obviously this is inconsistent with an idea that aggregate demand inevitably gravitates toward aggregate supply, but that’s ok. It might indeed be the case that demand deficiencies an persist indefinitely, requiring an indefinite maintenance of lower rates. There’s a good case that something like this response was Keynes’ view. [3] But while this idea isn’t crazy, it’s certainly not how central banks normally describe what they’re doing. And Kashkari’s post doesn’t present itself as a radical reformulation of monetary policy’s goals, or mention secular stagnation or anything like that.

I don’t know which if any of these responses Kashkari would agree with. I suppose it’s possible he sincerely believes that policy is only effective when sustained for 5, 10 or even 30 years, and simply hasn’t noticed that this is inconsistent with a mission of stabilizing demand over business cycles that turn much more quickly. Given what I’ve read of his I feel this is unlikely. It also seems unlikely that he really thinks you can understand monetary policy while abstracting from banks, finance, credit and, well, money — that you can think of it purely in terms of an intertemporal “interest rate,” goods today vs goods tomorrow, which the central bank can somehow set despite controlling neither preferences nor production possibilities. My guess: When he goes to make concrete policy, it’s on the basis of some version of my response two, an awareness that policy operates through the concrete financial structures that theory abstracts from. And my guess is he wrote this post the way he did because he thought the audience he’s writing for would be more comfortable with a discussion of the expectations of abstract agents, than with a discussion of the concrete financial structures through which monetary policy is transmitted. It doesn’t hurt that the former is much simpler.

Who knows, I’m not a mind reader. But it doesn’t really matter. Whether the most progressive member of the FOMC has forgotten everything his predecessors knew about the transmission of monetary policy, or whether he merely assumes his audience has, the implications are about the same. “The Fed sets the interest rate” is not the right starting point for thinking about monetary policy manages aggregate demand.

 

[1] This is a weird statement, and seems clearly wrong. My wife and I just bought a house, and I can assure you we were not thinking at all about what interest rates would be many years from now. Why would we? — our monthly payments are fixed in the contract, regardless of what happens to rates down the road. Allowing the buyer to not care about future interest rates is pretty much the whole point of the 30-year fixed rate mortgage. Now it is true that we did care, a little, about interest rates next year (not in 5 years). But this was in the opposite way that Kashkari suggests — today’s low rates are more of an inducement to buy precisely if they will not be sustained, i.e. if they are not informative about future rates.

I think what may be going on here is a slippage between long rates — which the borrower does care about — and expected short rates over the length of the loan. In any case we can let it go because Kashkari’s argument does work in principle for lenders.

[2] Thanks to Nathan Tankus for pointing this article out to me.

[3] Leijonhufvud as usual puts it best:

Keynes looked forward to an indefinite period of, at best, unrelenting deflationary pressure and painted it in colors not many shades brighter than the gloomy hues of the stagnationist picture. But these stagnationist fears were based on propositions that must be stated in terms of time-derivatives. Modern economies, he believed, were such that, at a full employment rate of investment, the marginal efficiency of capital would always tend to fall more rapidly than the long rate of interest. … When he states that the long rate “may fluctuate for decades about a level which is chronically too high” one should … see this in the historical context of the “obstinate maintenance of misguided monetary policies” of which he steadily complained.

Readings: A Couple New Papers on Fiscal Policy

From the NBER working paper series — essential reading if you want to follow what the mainstream of the profession is up to — here are a couple interesting recent papers on fiscal policy. They offer some genuinely valuable insights, while also demonstrating the limits of orthodoxy.

Geographic Cross-Sectional Fiscal Spending Multipliers: What Have We Learned?
Gabriel Chodorow-Reich
NBER Working Paper No. 23577

Gabriel Chodorow-Reich has a useful new entry in the burgeoning literature on the empirics of fiscal multipliers — a review of the now-substantial work on state-level multipliers. Most of these papers are based on spending under the 2009 stimulus (the ARRA) — since many components of its spending were set by formulas not responsive to local economic conditions, cross-state variation can reasonably be considered exogenous. (Another reason the ARRA features so heavily in these papers is, of course, that the revival of mainstream interest in fiscal multipliers is mostly a post-crisis phenomenon.) Other studies estimate local multipliers based on  other public spending with plausibly exogenous regional variation, such as that involved in a military buildup or response to a natural disaster.

How do these local multipliers translate into the national multiplier we are usually more interested in? There are two main differences, pointing in opposite directions. On the one hand, states are more open than the US as a whole (or than other large countries, though perhaps not more than small European countries). This means more spillover of demand across borders, meaning a smaller multiplier. On the other hand, since states don’t conduct their own monetary policy (and since the US banking system is no longer partitioned by state) the usual channels of crowding out don’t operate at the state level. This implies a bigger multiplier. It’s hard to say which of these effects is bigger in general, but when interest rates are constrained, by the zero lower bound for example, crowding out doesn’t happen by that channel at the national level either. So at the zero lower bound, Chodorow-Reich argues, the national multiplier should be unambiguously greater than the average state multiplier.

Based on the various studies he discusses (including a couple of his own), he estimates a state-level multiplier of 1.8.  He subtracts an arbitrary tenth of a point to allow for financial crowding out even at the ZLB, giving a value of 1.7 as a lower bound for the national multiplier. This is toward the high end of existing estimates. For whatever reason, Chodorow-Reich makes no effort to even guess at the impact of the greater openness of state-level economies. But if we suppose that the typical import share at the state level is double the national import share, then a back-of-the-envelope calculation suggests that a state-level multiplier of 1.7 implies a national multiplier somewhere above 2.0. [1]

It’s a helpful paper, offering some more empirical support for the new view of fiscal policy that seems to be gradually displacing the balanced-budget orthodoxy of the past generation. But it must be said that it is one of those papers that presents some very interesting empirical results and is evidently attempting to deal with a concrete, policy-relevant question about economic reality — but that seems to devote a disproportionate amount of energy to making its results intelligible within mainstream theory. We’ll really have made progress when this kind of work can be published without a lot of apologies for the use of “non-Ricardian agents.”

The Dire Effects of the Lack of Monetary and Fiscal Coordination
Francesco Bianchi, Leonardo Melosi
NBER Working Paper No. 23605

The subordination of real-world insight to theoretical toy-train sets is much worse in this paper. But there is a genuine insight in it — that when you have a fiscal authority targeting the debt-GDP ratio and a monetary authority targeting inflation (or equivalently, unemployment or the output gap), then when they are independent their actions can create destabilizing feedback loops. In the simple case, suppose the monetary authority responds to higher inflation by raising interest rates. This raises debt service costs, forcing the fiscal authority to reduce spending or raise taxes to meet its debt target. The contractionary effect of this fiscal shift will have to be offset by the central bank lowering rates. This process may converge toward the unique combination of fiscal balance and interest rate at which both inflation and debt ratio are at their desired levels. But as Arjun Jayadev and I have shown, it can also diverge, with the interactions the actions of each authority provoking more and more violent responses from the other.

I’m glad to see some mainstream people recognizing this problem. As the authors note, the basic point was made by Michael Woodford. (Unsurprisingly, they don’t cite this recent paper by Peter Skott and Soon Ryoo, which carefully works through the possible dynamics between the two policy rules. [2]) The implications, as the NBER authors correctly state, are, first, that fiscal policy and monetary policy have to be seen as jointly affecting both the output gap and the public debt; and that if preventing a rising debt ratio is an important goal of policy, holding down interest rates and/or allowing a higher inflation rate are useful tools for achieving it. Unfortunately, the paper doesn’t really develop these ideas — the meat of it is a mathematical exercise showing how these results can occur in the world of a representative agent maximizing its utility over infinite time, if you set up the frictions just right.

 

[1] For the simplest case, suppose the multiplier is equal to (1-m)[1/(1-mpc)], where m is the marginal propensity to import and mpc is the marginal propensity to consume. Then if the state level import propensity is 0.4 and the state level multiplier is 1.7, that implies an mpc of 0.65. Combine that with a national import propensity of 0.2 and you get a national multiplier of 2.3.

[2] The paper was published in Metroeconomica in 2016, but I’m linking to the unpaywalled 2015 working paper version.

 

What Does Crowding Out Even Mean?

Paul Krugman is taking some guff for this column where he argues that the US economy is now at potential, or full employment, so any shift in the federal budget toward deficit will just crowd out private demand.

Whether higher federal spending (or lower taxes) could, in present conditions, lead to higher output is obviously a factual question, on which people may read the evidence in different ways. As it happens, I don’t agree that current output is close to the limits of current productive capacity. But that’s not what I want to write about right now. Instead I want to ask: What concretely would crowding out even mean right now?

Below, I run through six possible meanings of crowding out, and then ask if any of them gives us a reason, even in principle, to worry about over-expansionary policy today. (Another possibility, suggested by Jared Bernstein, is that while we don’t need to worry about supply constraints for the economy as a whole, tax cuts could crowd out useful spending due to some unspecified financial constraint on the federal government. I don’t address that here.) Needless to say, doubts about the economic case for crowding-out are in no way an argument for the specific deficit-boosting policies favored by the new administration.

The most straightforward crowding-out story starts from a fixed supply of private savings. These savings can either be lent to the government, or to business. The more the former takes, the less is left for the latter. But as Keynes pointed out long ago, this simple loanable-funds story assumes what it sets out to prove. The total quantity of saving is fixed only if total income is fixed. If higher government spending can in fact raise total income, it will raise total saving as well. We can only tell a story about government and business competing for a given pool of saving if we have already decided for some other reason that GDP can’t change.

The more sophisticated version, embodied in the textbook ISLM model, postulates a fixed supply of money, rather than saving. [1] In Hicks’ formulation, money is used both for transactions and as the maximally liquid store of wealth. The higher is output, the more money is needed for transactions, and the less is available to be held as wealth. By the familiar logic of supply and demand, this means that wealthholders must be paid more to part with their remaining stock of money. The price wealthholders receive to give up their money is interest; so as GDP rises, so does the interest rate.

Unlike the loanable funds story with fixed saving, this second story does give a logically coherent account of crowding out. In a world of commodity money, if such ever was, it might even be literally true. But in a world of bank-created credit money, it’s at best a metaphor. Is it a useful metaphor? That would require two things. First, that the interest rate (whichever one we are interested in) is set by the financial system. And second, that the process by which this happens causes rates to systematically rise with demand. The first premise is immediately rejected by the textbooks, which tell us that “the central bank sets the interest rate.” But we needn’t take this at face value. There are many interest rates, not just one, and the spreads between them vary quite a bit; logically it is possible that strong demand could lead to wider spreads, as banks stretch must their liquidity further to make more loans. But in reality, the opposite seems more likely. Government debt is a source of liquidity for private banks, not a use of it; lending more to the government makes it easier, not harder, for them to also lend more to private borrowers. Also, a booming economy is one in which business borrowers are more profitable; marginal borrowers look safer and are likely to get better terms. And rising inflation, obviously, reduces the real value of outstanding debt; however annoying this is to bankers, rationally it makes them more willing to lend more to their now less-indebted clients. Wicksell, the semi-acknowledged father of modern central banking theory, built his big book around the premise that in a credit-money system, inflation would give private banks no reason to raise interest rates.

And in fact this is what we see. Interest rate spreads are narrow in booms; they widen in crises and remain wide in downturns.

So crowding out mark two, the ISLM version, requires us to accept both that central banks cannot control the economically relevant interest rates, and that private banks systematically raise interest rates when times are good. Again, in a strict gold standard world there might something to this — banks have to raise rates, their gold reserves are running low — but if we ever lived in that world it was 150 or 200 years ago or more.

A more natural interpretation of the claim that the economy is at potential, is that any further increase in demand would just  lead to inflation. This is the version of crowding out in better textbooks, and also the version used by MMT folks. On a certain level, it’s obviously correct. Suppose the amount of money-spending in an economy increases. Then either the quantity of goods and services increases, or their prices do. There is no third option: The total percent increase in money spending, must equal the sum of the percent increase in “real” output and the percent increase in average prices. But how does the balance between higher output and higher prices play out in real life? One possibility is that potential output is a hard line: each dollar of spending up to there increases real output one for one, and leaves prices unchanged; each dollar of spending above there increases prices one for one and leaves output unchanged. Alternatively, we might imagine a smooth curve where as spending increases, a higher fraction of each marginal dollar translates into higher prices rather than higher output. [2] This is certainly more realistic, but it invites the question of which point exactly on this curve we call “potential”. And it awakens the great bane of postwar macro – an inflation-output tradeoff, where the respective costs and benefits must be assessed politically.

Crowding out mark three, the inflation version, is definitely right in some sense — you can’t produce more concrete use values without limit simply by increasing the quantity of money borrowed by the government (or some other entity). But we have to ask first, positively, when we will see this inflation, and second, normatively, how we value lower inflation vs higher output and income.

In the post-1980s orthodoxy, we as society are never supposed to face these questions. They are settled for us by the central bank. This is the fourth, and probably most politically salient, version of crowding out: higher government spending will cause the central bank to raise interest rates. This is the practical content of the textbook story, and in fact newer textbooks replace the LM curve — where the interest rate is in some sense endogenous — with a straight line at whatever interest rate is chosen by the central bank. In the more sophisticated textbooks, this becomes a central bank reaction function — the central bank’s actions change from being policy choices, to a fundamental law of the economic universe. The master parable for this story is the 1990s, when the Clinton administration came in with big plans for stimulus, only to be slapped down by Alan Greenspan, who warned that any increase in public spending would be offset by a contractionary shift by the federal reserve. But once Clinton made the walk to Canossa and embraced deficit reduction, Greenspan’s fed rewarded him with low rates, substituting private investment in equal measure for the foregone public spending. In the current contest, this means: Any increase in federal borrowing will be offset one for one by a fall in private investment —  because the Fed will raise rates enough to make it happen.

This story is crowding out mark four. It depends, first, on what the central bank reaction function actually is — how confident are we that monetary policy will respond in a direct, predictable way to changes in the federal budget balance or to shifts in demand? (The more attention we pay to how the monetary sausage gets made, the less confident we are likely to be.) And second, on whether the central bank really has the power to reliably offset shifts in fiscal policy. In the textbooks this is taken for granted but there are reasons for doubt. It’s also not clear why the actions of the central bank should be described as crowding out by fiscal policy. The central bank’s policy rule is not a law of nature. Unless there is some other reason to think expansionary policy can’t work, it’s not much of an argument to say the Fed won’t allow it. We end up with something like: “Why can’t we have deficit-financed nice things?” “Because the economy is at potential – any more public spending will just crowd out private spending.” “How will it be crowded out exactly?” “Interest rates will rise.” “Why will they rise?” “Because the federal reserve will tighten.” “Why will they tighten?” “Because the economy is at potential.”

Suppose we take the central bank out of the picture. Suppose we allow supply constraints to bind on their own, instead of being anticipated by the central planners at the Fed. What would happen as demand pushed up against the limits of productive capacity? One answer, again, is rising inflation. But we shouldn’t expect prices to all rise in lockstep. Supply constraints don’t mean that production growth halts at once; rather, bottlenecks develop in specific areas. So we should expect inflation to begin with rising prices for inputs in inelastic supply — land, oil, above all labor. Textbook models typically include a Phillips curve, with low unemployment leading to rising wages, which in turn are passed on to higher prices.

But why should they be passed on completely? It’s easy to imagine reasons why prices don’t respond fully or immediately to changes in wages. In which case, as I’ve discussed before, rising wages will result in an increase in the wage share. Some people will object that such effects can only be temporary. I’m not sure this makes sense — why shouldn’t labor, like anything else, be relatively more expensive in a world where it is relatively more scarce? But even if you think that over the long-term the wage share is entirely set on the supply side, the transition from one “fundamental” wage share to another still has to involve a period of wages  rising faster or slower than productivity growth — which in a Phillips curve world, means a period above or below full employment.

We don’t hear as much about the labor share as the fundamental supply constraint, compared with savings, inflation or interest rates. But it comes right out of the logic of standard models. To get to crowding out mark five, though, we have to take one more step. We have to also postulate that demand in the economy is profit-led — that a distributional shift from profits toward wages reduces desired investment by more than it increases desired consumption. Whether (or which) real economies display wage-led or profit-led demand is a subject of vigorous debate in heterodox macro. But there’s no need to adjudicate that now. Right now I’m just interested in what crowding out could possibly mean.

Demand can affect distribution only if wage increases are not fully passed on to prices. One reason this might happen is that in an open economy, businesses lack pricing power; if they try to pass on increased costs, they’ll lose market share to imports. Follow that logic to its endpoint and there are no supply constraints — any increase in spending that can’t be satisfied by domestic production is met by imports instead. For an ideal small, open economy potential output is no more relevant than the grocery store’s inventory is for an individual household when we go shopping. Instead, like the household, the small open economy faces a budget constraint or a financing constraint — how much it can buy depends on how much it can pay for.

Needless to say, we needn’t go to that extreme to imagine a binding external constraint. It’s quite reasonable to suppose that, thanks to dependence on imported inputs and/or demand for imported consumption goods, output can’t rise without higher imports. And a country may well run out of foreign exchange before it runs out of domestic savings, finance or productive capacity. This is the idea behind multiple gap models in development economics, or balance of payments constrained growth. It also seems like the direction orthodoxy is heading in the eurozone, where competitiveness is bidding to replace inflation as the overriding concern of macro policy.

Crowding out mark six says that any increase in demand from the government sector will absorb scarce foreign exchange that will no longer be available to private sector. How relevant it is depends on how inelastic import demand is, the extent to which the country as a whole faces a binding budget or credit constraint and, what concrete form that constraint faces — what actually happens if international creditors are stiffed, or worry they might be? But the general logic is that higher spending will lead to a higher trade deficit, which at some point can no longer be financed.

So now we have six forms of crowding out:

1. Government competes with business for fixed saving.

2. Government competes with business for scarce liquidity.

3. Increased spending would lead to higher inflation.

4. Increased spending would cause the central bank to raise interest rates.

5. Overfull employment would lead to overfast wage increases.

6. Increased spending would lead to a higher trade deficit.

The next question is: Is there any reason, even in principle, to worry about any of these outcomes in the US today? We can decisively set aside the first, which is logically incoherent, and confidently set aside the second, which doesn’t fit a credit-money economy in which government liabilities are the most liquid asset. But the other four certainly could, in principle, reflect real limits on expansionary policy. The question is: In the US in 2017, are higher inflation, higher interest rates, higher wages or a weaker balance of payments position problems we need to worry about? Are they even problems at all?

First, higher inflation. This is the most natural place to look for the costs of demand pushing up against capacity limits. In some situations you’d want to ask how much inflation, exactly, would come from erring on the side of overexpansion, and how costly that higher inflation would be against the benefits of lower unemployment. But we don’t have to ask that question right now, because inflation is by conventional measures, too low; so higher inflation isn’t a cost of expansionary policy, but an additional benefit. The problem is even worse for Krugman, who has been calling for years now for a higher inflation target, usually 4 percent. You can’t support higher inflation without supporting the concrete action needed to bring it about, namely, a period of aggregate spending in excess of potential. [2] Now you might say that changing the inflation target is the responsibility of the Fed, not the fiscal authorities. But even leaving aside the question of democratic accountability, it’s hard to take this response seriously when we’ve spent the last eight years watching the Fed miss its existing target; setting a new higher target isn’t going to make a difference unless something else happens to raise demand. I just don’t see how you can write “What do we want? Four percent! When do we want it? Now!” and then turn around and object to expansionary fiscal policy on the grounds that it might be inflationary.

OK, but what if the Fed does raise rates in response to any increase in the federal budget deficit, as many observers expect? Again, if you think that more expansionary policy is otherwise desirable, it would seem that your problem here is with the Fed. But set that aside, and assume our choice is between a baseline 2018-2020, and an alternative with the same GDP but with higher budget deficits and higher interest rates. (This is the worst case for crowding out.) Which do we prefer? In the old days, the low-deficit, low-interest world would have been the only respectable choice: Private investment is obviously preferable to whatever government deficits might finance. (And to be fair, in the actual 2018-2020, they will mostly be financing high-end tax cuts.) But as Brad DeLong points out, the calculation is different today. Higher interest rates are now a blessing, not a curse, because they create more running room for the Fed to respond to a downturn. [3] In the second scenario, there will be some help from conventional monetary policy in the next recession, for whatever it’s worth; in the first scenario there will be no help at all. And one thing we’ve surely learned since 2008 is the costs of cyclical downturns are much larger than previously believed. So here again, what is traditionally considered a costs of pushing past supply constraints turns out on closer examination to be a benefit.

Third, the danger of more expansionary policy is that it will lead to a rise in the wage share. You don’t hear this one as much. I’ve suggested elsewhere that something like this may often motivate actual central bank decisions to tighten. Presumably it’s not what someone like Krugman is thinking about. But regardless of what’s in people’s heads, there’s a serious problem here for the crowding-out position. Let’s say that we believe, as both common sense and the textbooks tells us, that the rate of wage growth depends on the level of unemployment. Suppose  we define full employment in the conventional way as the level of unemployment that leads to nominal wage growth just equal to productivity growth plus the central bank’s inflation target. Then by definition, any increase in the wage share requires a period of overfull employment — of unemployment below the full employment level. This holds even if you think the labor share in the long run is entirely technologically determined. A forteori it holds if you think that the wage share is in some sense political, the result of the balance of forces between labor and capital.

Again, I’m simply baffled how someone can believe at the same time that the rising share of capital in national income is a problem, and that there is no space for expansionary policy once full employment is reached. [4] Especially since the unemployment target is missed so often from the other side. If you have periods of excessively high unemployment but no periods of excessively low unemployment, you get a kind of ratchet effect where the labor share can only go down, never up. I think this sort of cognitive dissonance happens because economics training puts aggregate demand in one box and income distribution in another. But this sort of hermetic separation isn’t really sustainable. The wage share can only be higher in the long run if there is some short-run period in which it rises.

Finally, the external constraint. It is probably true that more expansionary fiscal policy will lead to bigger trade deficits. But this only counts as crowding out if those deficits are in some sense unsustainable. Is this the case for the US? There are a lot of complexities here but the key point is that almost all our foreign liabilities (and all of the government’s) are denominated in dollars, and almost all our imports are invoiced in dollars. Personally, I think the world is still more likely to encounter a scarcity of dollar liquidity than a surfeit, so the problem of an external constraint doesn’t even arise. But let’s say I’m wrong and we get the worst-case scenario where the world is no longer willing to hold more dollar liabilities. What happens? Well, the value of the dollar falls. At a stroke, US foreign liabilities decline relative to foreign assets (which are almost all denominated in their home currencies), improving the US net international investment position; and US exports get cheaper for the rest of the world, improving US competitiveness. The problem solves itself.

Imagine a corporation with no liabilities except its stock, and that also paid all its employers and supplies in its own stock and sold its goods for its own stock. How could this business go bankrupt? Any bad news would instantly mean its debts were reduced and its goods became cheaper relative to its competitors’. The US is in a similar position internationally. And if you think that over the medium term the US should be improving its trade balance then, again, this cost of over-expansionary policy looks like a benefit — by driving down the value of the dollar, “irresponsible” policy will set the stage for a more sustainable recovery. The funny thing is that in other contexts Krugman understands this perfectly.

So as far as I can tell, even if we accept that the US economy has reached potential output/full employment, none of the costs for crossing this line are really costs today. Perhaps I’m wrong, perhaps I’m missing something. but it really is incumbent on anyone who argues there’s no space for further expansionary policy to explain what concretely would be the results of overshooting.

In short: When we ask how close the economy is to potential output, full employment or supply constraints, this is not just a factual question. We have to think carefully about what these terms mean, and whether they have the significance we’re used to in today’s conditions. This post has been more about Krugman than I intended, or than he deserves. A very large swathe of established opinion shares the view that the economy is close to potential in some sense, and that this is a serious objection to any policy that raises demand. What I’d like to ask anyone who thinks this is: Do you think higher inflation, a higher “natural” interest rate, a higher wage share or a weaker dollar would be bad things right now? And if not, what exactly is the supply constraint you are worried about?

 

[1] The LM in ISLM stands for liquidity-money. It’s supposed to be the combination of interest rates and output levels at which the demand for liquidity is satisfied by a given stock of money.

[2] OK, some people might say the Fed could bring about higher inflation just by announcing a different target. But they’re not who I’m arguing with here.

[3] Krugman himself says he’d “be a lot more comfortable … if interest rates were well clear of the ZLB.” How is that supposed to happen unless something else pushes demand above the full employment level at current rates?

[4] It would of course be defensible to say that the downward redistribution from lower unemployment would be outweighed by the upward redistribution from the package of tax cuts and featherbedding that delivered it. But that’s different from saying that a more expansionary stance is wrong in principle.

Lost in Fiscal Space

Arjun and Jayadev and I have a working paper up at the Washington Center for Equitable Growth on the conflict between conventional macroeconomic policy and Lerner-style functional finance. Here’s the accompanying blogpost, cross-posted from the WCEG blog.

 

One pole of current debates about U.S. fiscal policy is occupied by the “functional finance” position—the view usually traced back to the late economist Abba Lerner—that a government’s budget balance can be set at whatever level is needed to stabilize aggregate demand, without worrying about the level of government debt. At the other pole is the conventional view that a government’s budget balance must be set to keep debt on a sustainable trajectory while leaving the management of aggregate demand to the central bank. Both sides tend to assume that these different policy views come from fundamentally different ideas about how the economy works.

A new working paper, “Lost in Fiscal Space,” coauthored by myself and Arjun Jayadev, suggests that, on the contrary, the functional finance and the conventional approaches can be understood in terms of the same analytic framework. The claim that fiscal policy can be used to stabilize the economy without ever worrying about debt sustainability sounds radical. But we argue that it follows directly from the standard macroeconomic models that are taught to undergraduates and used by policymakers.

Here’s the idea. There are two instruments: first, the interest rate set by the central bank; and second, the fiscal balance—the budget surplus or deficit. And there are two targets: the level of aggregate demand consistent with acceptable levels of inflation and unemployment; and a stable debt-to-GDP ratio. Each instrument affects both targets—output depends on both the interest rate set by monetary authorities and on the fiscal balance (as well as a host of other factors) while the change in the debt depends on both new borrowing and the interest paid on existing debt. Conventional policy and functional finance represent two different choices about which instrument to assign to which target. The former says the interest rate instrument should focus on demand and the fiscal-balance instrument should focus on the debt-ratio target, the latter has them the other way around.

Does it matter? Not necessarily. There is always one unique combination of interest rate and budget balance that delivers both stable debt and price stability. If policy is carried out perfectly then that’s where you will end up, regardless of which instrument is assigned to which target. In this sense, the functional finance position is less radical than either its supporters or its opponents believe.

In reality, of course, policies are not followed perfectly. One common source of problems is when decisions about each instrument are made looking only at the effects on its assigned target, ignoring the effects on the other one. A government, for example, may adopt fiscal austerity to bring down the debt ratio, ignoring the effects this will have on aggregate demand. Or a central bank may raise the interest rate to curb inflation, ignoring the effects this will have on the sustainability of the public debt. (The rise in the U.S. debt-to-GDP ratio in the 1980s owes more to Federal Reserve chairman Paul Volcker’s interest rate hikes than to President Reagan’s budget deficits.) One natural approach, then, is to assign each target to the instrument that affects it more powerfully, so that these cross-effects are minimized.

So far this is just common sense; but when you apply it more systematically, as we do in our working paper, it has some surprising implications. In particular, it means that the metaphor of “fiscal space” is backward. When government debt is large, it makes more sense, not less, to use active fiscal policy to stabilize demand—and leave the management of the public debt ratio to the central bank. The reason is simple: The larger the debt-to-GDP ratio, the more that changes in the ratio depend on the difference in between the interest rate and the growth rate of GDP, and the less those changes depend on current spending and revenue (a point that has been forcefully made by Council of Economic Advisers Chair Jason Furman). This is what we see historically: When the public debt is very large, as in the United States during and immediately after the Second World War, the central bank focused on stabilizing the public debt rather than on stabilizing demand, which means responsibility for aggregate demand fell to the budget authorities.

We hope this paper will help clarify what’s at stake in current debates about U.S. fiscal policy. The question is not whether it’s economically feasible to use fiscal policy as our primary instrument to manage aggregate demand. Any central bank that is able to achieve its price stability and full employment mandates is equally able to keep the debt-to-GDP ratio constant while the budget authorities manage demand. The latter task may even be easier, especially when debt is already high. The real question is who we, as a democratic society, trust to make decisions about the direction of the economy as a whole.

UPDATE: Nick Rowe has an interesting response here. (And an older one here, with a great comments thread following it.)

How Should We Count Debt Owed to the Fed?

How big is US government debt? If you google this question looking for a number, your first hit is likely to be a site like this, giving a figure (as of June 2016) around $19.5 trillion, or a bit over 100 percent of GDP. That’s the total public debt as reported by the US Treasury.

If you are reading this blog, you probably don’t take that number at face value. You probably know the preferred number is federal debt held by the public. As of June 2016, that’s $14 trillion, or a bit over 70 percent of GDP. That’s the number more likely to be used in academic papers or by official bodies. (Wikipedia seems to mix the two numbers at random.)

Debt held by the public is meant to exclude debt the federal government owes to itself.  For the US, that means subtracting the $2.8 trillion in debt held by the Social Security trust fund, the $1.7 trillion held by by federal employee retirement funds, and $1 trillion various other federal trust funds. It leaves in, however, the debt held by the Federal Reserve.

I wonder how many people, the sort of people who read this blog, know that. I wonder how many people know that today, one fifth of the federal debt “held by the public” is actually held by the Fed. I certainly didn’t, until recently.

Here’s a breakdown of federal debt by who owns it. Total public debt is the whole thing. Debt held by the public is the heavy black line. Debt held by the Fed is the blue area just below that line. (Source is various series from the Financial Accounts.)

debt-holdingsAs you can see, the Fed accounts for quite a bit of federal debt holdings — $2.5 trillion, 16 percent of GDP, or 19 percent of debt “held by the public”.

There’s some other interesting stuff in there. Most obviously, the dramatic fall in the share of debt held by households and nonfinancial businesses (the orange area), and rise of the foreign share (yellow). In the 1950s Abba Lerner could talk with some plausibility about the demand-boosting effects of federal interest payments to households; but it’s silly to suggest — as some modern Lernerians do — that higher rates might boost demand through this channel today. The declining share of the financial sector (red) is also interesting. I’ve suggested that this was a factor in rising liquidity premiums and financial fragility. If, as Zoltan Pozsar argues, we’re seeing a lasting shift from “market liquidity” to “base liquidity” this may include a permanently larger share of federal debt on bank balance sheets.

But what about the Fed share? Should it be counted in debt held by the public, or not? I can’t find the reference at the moment, but I believe there is no consistent rule on this between countries. (As I recall, the UK excludes it.) In any case, the phenomenon of large central bank holdings of government debt is not unique to the US. Here, from the OECD (p. 41), are the shares of government debt held by central banks in various countries:

Screen Shot 2016-06-02 at 9.33.51 AM

If you want to say that debt held by the Fed definitely shouldn’t be counted, I won’t object. After all, any interest earnings on the debt are simply returned to the Treasury at the end of the year, so this debt literally represents payments the government is making to itself. But that’s not what I want to say. To be honest, I can see valid arguments on both sides — yes, the Fed is a part of government just as much as the Social Security Administration; but on the other hand, the Fed’s holdings were acquired in market purchases from the private sector, while the holdings of the various trust funds are nonmarketable securities that exist only as bookkeeping devices for future payments to beneficiaries. And if you think the Fed will reduce its holdings in the near future, then it makes sense to count them for any target you might have for holdings by the private sector. But of course, in that case how much you count them will depend on whether, when and how much you think the Fed will unwind its 2009-2013 balance sheet expansions. And this is my point: There is no true level of the federal debt. The “debt” is not an object out in the world. It is a way of talking about some set of the payment commitments by some set of economic units, sets whose boundaries are inherently arbitrary.

Again, debt “held by the public” does not include the notional debt in the Social Security Trust Fund, or in the various retirement funds for  federal employees. But what about the debt (currently about 5 percent of GDP) held by state and local governments in similar trust funds? Fundamentally, these represent commitments by the federal government to help with pension payments to retired state and local government employees. But this is the same commitment embodied in the Social Security Trust Fund. And on the other hand, the federal government has a vast number of payment commitments to state and local governments — transfers from the federal government make up more than a quarter of total state government revenue. Why count the commitments that happen to be recorded as debt holding in retirement funds as federal debt but not the rest of them?

For that matter, what about the future claims of Social Security recipients? They certainly represent payment commitments by the federal government. Lawrence Kotlikoff thinks there is no difference between the commitment to make future Social Security payments and the commitment to make payments on the debt, so we should add them up and say debt held by the public is over 200 percent of GDP. Other people want to add in public pensions of all kinds. Why not throw in Medicare, too? True, retirement benefits are not marketable, but checking your expected benefits at https://www.ssa.gov/myaccount is not much harder than checking your bank balance online. And for the MMT-inclined, don’t future Social Security benefits have as good a claim to be “net wealth” for the private sector as federal debt, maybe better?

One takeaway from all this is the point eloquently made by Merijn Knibbe, that one of the big problems in the economics profession today is the complete disconnect between theory and measurement. Most public discussions and economic models — and a lot of empirical work for that matter — treat “debt”  as an object that simply exists in the world. (It’s worth noting that the question of how exactly debt is defined, and who it is owed to, does get some attention in undergraduate econ textbooks, but none at all in graduate ones.) It seems to me that the large share of debt held by central banks is a case in point of how we have to make a conscious choice about which commitments we classify as “debt”, and recognize that the best place to draw the line is going to depend on the question we’re asking. We need to treat economic categories like debt not as primitives but as provisional shorthand, and we need to be constantly walking back and forth between our abstractions and the concrete phenomena they are trying to describe. You can’t, it seems to me, do useful scholarship on something like government debt, except on the basis of a deep engagement with the concrete practices and public debates that the term is part of.

More concretely: Whenever you take a functional finance line, someone is going to stand up and start demanding in a prosecutorial tone whether you really think government debt could rise to 10 times or 100 times GDP. How about 1,000 times? a million times? — until you say something noncommittal and move on to the next question (or mute them on Twitter). But of course the answer is, it depends. It depends, first, on the concrete institutional arrangements under which debt is held, which determine both economic impacts and financial constraints, if any.  (For example, whether the debt held by central banks should be counted as held by the public depends on when or if those positions will be unwound.) And it depends, second, on how we are counting debt.

Consider a trust fund holding federal debt. What the federal government has actually committed to is a stream of payments in the future which in turn will allow the fund to fulfill its own payment commitments. Converting that flow of future payments to a liability stock in the present depends on the discount rate we assign to them. But we can follow that same procedure for any future spending, whether or not it is officially recognized as someone’s asset. As Dean Baker likes to say, given that we don’t prefund education, the military, etc., pretty much all government spending could be called an unfunded liability for the federal government. How big a liability depends on the discount rate. If the discount rate is less than the nominal growth rate, then the present value of future spending grows without limit as we consider longer periods.

Here’s an exercise. Let’s go full Kotlikoff and call all future government spending a liability of taxpayers today. Say that federal spending is a constant 20 percent of GDP and nominal growth is 5 percent per year.  If we use the current 10-year Treasury rate of around 2 percent as our discount rate, then the present value of federal spending over the next 20 years works out to, let’s see, $10 quadrillion, or 55,000 percent of GDP. That’s $30 million per person. Whoa. Can I have a Time magazine cover story now? [No I cannot, because I am bad at math. See below.]

So yeah. 20 percent of debt “held by the public” is actually owed to the Fed. An interesting fact which perhaps you did not know.

 

UPDATE: As commenter Matt points out below, the math in the next-to-last paragraph is wrong. The calculation as given yields $110  trillion, a measly 600 percent of GDP. On the other hand, if we stretch it out to the next 30 years, we get nearly $200 trillion, which is 1,000 percent of GDP or more than $600,000 per person. I guess that will do.

The Myth of Reagan’s Debt

BloomCounty
… or at least don’t blame him for increased federal debt.

 

Arjun and I have been working lately on a paper on monetary and fiscal policy. (You can find the current version here.) The idea, which began with some posts on my blog last year, is that you have to think of the output gap and the change in the debt-GDP ratio as jointly determined by the fiscal balance and the policy interest rate. It makes no sense to talk about the “natural” (i.e. full-employment) rate of interest, or “sustainable” (i.e. constant debt ratio) levels of government spending and taxes. Both outcomes depend equally on both policy instruments. This helps, I think, to clarify some of the debates between orthodoxy and proponents of functional finance. Functional finance and sound finance aren’t different theories about how the economy works, they’re different preferred instrument assignments.

We started working on the paper with the idea of clarifying these issues in a general way. But it turns out that this framework is also useful for thinking about macroeconomic history. One interesting thing I discovered working on it is that, despite what we all think we know,  the increase in federal borrowing during the 1980s was mostly due to higher interest rate, not tax and spending decisions. Add to the Volcker rate hikes the deep recession of the early 1980s and the disinflation later in the decade, and you’ve explained the entire rise in the debt-GDP ratio under Reagan. What’s funny is that this is a straightforward matter of historical fact and yet nobody seems to be aware of it.

Here, first, are the overall and primary budget balances for the federal government since 1960.  The primary budget balance is simply the balance excluding interest payments — that is, current revenue minus . non-interest expenditure. The balances are shown in percent of GDP, with surpluses as positive values and deficits as negative. The vertical black lines are drawn at calendar years 1981 and 1990, marking the last pre-Reagan and first post-Reagan budgets.

overall_primary

The black line shows the familiar story. The federal government ran small budget deficits through the 1960s and 1970s, averaging a bit more than 0.5 percent of GDP. Then during the 1980s the deficits ballooned, to close to 5 percent of GDP during Reagan’s eight years — comparable to the highest value ever reached in the previous decades. After a brief period of renewed deficits under Bush in the early 1990s, the budget moved to surplus under Clinton in the later 1990s, back to moderate deficits under George W. Bush in the 2000s, and then to very large deficits in the Great Recession.

The red line, showing the primary deficit, mostly behaves similarly to the black one — but not in the 1980s. True, the primary balance shows a large deficit in 1984, but there is no sustained movement toward deficit. While the overall deficit was about 4.5 points higher under Reagan compared with the average of the 1960s and 1970s, the primary deficit was only 1.4 points higher. So over two-thirds of the increase in deficits was higher interest spending. For that, we can blame Paul Volcker (a Carter appointee), not Ronald Reagan.

Volcker’s interest rate hikes were, of course, justified by the need to reduce inflation, which was eventually achieved. Without debating the legitimacy of this as a policy goal, it’s important to keep in mind that lower inflation (plus the reduced growth that brings it about) mechanically raises the debt-GDP ratio, by reducing its denominator. The federal debt ratio rose faster in the 1980s than in the 1970s, in part, because inflation was no longer eroding it to the same extent.

To see the relative importance of higher interest rates, slower inflation and growth, and tax and spending decisions, the next figure presents three counterfactual debt-GDP trajectories, along with the actual historical trajectory. In the first counterfactual, shown in blue, we assume that nominal interest rates were fixed at their 1961-1981 average level. In the second counterfactual, in green, we assume that nominal GDP growth was fixed at its 1961-1981 average. And in the third, red, we assume both are fixed. In all three scenarios, current taxes and spending (the primary balance) follow their actual historical path.

counterfactuals

In the real world, the debt ratio rose from 24.5 percent in the last pre-Reagan year to 39 percent in the first post-Reagan year. In counterfactual 1, with nominal interest rates held constant, the increase is from 24.5 percent to 28 percent. So again, the large majority of the Reagan-era increase in the debt-GDP ratio is the result of higher interest rates. In counterfactual 2, with nominal growth held constant, the increase is to 34.5 percent — closer to the historical level (inflation was still quite high in the early ’80s) but still noticeably less. In counterfactual 3, with interest rates, inflation and real growth rates fixed at their 1960s-1970s average, federal debt at the end of the Reagan era is 24.5 percent — exactly the same as when he entered office. High interest rates and disinflation explain the entire increase in the federal debt-GDP ratio in the 1980s; military spending and tax cuts played no role.

After 1989, the counterfactual trajectories continue to drift downward relative to the actual one. Interest on federal debt has been somewhat higher, and nominal growth rates somewhat lower, than in the 1960s and 1970s. Indeed, the tax and spending policies actually followed would have resulted in the complete elimination of the federal debt by 2001 if the previous i < g regime had persisted. But after the 1980s, the medium-term changes in the debt ratio were largely driven by shifts in the primary balance. Only in the 1980s was a large change in the debt ratio driven entirely by changes in interest and nominal growth rates.

So why do we care? (A question you should always ask.) Three reasons:

First, the facts themselves are interesting. If something everyone thinks they know — Reagan’s budgets blew up the federal debt in the 1980s — turns out not be true, it’s worth pointing out. Especially if you thought you knew it too.

Second is a theoretical concern which may not seem urgent to most readers of this blog but is very important to me. The particular flybottle I want to find the way out of is the idea that money is neutral,  veil —  that monetary quantities are necessarily, or anyway in practice, just reflections of “real” quantities, of the production, exchange and consumption of tangible goods and services. I am convinced that to understand our monetary production economy, we have to first understand the system of money incomes and payments, of assets and liabilities, as logically self-contained. Only then we can see how that system articulates with the concrete activity of social production. [1] This is a perfect example of why this “money view” is necessary. It’s tempting, it’s natural, to think of a money value like the federal debt in terms of the “real” activities of the federal government, spending and taxing; but it just doesn’t fit the facts.

Third, and perhaps most urgent: If high interest rates and disinflation drove the rise in the federal debt ratio in the 1980s, it could happen again. In the current debates about when the Fed will achieve liftoff, one of the arguments for higher rates is the danger that low rates lead to excessive debt growth. It’s important to understand that, historically, the relationship is just the opposite. By increasing the debt service burden of existing debt (and perhaps also by decreasing nominal incomes), high interest rates have been among the main drivers of rising debt, both public and private. A concern about rising debt burdens is an argument for hiking later, not sooner. People like Dean Baker and Jamie Galbraith have pointed out — correctly — that projections of rising federal debt in the future hinge critically on projections of rising interest rates. But they haven’t, as far as I know, said that it’s not just hypothetical. There’s a precedent.

 

[1] Or in other words, I want to pick up from the closing sentence of Doug Henwood’s Wall Street, which describes the book as part of “a project aiming to end the rule of money, whose tyranny is sometimes a little hard to see.” We can’t end the rule of money until we see it, and we can’t see it until we understand it as something distinct from productive activity or social life in general.