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.
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