Washington refuses to understand that debt can be an essential tool for economic growth. Can we overcome this irrational and destructive fear?
Little distinction in magnitudes: There’s a difference between “small” and “large” federal budget deficits. But when all debt is evil, such distinctions get lost. The concept of “primary” balance is important here. A deficit that is in primary balance is small enough that the government is raising adequate revenue to pay its operating budget—that is, everything it spends money on except the interest on the debt. Once the budget deficit is at least in primary balance, the debt-to-GDP ratio stabilizes—it stops growing. Deficits below about 3 percent of GDP right now would constitute primary balance. Indeed, the budget plan recently released by President Obama gets deficits down to below 3 percent by 2014 through the rest of the decade. Sure enough, the debt-to-GDP ratio peaks in 2013 at 76.9 percent, then falls to 73 percent by 2021.
Again, the point is that the failure to make this distinction contributes to austerity frenzy, such as the pervasive calls for a balanced budget amendment and aggressive budget cuts. When the economy is on a solid expansion trajectory, we want the deficit-to-GDP ratio shrinking each year, but it doesn’t have to go to zero or surplus right away. Primary balance is a fine intermediate goal.
“Tighten our belts”—an awful analogy: Beware simple, folksy metaphors that emanate wisdom but convey exactly the wrong message. My candidate for the most destructive of all is that old saw about deficit reduction: “Hey, families have to tighten their belts when things get tough…government should too.” President Obama himself has made this mistake.
Sounds right, but it’s totally backwards. When the economy stumbles and family income stumbles with it, then sure, families have to tighten up. But this is precisely why government has to loosen its belt. That’s the whole point of countercyclical policy: When the private sector is contracting, the public sector temporarily expands, and vice versa. The analogy is wrong on both ends: When the private sector is humming along, and working families can maybe loosen their belts a bit, that’s when the government needs to tighten its belt.
Who owns the debt?: It’s always important to remember that one person’s debt is another person’s asset. When it comes to the budget deficit, while we owe about half of it to foreign holders of Treasuries (China and Japan being the most prominent lenders), we owe the other half to ourselves. That doesn’t mean we can afford to ignore unsustainable borrowing. But from a macroeconomic perspective, it doesn’t necessarily hurt the economy to borrow from ourselves to invest in productivity-enhancing initiatives that increase the future wealth of our progeny.
Taken as a whole, these misguided beliefs combine to distort our fiscal policy, and they do so in one direction: against deficit spending. This bias is preventing us from taking corrective action. It is also contributing to a dangerously misguided—and bipartisan—effort to reduce the size of government in an era when we’ll need increased federal outlays to meet coming challenges, such as environmental pressures and the health and retirement security of the baby boomers. It’s one thing to take aim at wrong arguments like those above. But that does raise the question: What impact do federal budget deficits have on the economy? Was Dick Cheney right to argue that “Reagan proved deficits don’t matter”?
For economists, the issue comes down to “crowding out.” Under certain conditions, by running large deficits, the government can be in competition with private firms for capital, and the extra demand for loans pushes up interest rates. Higher interest rates mean less investment and slower private-sector growth than would otherwise occur. Crowding out makes sense in theory, and research has found some evidence of it. But the whole story is not so simple. In fact, neither interest rates nor investment have responded during this crisis the way the crude view predicts (interest rates haven’t risen with deficits, and neither investment nor capital stock consistently fell). The reason is that there is no competition for scarce funds right now—to the contrary, firms are sitting on trillions in cash reserves, and capital is flowing freely to the United States as a safe haven in uncertain times.
Economists’ focus on crowding out, given the lack of compelling evidence, is doing more harm than good. None of this is meant to signal indifference to budget deficits. I was as elated by the surpluses of the latter 1990s as I was discouraged by the growing deficits of the 2000s. But at the same time, I was not at all worried about the deficits of the last few years. Well, that’s not totally accurate—I worried that they weren’t large enough to help the economy get moving again. Over the long run, we have to live within our means. We cannot continue to spend increasingly more than we take in or we will be unable to both service our debt and provide the goods and services we want and need from the public sector. But the more immediately serious problem, the one we’re not even trying to deal with, is the fact that our system is so irrationally nervous about public debt that we’re actively under-spending on countercyclical policy. To do so is to accept implicitly a huge amount of slack in the current economy, most portentously the high un- and underemployment in the labor force.
When Debt Matters
Earlier I mentioned the need for a debt sobriety pledge, something akin to the Serenity Prayer adopted by Alcoholics Anonymous. Whereas AA invokes a deity to grant the wisdom to know and accept what we can and can’t control, we’d invoke Adam Smith, John Maynard Keynes, and especially Hyman Minsky: Help us to understand when borrowing is useful and productive, and when we are overleveraging.
I mention these three because each understood the extent to which market failure recurs in financial markets. Though Alan Greenspan and others have pointed to Smith’s insights on market incentives, it’s fascinating to contemplate the dressing down Smith would deliver to the “maestro” regarding contemporary theories on self-correcting financial markets. As recounted in John Cassidy’s essential book How Markets Fail, “Smith and his successors…believed that the government had a duty to protect the public from financial swindles and speculative panics, which were both common in eighteenth- and nineteenth-century Britain.” Today’s policy-makers conveniently ignore this Smith, who wrote in The Wealth of Nations:
Such regulations may, no doubt, be considered as in some respects a violation of natural liberty. But these exertions of the natural liberty of a few individuals, which might endanger the security of the whole society are, and ought to be, restrained by the laws of all governments…. The obligation of building party walls, in order to prevent the communication of fire, is a violation of natural liberty, exactly of the same kind with the regulations of the banking trade which are here proposed.
Keynes, ever the realist, was well aware of Smith’s insights, and would have been particularly skeptical of the “rational expectations” hypotheses that undergird modern market theories. While these theories are built on the belief that market participants are aware of all the relevant information needed to make rational economic choices, Keynes recognized that “human decisions…cannot depend on strict mathematical expectation.” Sometimes we have the information we need to make rational economic decisions, but at other times we’re forced to fall back “on whim or sentiment or chance.” That means we will sometimes borrow to speculate on bets that don’t make sense, like taking out mortgages that we can afford only if home prices continue to rise. If enough of us do so at the same time, as was the case in the 2000s, we introduce a level of instability into the system with the potential for precisely the consequences confronting us today.
But it was Minsky, a Harvard-trained economist well versed in Keynesianism, who most deeply understood and articulated the way contemporary debt cycles spin out of control. If we’re ever to avoid these pitfalls that have plagued us since Adam (Smith, of course), then we need to pay close attention to Minsky’s work and think long and hard about how to map it onto public policy.
Minsky proceeded from two key insights, both of which diverged sharply from the orthodoxy of the day (he died in 1996): first, the centrality of debt to a functioning economy, and second, the tendency of financial markets toward instability. As I stressed at the beginning of this essay, the basic idea of debt is not only sound but essential to growth. Borrowing from the future to invest in the present is one way to improve that future. And some of the economic gains that flow from the investment will be used to pay down the debt.
Minsky’s second insight, about instability, was once nicely summed up by the great game theorist Yogi Berra, who pointed out, “It’s tough to make predictions, especially about the future.” So uncertainty and risk must be accounted for, and in a rational market, the rate of interest would put a price on the loan that accurately reflected its risk. And in fact, that’s often the case at the beginning of economic recoveries. Growth is newly back on the scene, businesses and households start to get active again, and lenders tend toward a reasonable degree of caution in evaluating their loan prospects.
However, as the recovery ages and growth picks up speed, risk aversion diminishes. Loans that didn’t seem creditworthy a year ago start looking pretty good. Minsky also recognized that new forms of lending often begin to sprout up at this stage—“innovations” that enable their inventors to lend into the accelerating cycle ahead of their competitors. These innovations may be poorly understood, and not just by the borrower, but by the lender as well. They may involve gambles that can’t possibly end well, such as loans whose repayment is wholly dependent on a price bubble in the underlying asset, or even outright fraud, like what came to be called “liar loans,” where lending intermediaries ignored or falsified documentation to create the appearance of credit worthiness.
Minsky’s model could be viewed mistakenly as simple common sense: a) Debt financing is pro-cyclical, and b) lenders get sloppy (or cryptic) as the cycle proceeds. But his model says more than this. As Cassidy puts it, “At the risk of oversimplifying, Minsky’s argument can be reduced to three words: stability is destabilizing.” Under this model, debt can be like a virus in the body of a business cycle. It starts out supporting the organism in ways salutary and safe, but is unable to modulate its growth, and it ultimately infects the system under the weight of leverage.
Our failure to understand this dynamic has led to our current pass: a fixation on debt when the system needs more of it, and complacency about debt when we need vigilance. Minsky would have recognized the signs that something was amiss as the 2000s debt cycle shifted into overdrive. The underpricing of risk, financial innovations, leverage ratios that were multiples of their historical averages, and the shadow banking system—all signaled that the virus had been activated and would soon destabilize the system.
Where Does This All Leave Us?
As I’ve stressed throughout, debt is not just important—it is an essential tool of economic growth. Neither families nor firms nor governments can adequately help themselves or their constituents without the ability to borrow from the future to spend or invest in the present. Yet market and political failures have undermined this essential function, and the politics of budget deficits have devolved to the point where, at least rhetorically, any debt is bad debt. It is impossible to overemphasize the lasting harm done by this anti-deficit fervor.
The good news is that—putting politics aside—all of this is fixable. The United States still hosts mature, flexible, adequately capitalized credit markets. In fact, credit markets are working exactly as they should be right now, with interest rates signaling us—if not screaming at us—to borrow and apply fiscal stimulus. Over at the Federal Reserve, the interest rate has been stuck at zero. But households are still deleveraging and still on insecure economic ground, so they’re not much moved by the low rates. It’s the same with firms that are flush with cash reserves but not moved to use them unless they see a profitable reason to do so.
What’s needed is more demand, more customers, more factory orders. Absent those, monetary stimulus—the Fed’s Operation Twist, quantitative easing—risks “pushing on a string.” But if more folks could get back to work and increase their hours and paychecks, then businesses would see more foot traffic and investors could see some profitable openings. As Vice President Biden’s chief economist, I saw up close that the Recovery Act helped significantly in this regard. Upon its passage, the loss rates of both GDP and jobs began to diminish; GDP turned positive in mid-2009 and employment began to grow in the spring of 2010. But while the Recovery Act (along with aggressive monetary policy by the Federal Reserve) arrested the decline, it only helped shift the economy from reverse into neutral. We’re stuck in the doldrums with deep excess capacity, and monetary policy alone can’t get us out. We need temporary measures that would borrow a lot more; I liked the President’s jobs plan but I’d have gone twice as large (though truth be told, in today’s climate it’s actually an ambitious plan). But we won’t do it because we’re too damn scared of deficits and debt.
We also have the means to take a solid stab at fixing the instability cycle in financial markets. That’s the purpose of the Dodd-Frank financial reform legislation, which I view as the first real attempt at “Minsky insurance”—that is, of protecting against the next financial instability cycle-debt bubble—in decades. It’s not perfect, but it has the right attributes, all of which could be fine-tuned if we can only fight back against the amnesiacs who can’t remember what happened a few years ago.
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