Deficits: the Keynesian perspective

This is a very informative piece by Paul Krugman which accurately describes how the Keynesians regard budget deficits. I’d intended to post on it prior to the spending/income equivalency discussion, but as it happens, the two are tangentially related so this will make for a nice step into the deeper examination of why Keynesians place such importance on what I assert to be a false simplicity that is the result of them practicing the Ricardian Vice:

Broadly speaking, there are two ways you can get into severe deficits: fundamental irresponsibility, or temporary emergencies. There’s a world of difference between the two.

Consider first the classic temporary emergency — a big war. It’s normal and natural to respond to such an emergency by issuing a lot of debt, then gradually reducing that debt after the emergency is over. And the operative word is “gradually”: it would have been incredibly difficult for the United States to pay off its World War II debt in ten years, which Jim apparently thinks is the right way to view debts incurred more recently; but it was no big deal to stabilize the nominal debt, which is roughly what happened, and as a result gradually reduce debt as a percentage of GDP.

Consider, on the other hand, a government that is running big deficits even though there isn’t an emergency. That’s much more worrisome, because you have to wonder what will change to stop the soaring debt. In such a situation, markets are much more likely to conclude that any given debt is so large that it creates a serious risk of default.

Now, back in 2003 I got very alarmed about the US deficit — wrongly, it turned out — not so much because of its size as because of its origin. We had an administration that was behaving in a deeply irresponsible way. Not only was it cutting taxes in the face of a war, which had never happened before, plus starting up a huge unfunded drug benefit, but it was also clearly following a starve-the-beast budget strategy: tax cuts to reduce the revenue base and force later spending cuts to be determined. In effect, it was a strategy designed to produce a fiscal crisis, so as to provide a reason to dismantle the welfare state. And so I thought the crisis would come.

In fact, it never did. Bond markets figured that America was still America, and that responsibility would eventually return; it’s still not clear whether they were right, but the housing boom also led to a revenue boom, whittling down those Bush deficits.

Compare and contrast the current situation.

Most though not all of our current budget deficit can be viewed as the result of a temporary emergency. Revenue has plunged in the face of the crisis, while there has been an increase in spending largely due to stimulus and bailouts. None of this can be seen as a case of irresponsible policy, nor as a permanent change in policy. It’s more like the financial equivalent of a war — which is why the WWII example is relevant.

So the debt question is what happens when things return to normal: will we be at a level of indebtedness that can’t be handled once the crisis is past?

And the answer is that it depends on the politics. If we have a reasonably responsible government a decade from now, and the bond market believes that we have such a government, the debt burden will be well within the range that can be managed with only modest sacrifice.

Krugman’s reference to the “classic temporary emergency” is a reference to Samuelson’s explanation of the difference between internal and external debt in Chapter 18 of Economics, entitled Fiscal Policy and Full Employment Without Inflation. In creating his example, Samuelson concocts a scenario which posits a) present day munitions are necessary (true), b) there is no outside nation to lend goods (unlikely), c) Congress is unwilling to raise taxes enough to balance the budget (usually true), d) price-control and rationing laws are necessary (irrelevant, as Samuelson himself points out). And Samuelson makes an unintentionally important point when he mentions, offhand, that “Fortunately, the United States has come out of the most costly war in all history with little impairment of capital equipment and internal debt.”

(Sorry, had to do an interview there.)

Now, Krugman begins by posting a somewhat misleading distinction. There is no reason why a temporary emergency cannot be the result of fundamental irresponsibility. In fact, since the present political system is now built on the concept of the permanent campaign and the permanent crisis, one can quite reasonably ask if the idea of a “temporary emergency” is an oxymoron when modern government is taken into account. But if, for the sake of argument, we accept the distinction, it is fairly reasonable to subsequently accept the idea that a big war in which the survival of the nation is at stake would a) trump budgetary concerns, and b) not represent a permanent outlay.

However, it has to be kept in mind that this cannot be applied to all wars or all emergencies. The war has to pose a real threat to the nation’s survival, since losing the war renders future interest payments irrelevant. There is no point in going into massive debt for war if you’re going to have to pay it off regardless of the outcome; losing the war has to represent a worse fate than going into debt. Therefore, the equation varies depending upon whether you are being attacked by killer cannibals from Papua New Guinea or Victoria’s Secret Army. The war has to be short-term, and it also has to favor the odds of not destroying your capital base. Needless to say, this pretty much eliminates every shooting war in which the USA has engaged since, well, WWII.

The next problematic point made by Krugman is that the present crisis is NOT the result of irresponsible policy and that it is temporary. This is, to put it bluntly, incorrect and arguably insane. Numerous books, including RGD, have been written to explain how the present crisis is the direct and predictable result of irresponsible monetary and fiscal policies. Moreover, since total credit market debt grew from $37.8 trillion in 2004 to $52.9 trillion in 2009, there is absolutely no reason to believe that the crisis is temporary either; it will likely take decades of debt-deleveraging and economic contraction to reduce debt/GDP from its present 3.7 to the sustainable long term level of 1.5.

Finally, the Bush tax cuts were not “a strategy designed to produce a fiscal crisis, so as to provide a reason to dismantle the welfare state”. Bush actually expanded Federal entitlements and never made any effort to reduce, let alone dismantle, the welfare state. The tax cuts were actually straight out of the Keynesian playbook, being an expansionary contracyclical policy enacted during the economic slowdown of 2000-2001. Krugman not only fails to support his case here, but provides an argument that is ludicrously easy to disprove.

Therefore, it is downright laughable to attempt to claim that the $450 billion deficit in 2003 was more troublesome than is the $1.8 trillion deficit in 2009. The economic crisis is not the financial equivalent of war because it does not threaten the nation’s survival, it obviously does not represent a fate worse than debt, it is not temporary, and it is the result of fundamentally irresponsible policies.