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Friday, May 17, 2013
Uncertainty, debt, and fiscal stimulus
A blog of Bridge Environment, updated most Thursdays
The current controversy surrounding government fiscal stimulus looks a lot like an environmental policy debate. Like environmental issues, there is tremendous uncertainty about future performance. Also like environmental issues, there is conflict over competing objectives. Today I will use this analogy to shed some light on the stimulus controversy and suggest a way forward.
Here is the issue. The US economy went into a tailspin starting in late 2007. Though it bottomed out by mid-2009, recovery has been slow and uneven. The US’s recession prompted a worldwide economic downturn, which triggered debt crises in several European countries, most notably Greece. Initially, the US government took on debt to help stimulate the economy, first with tax rebates in 2008 (enacted under the second President Bush) and then with a mix of tax credits and short-time horizon spending programs, including many infrastructure projects (enacted under President Obama). These sorts of responses follow the advice of Keynesian macroeconomic theory. Under this theory, the government can smooth out economic fluctuations by spending when the economy is slow and saving when it picks back up. If you listen to many prominent economists, Paul Krugman chief among them, it is a no-brainer that the government should use this approach to combat recession.
The challenge with this approach is the associated debt. The US was already running up major budget deficits prior to 2007. The tax cuts and new spending only accelerated borrowing, particularly because the recessed economy was generating fewer dollars to be taxed. Debt sounds bad, but it’s important to understand exactly why. High debt risks the potential for default. The US is generally seen as a safe lender with a low chance of default. As a result, the government is able to borrow cheaply, at very low interest rates. If there were ever to be a crisis of confidence, though, the government would have to offer higher interest rates in order to service its debt, and these higher interest rates would exacerbate the debt. This vicious cycle is what caused debt crises in European countries. Once investors believe there is a problem, their hesitation to invest can cause one whether their initial belief was correct or not. Conservatives make this argument, supported by some economists, chief among them Carmen Reinhart and Kenneth Rogoff. They published an influential paper in 2010 that claimed there is a dramatic falling off of economic growth when countries hit a public debt level of 90% of gross domestic product (GDP), essentially a tipping point. Ninety percent of GDP means being in the hole enough that it would take nearly a year to pay it back if the entire economy were devoted to debt repayment, and is about the amount of debt the US had when President Obama took office. Recently, other investigators found some errors and subjective judgments in Drs. Reinhart and Rogoff’s work. When corrected and revisited, the results still show a dropping off of economic growth with higher debt, but not as dramatic a drop-off at 90% of GDP. Whereas the liberal economists focus almost entirely on the benefits of stimulus spending, the conservative ones focus almost exclusively on the risks associated with high debt.
On balance, most economists, myself included, think that more fiscal stimulus in the US would have been and is still worth the risk. Analysts like Dr. Krugman make a solid case that fiscal stimulus does work to flatten out the negative effects of recession, and given the confidence the world has shown in US debt, we could take on more. But, we have done a lousy job of selling this argument. A better sales job would acknowledge we are taking a risk by racking up more debt, make a strong case for the need to plan for debt reduction in the long run, and then highlight the benefits we would achieve by stimulus spending now. For the most part, we have only made the last of these three points well.
In the next blog entry or two, I will explore the concept of debt reduction and then talk more broadly about fiscal policy as a balancing act among competing objectives, including risk reduction.
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