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Rethinking Debt
Washington refuses to understand that debt can be an essential tool for economic growth. Can we overcome this irrational and destructive fear?
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.
Ever hear of the agency problem of economics? Well, the government has it. In spades. So more debt to an incompetent government, who engineered the crisis, and to its venal and equally incompetent campaign contributing revolving door bank cronies, will do nothing whatsoever. Except maybe land you a cushy sinecure, you damn proto-wannabe bureaucrat.
Dec 13, 2011, 2:53 PMMizrahi -- your comments (well, actually, one posted twice) are quite substantive and important to a resolution to our problems.
(Sadly, the vitriol almost sent me running before I took the time to see what you're trying to say.)
It would be insane to keep expanding a government with a poor track record. At some point, drastic measures need be taken to change the way government operates.
We hope we can accomplish this without resorting to anarchy while waiting for a new government to evolve.
regards, common man bob
Dec 13, 2011, 5:42 PMI would add Evsey Domar to the wise troika. He formally and clinically defined debt sustainability.
Dec 14, 2011, 7:14 AMI don't really see any validation here of your claim that debt is an essential tool for growth. You say "Borrowing from the future to invest in the present is one way to improve that future." Well if that's the measure for essentialness, then I guess saving for future spending would also qualify. What makes spending now better than not spending now? If we could claim that the spending bought us something that matters, that would help. Putting people to work would be nice, but if you want the economy to function those people need to be creating value. This essay appears to me to be a very long-winded way of screaming "Breathe!" at a dying patient.
Dec 14, 2011, 3:50 PMMizrahi never read Irving Fisher's accurate description of a debt/deflation cycle Jared, so you're wasting your talent on him.
Plus Mizrah's favorite political party, I'm thinking, invented crony capitalism a century ago, and in 2002 eliminated paygo so they could run up the debt bill in good times. Madness.
Run the bill up. They're paying us to take their money. Time to invest instead of dropping bombs on Muslims, or paying oil companies not to drill.
Dec 14, 2011, 3:55 PMI think Modern Monetary Theory economists like Warren Mosler make a better case against debt and deficit panic by pointing out the fundamental fact that government debt = private sector savings to the penny.
Treasury securities are in essence savings accounts and "paying off debt" when they mature is as simple and pain free as moving balances from these savings accounts to checking (reserve) accounts at the Fed.
Dec 15, 2011, 10:43 AMLots of good points in this article... But it's worth pointing out that it's ridiculous to increase the level of debt as a substitute for our generation's unwillingness (esp. that of our generation's rich) to pay their way. Taxes in the US are at historic lows and that's the main reason we have deficits and a national debt.
Secondly, public spending in a recession makes sense in theory... but given the way that the US economy has changed in relation to the world (given our status as a huge importer), we should think twice before just throwing govt money at growing our GDP... even in a recession. The multipliers now appear in China even more than here. It's time to think differently (at least for us to think differently). We should be targeting govt investment to create sustainable jobs and exports... like Europe, Japan and China. We shouldn't be funding "shovel ready" jobs that disappear with govt funding.
The folks setting policy, including Bernstein, need to get smarter. Flying our economy according to the old flight plans "ain't cutting it. "
Dec 15, 2011, 4:42 PMAnd btw, I'd say the govt bailout of Chrysler is a prime example of useful govt investment. Investing in green tech would be great too... but in light of a recent "scandal", we have to expect that' we'll sometimes pick losers as well as winners.
Dec 15, 2011, 4:51 PMTo say government engineered the economic crisis is not reality based thinking. It is fantasy. Did government create CDOs (collateralized debt obligations) that purposefully confused investors and cheated them? Did government gamble with Credit Default Swaps which still hang like death over credit markets? No. The government, shackled by ideology based thinkers in the Bush Administration and Congress, tied the hands of regulators that were prevented from doing the jobs that they were legally obligated to pursue. Republicans caused the economic crisis, then blamed in on government because government didn't let "bad firms fail." What a laugh. That was GW Bush and Wall Street's policy, pushed heavily by Republicans. That thinking is the cause of the economic crisis, not the government whose proper function is regulating the abuses of the private sector. It's time to let government do the regulatory job that it, and only it, can do.
Dec 15, 2011, 8:04 PM"A precious few economists warned of the housing bubble, which was the root cause of the recession."
This is oversimplification to the Nth degree. The "bubble" was not a bubble until two triggers:
1. Job loss...can't pay the mortgage without a job, duh!
2. Effective default of the credit insurance sector...AIG, for example and the incorrectly rating junk derivatives as AAA with no reserves to cover real mortgage defaults. Buffett called them financial weapons of mass destruction for a good reason.
Excellent essay. I am frustrated by President Obama's occasional comments that signal some level of agreement with the "We must shrink government and deficits immediately crowd." While these comments play well the political analysts who think they know what independents want (smaller government is their latest guess) these comments inadvertently help to spread harmful misunderstanding regarding when and how much the federal government needs to borrow. As the author has stated the US government should be paying down debt during good times and increasing borrowing to create missing demand during a slack economy. This isn't rocket science. It's Economics 101 in college.
Dec 17, 2011, 8:30 PM... timing the market? Perhaps I can sell you some stock?
Dec 19, 2011, 1:25 PMThe problem about debts is, that they make you dependent on the loaner. Means, if the state borrows money from banks you have to do what banks want you to do. And this means that politics in made by banks and not by the government and the people of a nation.
If America wants to be a free nation, they have to be free of debts first of all.
Though, bankers will tell you the opposite, for obvious reasons.
Feb 1, 2012, 3:07 PMPeople like that below me really discredit their own opinion with their anger, and also apparently didnt read the whole piece and completely deny the foundation of historical knowledge that support the basic ideas of public spending. Cronyism in our capitalism and an over concentration on incumbant economic power is a real problem, and legitimate concern, but the fear based reactionary criticism of strongly supported ideas is out of focus, a true rejection of all relevant information.
Feb 3, 2012, 10:46 PMPeople like that below me really discredit their own opinion with their anger, and also apparently didnt read the whole piece and completely deny the foundation of historical knowledge that support the basic ideas of public spending. Cronyism in our capitalism and an over concentration on incumbant economic power is a real problem, and legitimate concern, but the fear based reactionary criticism of strongly supported ideas is out of focus, a true rejection of all relevant information.
Feb 3, 2012, 10:48 PMPost a Comment
Jared Bernstein is a senior fellow at the Center on Budget and Policy Priorities and was formerly chief economist to Vice President Joe Biden.
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