Alarmed by the rise in the deficit and the national debt, which now tops $22 trillion? More and more intellectuals are here to tell you not to worry so much.
On the left, Stephanie Kelton argues that deficits are worrisome only when they produce inflation, and inflation remains low. On the center-left, Jason Furman and Lawrence Summers suggest that low interest rates are a reason to increase “worthwhile investments in such areas as education, health care, and infrastructure.” On the center-right, Ross Douthat writes that the U.S. “should be willing to live with a loose fiscal policy when wage growth is disappointing and inflation low.”
The worriers – Furman and Summers call them “deficit fundamentalists” – have been wrong in the past. In the 1980s, critics of President Ronald Reagan’s economic policy said his deficits would raise inflation and interest rates. In the 2010s, opponents of President Barack Obama warned that Greece’s economic crisis was a foretaste of what the U.S. would experience thanks to his deficits.
But over the last several decades, large and rising deficits have been compatible with low and falling inflation and interest rates.
The current cheeriness about deficits, however, tends to ignore two points.
The first is that low interest rates do not necessarily strengthen the case for deficit-financed investment. If our economy has shifted for the duration to a lower gear, we would expect interest rates to fall on that account. But we would also expect the returns to investments to fall.
So the case for increased federal spending on, say, infrastructure – a great deal of which would go toward the most politically rather than economically promising projects – might not be any better with a low interest rate than with a high one. (A recent paper develops a mathematical model to show that “if interest rates are low because of a decline in trend output growth, then it is not sustainable to increase deficit financed spending.”)
The second is that increased deficit spending generally entails a smaller private sector. This relationship follows from our old friend, monetary offset. The Federal Reserve has an announced target of 2 percent annual inflation. To the extent it is effective at hitting that target, increased deficit spending cannot do much to stimulate the economy.
If the increased spending threatens to raise inflation above the target, the Federal Reserve will do something, such as raise the federal-funds rate (or announce a faster series of increases than it had previously planned), to bring it back down. Total spending throughout the economy stays roughly the same, but the proportion of it done through the government rises and the proportion done outside it falls.
The standard argument for fiscal stimulus in a depressed economy assumes that when interest rates are extremely low, monetary policy may be unable to raise spending and inflation. But we are rarely in such a “liquidity trap,” and are certainly not today.
Taken together, these points do not mean that higher deficits are always harmful, let alone that they court imminent disaster. Maybe a deficit-financed infrastructure project really would increase the country’s economic capacity, and the displaced private-sector spending would have been less productive. Our judgment of a planned project should turn on its specific details, and on our general confidence in the federal government.
Low interest rates by themselves should not bias us toward supporting a deficit-increasing project, or lead us to ignore the opportunity costs – to ignore, that is, all the other ways the same resources could have been used either by the government or by households and businesses. Nor should we ignore that much of what the federal government spends is consumption rather than investment.
Even Furman and Summers, after scolding the deficit scolds, concede that we do not know the costs and benefits of our current fiscal course and that “it would be prudent to keep government debt in check.” (They recommend tax increases for that purpose.) They are right about that.
But fiscal prudence has rarely been a politically powerful rallying cry. It is therefore also imprudent to hand politicians additional rationalizations for the deficit spending of which they have already proved themselves too fond.