Deeper in debt, according to my sixteen tons essay. A very brief except:
The historical record does not clearly support the Keynesian view. There are many instances in which fiscal expansions did not produce economic expansions and in which fiscal contractions did not produce economic contractions.
The IGM expert panel is asked whether they agree with
Because all federal spending and taxes must be approved by both houses of Congress and the executive branch, a separate debt ceiling that has to be increased periodically creates unneeded uncertainty and can potentially lead to worse fiscal outcomes.
Almost nobody disagrees, so I will not argue. Instead, let me propose a defensive question. Ask the experts to agree or disagree with the following:
Because the ratio of debt to GDP cannot keep growing indefinitely, the failure of the executive branch and the Senate to offer a sustainable long-term Budget creates unneeded uncertainty and can potentially lead to worse fiscal outcomes.
I would venture to suggest that this is a more serious source of uncertainty and political friction than the debt ceiling.
I also would venture to offer this guide to budget politics: those who maximize the symbolic significance of short-term budget controversies do so in order to avoid acting on the long-term problem.
She writes in the New York Times Magazine.
“We get about 15 cents of every procurement dollar spent by the federal government,” says Stephen Fuller, a professor of public policy at George Mason University and an expert on the region. “There’s great dependence there.” And with dependence comes fragility. About 40 percent of the regional economy, Fuller says, relies on federal spending…
The amorphous war on terror and the creation of the Department of Homeland Security — plus the wars in Afghanistan and Iraq — bloated the country’s spending by about $1 trillion. The contracting dollars that were pumped into the local economy, Fuller says, more than doubled between 2000 and 2010, when it reached $80 billion a year.
However, elsewhere she advocates more deficit spending now to stimulate growth. The most charitable interpretation I can give is that she thinks in terms of “good” spending and “bad” spending on the part of government. The former adds to overall economic growth. The latter just sucks wealth into Washington. The bad spending comes from President Bush and the war on terror. The good spending comes from President Obama and the stimulus.
Some concerns that I have.
1. A lot of the wealth goes to lobbyists for whom the distinction between good spending and bad spending is not meaningful.
2. A lot of the influence on the direction of the spending comes from lobbyists for whom the distinction between good spending and bad spending is not meaningful.
3. The good spending is justified as needed temporarily to boost the economy. But will this temporary spending ever subside? The Keynesian argument for countercyclical government spending seems to get made when the economy gets weak but never when the economy is strong.
4. For that matter, there is also an asymmetry in the argument for more government spending when interest rates are low. I would give this more credibility if those making the argument had ever advocated reducing government spending because interest rates were high.
Of course, my own view is that the evidence that more spending by the federal government benefits the economy as a whole is not compelling. I find it much more believable that such spending benefits Washington.
One has to assume that the law of gravity will not be repealed and that investors will want something more than 2% on the ten-year bond if inflation is at 2%. If the ten-year bond were to rise by 2%, Japan would soon be spending over 50% of its tax revenues on the interest carry alone.
Perhaps bond investors are willing to accept negative real rates of return. Folks have bid up TIPS in the U.S. to negative real rates.
Negative real interest rates are very good for holding down the ratio of debt to GDP. We saw that in the United States in the 1970s. But the 1970s are not so fondly remembered as far as economic performance and financial wealth are concerned.
In a study of the prospects for Canadian provinces, Marc Joffe writes,
This method employs a multi-year fiscal simulation with a default threshold stated in terms of an interest expense to total revenue ratio (or interest bite). Using evidence from our historical survey, the conclusion is that default is likely at a 25% interest bite, so the simulations simply estimate the probability of each province reaching that level.
One way to think of this is that the political system will not tolerate debt payments that absorb more than 25 percent of revenue, and investors know that. So once the interest rate rises to the point where the interest bite hits .25, expect a debt crisis. That is, at that point, the government (in this case, a Canadian province) will consider default. The interest bite, B, is the average interest rate on debt, r, times the amount of debt, D, divided by tax revenue, T.
B = rD/T
Suppose that the ratio of debt to GDP is 50 percent and the ratio of revenue to GDP is 20 percent. Then we have
B = 2.5r
which means that once the average interest rate on debt hits 10 percent we are in crisis territory.
For the U.S. federal government, the ratio of debt to GDP is at least 70 percent (perhaps it is at least 100 percent), and the ratio of tax revenue to GDP tends to max out at 20 percent. At 70 percent, B = 35r. If we stick to the rule of thumb that a 25 percent interest bite is the point at which default becomes thinkable, then it would take an average interest rate of about 7 percent to reach that point. Note that because we have locked in low rates on some of the debt by issuing long-term bonds, it would take an increase in rates well above 7 percent in order to make the average interest rate on our debt reach 7 percent.
Some other thoughts:
1. It is hard to know what the rule of thumb might be for a U.S. default. It’s not like we have historical examples to serve as benchmarks.
2. For U.S. states, or for Canadian provinces for that matter, I wonder if pension payments to government workers should be added in order to estimate an “interest plus pension cost” bite. My thinking is that the political process may be stressed by taxpayers not receiving current services in return for their tax payments, and neither interest payments nor pension payments can be used to purchase current services.
3. Canadian provinces do not have balanced budget amendments, and consequently at least some of them are in more trouble than U.S. states. I am becoming more and more convinced that it is really hard to keep a democratic polity out of a debt trap in the absence of a Constitutional restraint.
4. Also, the Canadian single-payer health care system is run at the provincial level, so rising health care spending is a big driver of provincial fiscal problems.
5. I like the simplicity of Joffe’s rule of thumb. However, my own analysis of crisis triggers warns that the problem is complex and there are limits to what objective analysis can accomplish.
Glenn Hubbard and Tim Kane write,
One new approach has been proposed by Congressman Justin Amash (a Republican from Michigan) and has won some bipartisan support. His plan would essentially involve balancing the budget over the years of a business cycle. For instance, the proposal’s rule constraining annual outlays (including changes in accrued net liabilities in entitlement programs, as noted above) to a level no greater than the average annual tax revenue of the previous three fiscal years would be far easier for Congress to adhere to. Congress could, with a three-fourths vote, override that constraint during wars or deep recessions.
The parenthetical remark about accrued net liabilities is important. Each year, as demographics and other factors change, the outlook for Social Security and Medicare changes (typically, for the worse). Accrual accounting would put these changes onto the budget.
Before 2008, the bubble that some economists expected to pop was the value of the dollar. Paul Krugman used a colorful metaphor to describe this.
So it seems likely that there will be a Wile E. Coyote moment when investors realize that the dollar’s value doesn’t make sense, and that value plunges.
I found this in an old post from Mark Thoma. Feel free to use Google to find other citations.
Nowadays, when he looks at the prices of U.S. government bonds, Krugman sees rational expectations at work. He looks at the low long-term interest rates as a sign of the market’s wisdom in predicting low inflation for ten years.
But what I see is a market that could have a Wile E. Coyote moment. Once enough investors decide to dump our bonds, interest rates will rise. It will become clear that at those interest rates the government cannot afford to pay off the bonds, so more investors will dump bonds. etc.
Now the Fed can always buy our bonds. It is doing a lot of that, and I can see where an investor with a sufficiently short time horizon who believes that he won’t be the one still holding bonds when they start to lose value might say, “Don’t fight the Fed. Just ride the yield curve for a little while longer.”
But suppose that our Wile E. Coyote moment comes when inflation has been heating up. (Indeed, the Wile E. Coyote moment could come because inflation heats up, and at that point investors decide that the Fed may no longer be their friend.) Under this scenario, the Fed wants to be a bond seller, not a bond buyer, in order to keep inflation in check. If the Fed feels constrained not to sell too many bonds, then inflation could really take off.
How can I justify a fear of inflation, given recent behavior? In recent years, the Fed has created a lot of money, and we have not seen a lot of inflation. What is going on?
1. Perhaps money and inflation have no connection. We should go back to using the Phillips Curve. When unemployment is high, inflation is low, and conversely. After all, wages are 70 percent of costs, and it seems unlikely that wage inflation will get much traction with folks having a hard time finding jobs.
2. Perhaps we are suffering from tight money. This is the Scott Sumner argument. Money and inflation (he would prefer nominal GDP) are related, inflation is low, ergo we must have tight money.
For the short run, I believe something like (1). However, I am old enough to remember the 1970s. Based on that experience, I would say that inflation is subject to regime shifts. There is a regime in which inflation is low and relatively stable. There is another regime in which inflation is high and volatile. Finally, there is a regime of hyperinflation.
I think that with enough persistence, the Fed can move us between the low, stable regime and the high, volatile regime. The Fed spent the 1970’s getting us into the high, volatile regime, and it spent the 1980s getting us out of it.
Hyperinflation is a fiscal phenomenon. A government that can balance its budget is never going to have hyperinflation.
The scenario I have in mind is one in which the economy has begun to shift to the regime of high and volatile inflation. Then the Wile E. Coyote moment arrives, and the Fed feels pressed to keep the U.S. bond market “orderly” by not selling bonds. In fact, interest rates are rising so quickly that the Fed decides that it needs to buy bonds. This sets off a spiral of money-printing and price increases, threatening to bring on hyperinflation. In which case, the bond market will not be orderly. Nor will anything else.
In 2005, I listed five stories that I thought would have long-term significance: productivity; cognitive neuroscience, solar power, cancer therapy, and mainstream media meltdown. All five were areas where the trends were not clear. My inclination at the time was to take the optimistic view in all areas (in the case of the mainstream media, being optimistic to me means believing that the meltdown will be rapid).
Today, I would be less optimistic. Moreover, I think that the unsustainable fiscal outlook and its consequences have become one of the most important stories.
In 2003, I wrote one of my favorite essays, on what I called The Great Race between Moore’s Law and Medicare. There is an optimistic scenario for economic growth (think Ray Kurzweil) which would make all concerns about the long-term budget outlook seem foolish. However, other scenarios are less favorable. Recently, the budget situation has been deteriorating faster than the technological outlook has been improving. In terms of the great race, the wrong horse is gaining.
This essay appeared almost three weeks ago.
just as the doc fix has become a yearly congressional ritual with no end in sight, it may be that many of the temporary policies of the fiscal cliff become permanent fixtures on our policy calendar.
And if the doc fix is any guide, that will have deleterious effects on both the budget and the economy. It will provide a convenient way to hide long-term spending commitments inside repeat extensions of temporary policies. And it will result in nagging economic uncertainty as the private sector endlessly worries that this year just might be the fluke year that Congress won’t act like it normally does and make a deal. At the same time, it will have the larger effect of distracting Congress from fixing the budget’s real long term problems by focusing legislators’ attention on an infinite loop of short-term problems. It’ll be the doc fix for everything—and the fiscal cliff forever.
Read the whole thing. Along with my Lenders and Spenders, it provides you with a pretty complete cynical picture.
The economic and fiscal thinking of the Tea Party movement had much in common with that of traditional American conservatism, and with theorists such as Friedrich Hayek and Ludwig von Mises. It had much less in common with the economic and fiscal thinking of reinvented conservatism, and with theorists such as Friedman and the monetarists. Indeed, the thinking of the Tea Party movement was largely the same as that of the libertarian movement, which had long been a marginal element within the Republican Party.
…American conservatism is now split between two tendencies: (1) a partially-discredited reinvented conservatism, which nevertheless continues to dominate the leadership or “establishment” of the Republican Party because it corresponds to the economic interests of the party’s elites and big donors, and (2) a partially-revived traditional conservatism, which is a significant insurgent force within the Republican Party, because it corresponds to the economic interests of much of the party’s base and many of its core voters.
It is a long essay, which I recommend reading even though I disagree with a fair amount of it. Some thoughts:
1. What is the plural of post mortem? It seems to me that we have seen a lot of them after the election. I had a traumatic experience after 2008, in which I made the case that the U.S. was going to turn into a one-party state. Bryan Caplan challenged me to a bet, which I lost when the Republicans won the House in the 2010 mid-terms. Still, I may have been correct, at least in terms of national politics. But it is interesting that so many states are in Republican hands.
2. Kurth’s history of conservatism has traditional conservatives favoring free markets, while what he calls “reinvented conservatism” comes across as cronyism. He associates “reinvented conservatism” with Milton Friedman and Ronald Reagan, which I am sure will annoy fans of those two icons.
3. As those of you have read Not What They Had in Mind know, I disagree with Kurth’s narrative in which banks fought for and achieved deregulation, leading to the financial crisis. First, this ignores the role played by housing policy and capital regulations. Second, it ignores the views of regulators, who did not think that they were loosening up the reins but thought that they were in fact exercising better control and fostering an environment of reduced risk-taking by banks. There is a huge hindsight bias in claiming that the regulators were intentionally easing up.
4. Kurth summarizes the current state of affairs as follows:
The core voting groups for the progressive coalition and the Democratic Party are (1) blacks, (2) Hispanics, and (3) workers in the public sector. Conversely, the core voting groups for the conservative coalition and the Republican Party are (1) economic and fiscal conservatives; (2) Evangelical or Bible-believing Protestants; and (3) white male workers in the private sector
…there remains one immense independent or swing group, and that is white women. A substantial majority of these now vote for Democratic candidates, with economic issues being primary for working-class women and social issues being primary for middle-class women. If these women continue to vote for the Democratic Party in the future, the prospects for the Republican Party to win most presidential and senatorial elections will remain bleak.
5. I think that what potential factor that could shape up electoral politics is the government debt problem. Will it cause continued political friction, as I predict? And will voters perceive the problem as unsustainable progressive programs or Republican recalcitrance? Keep in mind that objective reality, even assuming that it is knowable, may play little or no role in public perceptions.