The Deficit Debate
To answer the question directly, deficit reduction will undermine a needed stimulus. However, such stimulus will not ultimately lead to recovery and we will be fortunate to endure a Japanese style stagnation.
Bernanke recently addressed the argument that we are different then Japan by suggesting we dealt with the banks earlier. It has been over a decade since Japanese banks have offloaded their NPLs (non performing loans) and remedied their balance sheets. To what effect? They are still mired in a ZIRP environment.
Demographics is providing a terrible headwind for GDP as our population growth rate is declining. Japan has been dealing with it, however, their exporting nation of savers has buffeted some of the damage just as any less levered portfolio would outperform a more levered portfolio on the downside.
Free trade agreements theoretically tried to augment our population growth rate without the social service bills. They were unilateral in their effect, they only lowered input costs. The inflationary pressures from the increased overseas production leading to marginally higher input costs never materialized while the increased consumption stoking our exports also failed to materialize. The result...deflation.
This has not been lost on our fearless Fed. In November of 2001 the Fed addresses this:
"With small probabilities that short rates will move higher any time soon, the situation probably does not pose near-term concerns. But Japanese banks do have a stake in spreads staying tight and, given that the banks are also large holders of JGBs, in rates remaining low. Ergo, one quickly gets into the circular logic of the situation. The possible need to clean up bank balance sheets may force the government to issue more bonds to finance that endeavor, which in turn will raise yields and inflict losses on banks holding large JGB positions and large swap positions as well." http://www.federalreserve.gov/monetarypolicy/files/FOMC20011106meeting.pdf
One can basically substitute UST for JGB above. Examine the fiscal health of the Japanese consumer versus the US consumer at these similar inflection points. While I am confident we will recover I do not think it will be anytime soon, regardless of stimulus.
Fred Viole
The Optimal Evolution of Public Debt
My academic research (reference below) suggests that fiscal policy should slowly reduce government debt over time towards zero and allow for deviations from this path only if unexpected fluctuations in economic activity occur.
The motivation for implementing a downward drift in government debt follows from the following simple considerations. The recent dramatic increase in government debt implies that governments' future budget risks have also signifincantly increased. This so because naturally occuring fluctuations in economic activity (the tax base) give rise to larger tax revenue fluctuations when debt and thus taxes are higher to start with. These revenue fluctuations are optimally balanced through a combination of adjustments in government spending, debt and tax rates; and since the adjustments need to be larger, the larger is the outstanding level of government debt, countries with high debt levels also face larger 'spending and tax risks'. Governments can reduce these risks by (slowly) reducing debt over time towards zero. The speed of adjustment thereby depends largely on the predictability of economic fluctuations. In environments with high uncertainty or little predictability, which may characterize the U.S. today, it is optimal to reduce debt faster, as the risk argument carries then even more weight.
My research findings thus show that important motives for debt reduction exist and that these carry a particularly high weight in periods when uncertainty about future economic developments is high. A case for government debt reduction thus exists, even if issues of government solvency and government borrowing limits do not play a role.
Klaus Adam (2010), 'Government Debt and Optimal Monetary and Fiscal Policy', available at http://adam.vwl.uni-mannheim.de/1588.0.html
Japan Style Stagnation Can hardly be Avoided in Any Case
No matter how I dislike this sad truth, but I fear that under current demographic conditions Japan-style stagnation can bearly be avoided in the most of the developed world. The working-age population will keep declining in the coming years. At the same time the retirement age population will grow. This means that fast economic growth is hardly possible and that extravagant spending is bearly a reasonable option. The best thing to do in this situation is not to pursue economic growth, but to prepare for the coming stagnation and to make the best out of it.
Budget deficits
Not savings, but increased employment is the solution!
No one can deny, that budget deficits have grown; but the monetarist model is unable to give the right causal relationship for this imbalance, because it rely on the false assumption that in a market economy equilibrium requires a balanced budget. Hence, deviations from a balanced budget are considered as an abnormality, caused by excessive public expenditures. A quick glance at the huge deficit and a simplistic reference to prudent husbandry makes it easy to put forward such populist statements as: ‘any household knows from its own private economy, that it cannot continue to have a deficit', followed by the conclusion:'in such cases we have to reduce our expenditures’. And even worse, if the individual countries cannot find out how to save on the public budget, the EU-Commission, the IMF and, at the end of the EU-table, the German Chancellor is more than willing to set this requirement of budget cuts for obtaining any further loans.
The theoretical problem with the monetarist model is, that the public sector economics is not guided by the same principles as an individual household (or firm). This is the important novelty which can be learned from New Economic Thinking (which in many ways is a modernized version of Keynesian Economics). What is true in the private economy to avoid economic bankruptcy is not necessarily good economics for the public sector, not to speak of the economy as a whole. It is easy to shown how unemployment - waste of societal and human resources - goes hand in hand with the budget deficit. But, it is rising unemployment that causes the increase of the budget deficit. The causality runs from a fall in real expenditures in the private sector, domestically or abroad, which makes labour redundant and increases unemployment and reduces tax revenues. These derived consequences within a modern welfare state are unavoidable. In fact, they are called – for good reasons – automatic stabilizers to prevent further rise in unemployment; but with a negative impact on the public sector budget. Hence, the public deficit is a mirror picture of the initial imbalance within the private sector, where excess financial savings are the counterpart. If this duality between the private and the public sectors was properly understood, the arguments in favour of budget cuts, when unemployment is high, would cease.
Keynes said in 1933: 'Look after the unemployment, and the budget will look after itself'
Properly directed deficit-financed stimulus is needed
It is high time that some of real-life complexity entered economic debate.
Stimuli stemming from textbook assumptions that view the public as a uniform entity are not going to work in economically polarized societies, with most of the wealth and income going to a small percentage of the population. It is the middle class that generates most of the demand all over the world, pays taxes, and sustains all social systems. It is the middle class that has been shrinking to impoverishment. Any stimulus not aimed at strengthening the middle class is bound to fail. A stimulus aimed effectively at the middle class (including its widening by making lower classes join it) is bound to succeed.
Public deficit, used judiciously to strengthen the middle class, can do the job. Private sector growth will follow, as the stronger middle class is bound to use most of its added income for consumption of goods and services. Small scale local businesses will not face impoverished customers unable to purchase what they have to offer. And the economic factor will do its job.
The most effective way to do it is through creation of well paying jobs.
Most countries have experienced infrastructure and social system deterioration in recent decades. Repairing these damages (not just pouring cement: adding teachers, nurses, etc. is just as important and effective) can create millions of jobs. Tax payments by these employees, and other businesses and employees growing to supply their demand, are going to finance future deficit reduction at a moderate, sustainable rate.
Governments are required to act like social entrepreneurs, not just regulators.
Deficit Debate
The suggestion that additional deficit spending is a stimulus is based on the premise that borrowings are the same as earnings, which is true only in government accounting but not in the real world. If deficits were not added as part of GDP then a truer picture of the economy would be revealed and deficits would be shown to not be helpful at all.
Will public deficit reduction encourage private sector growth?
The solvency mathematics of the late Dr. Verne Atrill underline the problem that the US faces very nicely. It has reached what Atrill termed a "second-order insolvency" and like Japan before it, growth cannot occur at and beyond that point. Despite all the stimulus that the US authorities can throw at it, the economy is so burdened by debt that is has simply stalled out.
The sole debate that is worth taking place is how, and how quickly, can US indebtedness be brought down to a manageable level. In theory, there is roughly $31 trillion too much debt overhanging Americans. If that burden were to be lifted, US GDP would be approximately 22% higher than it is now.
If you think that this a crazy approach, just ask any former bankrupt person how he felt and what he did before and after his bankruptcy when his debt burden was lifted. The release of energy to pursue growth and expansion is palpable.
Deficit reduction all by itself will achieve nothing, of course, without debt reduction.
Is the deficit the right metric to focus on ?
Is the deficit the right metric to focus on ? And is it not misleading?
Any non economic expert with basic financial intuition would be surprised at the intensity of the debate on the deficit. After all what exactly is a deficit? it is when in any given year revenues fall short of expenses, forcing the government to borrow money to cover the shortfall, and the difference is called a deficit.
Thus defined, it appears that for individuals as well as companies in early life, normalcy is chronic deficit. We spend money on raising a child and their education for a long time before they start contributing to society; Likewise, for companies, in their startup or expansionary phases, revenues typically fall short of outlays without necessarily being the focus of concern.
Indeed the reason is that we look at each of these atomistic entities balance sheets rather than their cash flow statements from which a deficit might me read. The balance sheet allows us to clearly differentiate outlays as consumption or investment expenses. When expenses are mostly investments with high return prospects, value is created, regardless of deficit.
Focus on the balance sheet appropriately forces management to focus on value creation or enhancement. Why then do we have a different metric at the government level? The problem indeed is one of measurability or valuation. While the deficit is straightforward to compute, the value of assets on a balance sheet is not, especially at a government scale.
So how do we come to see the deficit as meaning anything? Through analytical shortcuts that distorts the perceptions and prescriptions of the uneducated. First we take the deficit or surplus as a proxy for loss or income, then we assume that value is the discounted value of future income.Therefore deficit means loss of value. But indeed this is a simplistic fallacy and leads to equally misguided prescriptions.
In the present circumstances should we be worried by the deficit? Yes indeed, but not because of the deficit itself, but because of the momentous loss of value in the real estate market and proliferating elsewhere that this points to. As pointed out by Jeffrey Benson of the blog Macroeconomic Dynamism "According to the Case Shiller Indices (the most accurate housing guage available) In 2006, the value of U.S. residential real estate totaled US$ 22.4 trillion. Since this recording the national pricing indices (based on 20 metropolitan areas) has decline 19.87%. This is a loss of asset valuation equal to $4.5 Trillion. To put this loss into perspective, according to the International Monetary Fund the U.S. Gross Domestic Product in 2007 was 13.8 Trillion."(http://econdynamism.blogspot.com/2008/05/housing-bubble-vs-tech-bubble-l...)
Does worrying about just the deficit points us to the right prescriptions out of the current predicament? No. In Europe, this is leading to blind budgetary cuts that are likely to increase suffering without necessarily increasing prospect for better days ahead. Here in the US, so called "Deficit Hawks" are increasingly more vociferous to a wideningly receptive audience.
Fortunately, a number of stakeholders and analysts in the United States see that the focus should be on value creation through high returns investments in innovations with practical prescriptions to achieve that goal. For instance, any New York Times Oped page reader would be gratified to read Thomas Friedman exhortations for focused investments in Entrepreneurship and Renewable/Clean energy (See most recently: http://www.nytimes.com/2010/08/04/opinion/04friedman.html?ref=thomaslfri... Broadway and the Mosque). This week saw a few thoughtful practical contributions in that direction; There is the piece by PAUL R. MICHEL and HENRY R. NOTHHAFT, "Inventing our way out of Joblessness" (http://www.nytimes.com/2010/08/06/opinion/06nothhaft.html?ref=contributors)where they recommend allocating more resources to the USPTO for streamlining the patent granting process and most importantly granting a $19K tax credit for any granted patent (What a great idea!); there is the piece by Edmund Phelphs, "The Economy Needs a Bit of Ingenuity"() where he proposes to create a First National Bank of Innovation — a state-sponsored network of merchant banks that invest in and lend to innovative projects(Another great idea!);
The focus on making the right kind of investments should have been the main driver of the conversation on stimulus efforts since the end of 2008. After 800 Billion in stimulus and yet 9.5% unemployment,and a turnover in the economic leadership team, let's hope it becomes the focus.
Our point here is that if the government balance sheet was the focus indicator, more effective stimulus would have come with less trial and error, geared towards all kinds of high returns investments, and some of the dogmatic and nonsensical and outdated arguments would not have had any meaningful audience.
But effective tools need to be available to make reliable valuations of such large and complex portfolios seamless. This is one more area where my work on BICs (http://tinyurl.com/cyxhpa)can provide distinctive value.
Deficit debate
The deficit debate in my opinion is completely out of course. Great economic thinkers from the past have concluded that demand is the final end of production. Less demand, less production and slow economic growth. Did anyone ever wonder what happened to the economic growth from 0-1570 A.D.? This is exactly what happened. Aggregate demand was low providing no stimulus for increased production. Industrial revolution and the so called welfare state policies change that in the 18th century.
Public deficit reduction is important but only in the long run. Financial markets are today anyway fragile and considered insecure and no drastic budget deficit cuts will change them. Recall A.W.Phillips and his article in 1962 - "It is my belief that one of the main reasons for the difficulties that have been experienced in devising and implementing appropriate economic policies is lack of adequate quantitative knowledge and understanding on how the economic system works. (…) But in order to bring this knowledge to bear on the problem of formulating and attaining a consistent set of policy objectives we require also knowledge of the quantitative relations between economic variables. In particular it is necessary to know what quantitative relations hold between those economic variables which are either the objectives of policy or the instruments through which we attempt to attain the objectives.".
Bravo to Phillips. Who can guarantee that deficit cuts now are proper economic policy? First we have to learn the true nature and dynamics of the system and how system works and only then discuss if strong public deficit reduction now is the proper course. More on the subject can be found in "Can There Be a Golden Triangle of Internal Equilibrium" (2010).
Cuts or not remains only an superficial debate and of no importance. I ardently agree with Phillips, we don't have solid knowledge about the true nature of economics and thus can not design proper economic policies. Question to cut or not public budget deficits can only be answer after we learned how economic system works - otherwise is is only a political and rhetorical debate in which all are being right (pro and con budget cuts) since we don't have even a small evidence to prove who is wrong. It is time we start thinking on economic as a real life thing with its natural laws and dynamics and not vandalize it as we are doing with the environment.
It is much more than the deficit
I think it's very interesting the complementary issue about growth. The real thing is how economic growth is helping people. As most are aware, recent period of economic expansion on US, for example, was accompanied by a worsening on income distribution, i.e. there are more poor people now than before this cycle (and when I say now I'm referring to pre crisis situation, today it is even worst)
So what I want to bring to the table is the issue of distribution, not only income distribution, but how public expenditure is distributed too.
Most of us studied with a text book that didn’t say anything about distributional issues because there was an assumption underlying the whole theory that everyone was worth the same. A poor individual is equivalent to a middle class one or a rich one when it comes to theoretical analysis.
However, we better start thinking that there should be a difference on valuation between people when thinking of public policy, otherwise we will continue believing that putting an additional dollar in the mouth of a starving individual (would he notice it?) will have the same economic effect of putting one more dollar on the pocket of a rich one (would he notice it?).
I do strongly believe that markets are the best way to assign resources on the economy, but in a pure competitive one. We are far away from having the kind of economic structure, which ever the country you are, that will guarantee this superior distributional arrangement. In the mean time, the government should make its part to support markets, and correct distributional mistakes.
So, should the government reduce deficit spending? Depends on what kind of expenditure are we talking about. Subsidies to keep homeownership high or, as Niall Ferguson putted in his book “The assent of money”, to keep the homeownership democracy alive? Sure not (this is not to say that financial institutions were doing right in mortgage generation and all the blain is on the government, at least one can say they lie to their customers.) Should government pursue higher quality education and health service for low income population? Sure yes.
I think the debate is misguided in this respect. I think it is somehow a false debate between cut or not cut, I think is more on where to cut (do anyone believe that 10% of GDP deficit is anyway sustainable?).
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