Aug 16 2011

Too much debt or not enough demand? A summary of the debate over America’s fiscal future

As yet another school year begins, we once again find ourselves returning to an atmosphere of economic uncertainty, sluggish growth, and heated debate over how to return the economies of the United States and Europe back onto a growth trajectory. In the last couple of weeks alone the US government has barely avoided a default on its national debt, ratings agencies have downgraded US government bonds, global stock markets have tumbled, confidence in the Eurozone has been pummeled over fears of larger than expected deficits in Italy and Greece, and the US dollar has reached historic lows against currencies such as the Swiss Franc and the Japanese Yen.

What are we to make of all this turmoil? I will not pretend I can offer a clear explanation to all this chaos, but I can offer here a little summary of the big debate over one of the issues above: the debate over the US national debt and what the US should be doing right now to assure future economic and financial stability.

There are basically two sides to this debate, one we will refer to as the “demand-side” and one we will call the “supply-side”. On the demand-side you have economists like Paul Krugman, and in Washington the left wing of the Democratic party, who believe that America’s biggest problem is a lack of aggregate demand.

Supply-siders, on the other hand, are worried more about the US national debt, which currently stands around 98% of US GDP, and the budget deficit, which this year is around $1.5 trillion, or 10% of GDP. Every dollar spent by the US government beyond what it collects in taxes, argue the supply-siders, must be borrowed, and the cost of borrowing is the interest the government (i.e. taxpayers) have to pay to those buying government bonds. The larger the deficit, the larger the debt burden and the more that must be paid in interest on this debt. Furthermore, increased debt leads to greater uncertainty about the future and the expectation that taxes will have to be raised sometime down the road, thus creating an environment in which firms and households will postpone spending, prolonging the period of economic slump.

The demand-siders, however, believe that debt is only a problem if it grows more rapidly than national income, and in the US right now income growth is almost zero, meaning that the growing debt will pose a greater threat over time due to the slow growth in income. Think of it this way, if I owe you $98 and I only earn $100, then that $98 is a BIG DEAL. But if my income increases to $110 and my debt grows to $100, that is not as big a deal. Yes, I owe you more money, but I am also earning more money, so the debt burden has actually decreased.

In order to get US income to grow, say the demand-siders, continued fiscal and monetary stimulus are needed. With the debt deal struck two weeks ago, however, the US government has vowed to slash future spending by $2.4 trillion, effectively doing the opposite of what the demand-siders would like to see happen, pursuing fiscal contraction rather than expansion. As government spending grows less in the future than it otherwise would have, employment will fall and incomes will grow more slowly, or worse, the US will enter a second recession, meaning even lower incomes in the future, causing a the debt burden to grow.

Now let’s consider the supply-side argument. The supply-siders argue that America’s biggest problem is not the lack of demand, rather it is the debt itself. Every borrowed dollar spent by the goverment, say the supply-siders, is a dollar taken out of the private sector’s pocket. As government spending continues to grow faster than tax receipts, the government must borrow more and more from the private sector, and in order to attract lenders, interest on government bonds must be raised. Higher interest paid on government debt leads to a flow of funds into the public sector and away from the private sector, causing borrowing costs to rise for everyone else. In IB and AP Economics, this phenomenon is known as  the crowding-out effect: Public sector borrowing crowds out private sector investment, slowing growth and leading to less overall demand in the economy.

Additionally, argue the supply-siders, the increase in debt required for further stimulus will only lead to the expectation among households and firms of future increases in tax rates, which will be necessary to pay down the higher level of debt sometime in the future. The expectation of future tax hikes will be enough to discourage current consumption and investment, so despite the increase in government spending now, the fall in private sector confidence will mean less investment and consumption, so aggregate demand may not even grow if we do borrow and spend today!

This debate is not a new one. The demand-side / supply-side battle has raged for nearly a century, going back to the Great Depression when the prevailing economic view was that the cause of the global economic crisis was unbalanced budgets and too much foreign competition. In the early 30’s governments around the world cut spending, raised taxes and erected new barriers to trade in order to try and fix their economic woes. The result was a deepening of the depression and a lost decade of economic activity, culminating in a World War that led to a massive increase in demand and a return to full employment. Let’s hope that this time around the same won’t be necessary to end our global economic woes.

Recently, CNN’s Fareed Zakaria had two of the leading voices in this economic debate on his show to share their views on what is needed to bring the US and the world out of its economic slump. Princeton’s Paul Krugman, a proud Keynesian, spoke for the demand-side, while Harvard’s Kenneth Rogoff represented the supply-side. Watch the interview below (up to 24:40), read my notes summarizing the two side’s arguments, and answer the questions that follow.

Summary of Krugman’s argument:

  • Despite the downgrade by Standard & Poor’s (a ratings agency) there appears to be strong demand for US government bonds right now, meaning really low borrowing costs (interest rates) for the US government.
  • This means investors are not afraid of what S&P is telling them to be afraid of, and are more than happy to lend money to the US government at low interest rates.
  • Investors are fleeing from equities (stocks in companies), and buying US bonds because US debt is the safest asset out there. The market is saying that the downgrade may lead to more contractionary policies, hurting the real economy. Investors are afraid of contractionary fiscal policy, so are sending a message to Washington that it should spend more now.
  • The really scary thing is the prospect of another Great Depression.
  • Can fiscal stimulus succeed in an environment of large amounts of debt held by the private sector? YES, says Krugman, the government can sustain spending to maintain employment and output, which leads to income growth and makes it easier for the private sector to pay down their debt.
  • With 9% unemployment and historically high levels of long-term unemployment, we should be addressing the employment problem first. We should throw everything we can at increasing employment and incomes.
  • Is there some upper limit to the national debt? Krugman says the deficit and debt are high, but we must consider costs versus benefits: The US can borrow money and repay in constant dollars (inflation adjusted) less than it borrowed. There must be projects the federal government could undertake with at least a constant rate of return that could get workers employed. If the world wants to buy US bonds, let’s borrow now and invest for the future!
  • If we discovered that space aliens were about to attack and we needed a massive military buildup to protect ourselves from invasion, inflation and budget deficits would be a secondary concern to that and the recession would be over in 18 months.
  • We have so many hypothetical risks (inflation, bond market panic, crowding out, etc…) that we are afraid to tackle the actual challenge that is happening (unemployment, deflation, etc..) and we are destroying a lot of lives to protect ourselves from these “phantom threats”.
  • The thing that’s holding us back right now in the US is private sector debt. Yes we won’t have a self-sustaining recovery until private sector debt comes down, at least relative to incomes. Therefore we need policies that make income grow, which will reduce the burden of private debt.
  • The idea that we cannot do anything to grow until private debt comes down on its own is flawed… increase income, decrease debt burden!
  • Things that we have no evidence for that are supposed to be dangerous are not a good reason not to pursue income growth policies.
  • When it comes down to it, there just isn’t enough spending in the economy!

Summary of Rogoff’s argument:

  • The downgrade was well justified, and the reason for the demand for treasuries is that they look good compared to the other options right now.
  • There is a panic going on as investors adjust to lower growth expectations, due to lack of leadership in the US and Europe.
  • This is not a classical recession, rather a “Great Contraction”: Recessions are periodic, but a financial crisis like this is unusual, this is the 2nd Great Contraction since the Depresssion. It’s not output and employment, but credit and housing which are contracting, due to the “debt overhang”.
  • If you look at a contraction, it can take up to 4 or 5 years just to get back where you started.
  • This is not a double dip recession, because we never left the first one.
  • Rogoff thinks continued fiscal stimulus would worsen the debt overhang because it leads to the expectation of future tax increases, thus causing firms and households increased uncertainty and reduces future growth.
  • If we used our credit to help facilitate a plan to bring down the mortgage debt (debt held by the private sector), Rogoff would consider that a better option than spending on employment and output. Fix the debt problem, and spending will resume.
  • Rogoff thinks we should not assume that interest rates of US debt will last indefinitely. Infrastructure spending, if well spent, is great, but he is suspicious whether the government is able to target its spending so efficiently to make borrowing the money worthwhile.
  • Rogoff thinks if government invests in productive projects, stimulus is a good idea, but “digging ditches” will not fix the economy.
  • Until we get the debt levels down, we cannot get back to robust growth.
  • It’s because of the government’s debt that the private sector is worried about where the country’s going. If we increase the debt to finance more stimulus, there will be more uncertainty, higher interest rates, possibly inflation, and prolonged stagnation in output and incomes.
  • When it comes down to it, there is just too much debt in the economy!

Discussion Question:

  1. What is the fundamental difference between the two arguments being debated above? Both agree that the national debt is a problem, but where do the two economists differ on how to deal with the debt?
  2. The issues of “digging ditches and filling them in” comes up in the discussion. What is the context of this metaphor? What are the two economists views on the effectiveness of such projects?
  3. Following the debate, Fareed Zakaria talks about the reaction in China to S&P’s downgrade of US debt. What does he think about the popular demands in China for the government to pull out of the market for US government bonds?
  4. Explain what Zakaria means when he describes the relationship between the US and China as “Mutually Assured Destruction (MAD)”.
  5. Should the US government pursue a second stimulus and directly try to stimulate employment and income? Or should it continue down the path to austerity, cutting government programs to try and balance its budget?

About the author:  Jason Welker teaches International Baccalaureate and Advanced Placement Economics at Zurich International School in Switzerland. In addition to publishing various online resources for economics students and teachers, Jason developed the online version of the Economics course for the IB and is has authored two Economics textbooks: Pearson Baccalaureate's Economics for the IB Diploma and REA's AP Macroeconomics Crash Course. Jason is a native of the Pacific Northwest of the United States, and is a passionate adventurer, who considers himself a skier / mountain biker who teaches Economics in his free time. He and his wife keep a ski chalet in the mountains of Northern Idaho, which now that they live in the Swiss Alps gets far too little use. Read more posts by this author

20 responses so far

20 Responses to “Too much debt or not enough demand? A summary of the debate over America’s fiscal future”

  1. Nathan R.on 16 Aug 2011 at 4:57 pm

    The fundamental difference between the two arguments is about how to resorb the debt. The demand-siders argue that it is necessary to invest now, increase government spending and income, so that in the long-run, the private sector will be able to pay off the debt as it begins to earn more money. On the other hand, the supply-siders argue that increasing the debt now crowds-out the private sector and increases uncertainty which will only result in an increase in the debt in the long-term so action must be rapid and decisive.

    Explain what Zakaria means when he describes the relationship between the US and China as “Mutually Assured Destruction (MAD)”.

    What Zakaria means is that if China goes down so does the US and if the US goes down so does China. The USA is the single largest economy in the world and provided a huge market place for products from China. China's economy relies heavily on net exports for growth and the USA is the main importer and consumer of Chinese made products. Hence, if the USA starts to consume less Chinese products, Chinese growth will fall alongside the fall in the demand for its products. On the other hand, China owns most of the US debt in the form of US government bonds. So, if the Chinese economy crashes, the USA will never be able to sustain their current level of debt and because the Chinese can no longer afford to buy off US debt, the US economy will crumble under the weight of what it owes to the private sector.

    Should the US government pursue a second stimulus and directly try to stimulate employment and income? Or should it continue down the path to austerity, cutting government programs to try and balance its budget?

    I believe the US should follow a second stimulus packet. What the Republicans and right-wing politicians seems to forget is that their is a significant part of the US population that cannot afford and sustain higher tax rates, even if the US does increase tax rates, government revenue is not likely to grow by much; instead, their should be a rise in the number of fiscal frauds. What the democrats propose, the stimulus, makes more sense. It insures that, by raising the income of the poor, the middle-class, and the rich, every American citizen will be able to repay part of the Government debt in tax. Like Paul Krugman said, if income rises, debt burden seems to decrease and people are more willing to pay and buy bonds avoiding the fraud that might occur with the Republican's plan.

  2. Thomason 16 Aug 2011 at 5:26 pm

    I agree with Nathan that a stimulus package would help the economy and would help reducing the debt. However I think that a combination of the two theories is needed in order to 'fix' the economy. On the one hand the US cannot introduce a policy of savings with swingeing spending cuts. However in the future an increase in the tax rates will be needed to finally pay off the debt. Therefore increasing the debt at the moment by throwing everything into the economy might make consumers suspicious and therefore will result in less investment and consumption happening. The US government cannot slash fiscal and monetary stimulus, but at the same time cannot spend more money that it receives as it happened before.

  3. Nathan Pon 16 Aug 2011 at 6:23 pm

    I agree with both Thomas and Nathan. The second stimulus package will help get the US economy back on the road to recovery. Despite this, there does need to be some sort of increase in the tax on the mega-wealthy, the people who can afford to pay taxes. These taxes will add to the raising of Government Revenue, and can be used to pay for such plans that the US government may pass in the future.

  4. Cedricon 16 Aug 2011 at 8:19 pm

    I agree with Nathan that the U.S should raise income for the poor, middle class and rich American's. This way, they will be able to help contribute and repay part of the government debt. I also agree with Thomas that in the future, tax rates must increase in order to help repay the government debt.

    Sharing my opinion based on both the demand and supply side, I must say that based on the demand side, increasing spending with over 14 Trillion dollars in debt and new investments does not guarantee that this debt can be paid off as investors and consumers would feel uneasy about investing and consuming in a government with such a debt. However on the other hand as Thomas already mentioned, cutting monetary spending will not solve the problem as debt will still remain. In order for such a problem to be solved, the government should increase income and then increase taxes which would help reduce the debt. Once the debt has been reduced, government funds for investments could then be allocated. This would reduce both investors and consumers suspicion and help attract further investment which would increase government revenue.

  5. Jake F.on 16 Aug 2011 at 9:39 pm

    "Following the debate, Fareed Zakaria talks about the reaction in China to S&P’s downgrade of US debt. What does he think about the popular demands in China for the government to pull out of the market for US government bonds?"

    Fareed knows that what many of the Chinese people are calling for would devastate China in many different ways. He said that if China were to stop buying these bonds then the value of the Yuan would rise, which would make Chinese exports more expensive and then employment in China would fall due to a decrease in the demand for the more expensive Chinese goods. The Chinese seem to be addicted to growth based on exporting goods, and if the rate of their exports to customers such as the United States, who are the largest in their export market, falls, then they too would be brought down and begin to suffer a financial crisis. Zakaria knows that China will have to continue to buy the US bonds as the other options available to them (Japan, Europe, the UK and Switzerland) aren't as big or as safe. Fareed then goes on to inform us that China is not actually doing the US a favour it is in fact the other way around. The US is in fact paying China $74 million a day on interest for the bonds.

  6. Alexandre Kon 16 Aug 2011 at 9:55 pm

    Several interesting points have been raised above by Nathan, Thomas and Cedric.

    However, I think that the main problem in today's economies is that government expenses, all across the world, are far beyond real. In all multinational corporations, the costs of operation are kept under very strict control. However, in governments, it seems that there has always been unlimited spending. Several examples have been shown in Europe as some countries are facing large debts – those situations are identical in the US.

    In Italy, for example, the cost of the operation of the democracy is approximately 24.7 billion Euros. Also, it is shocking to see that the President of the province of Bolzano in Italy earns 36,000 Euros more than Barrack Obama. In that field, governments have to start making cost cuts. In the US, currently hit by an economic crisis, there is also a lot of room for cost cuts for unnecessary expenses, that do not boost the economy in any way.

    Another solution, as Cedric mentioned, would be to increase taxes. However, increasing taxes year after year may be a solution but this cannot be a long-term solution. Beyond a certain point, this will encourage the richest (in particular) to move to tax-free countries, for example.

    The solutions mentioned above could potentially help the US in their difficult time, but would first require an effort from the government to cut their operating costs, for example.

  7. Tim B.on 16 Aug 2011 at 10:01 pm

    I strongly agree with Cedric, that demand side policies will not lead to "the solution", which is supposed to help recover the economy. However, I think it is of very high priority, that the investors and consumers’ confidence is reestablished, in order to increase government revenues, which would result in the repay of government’s depth. On one hand, taxes should be kept low, in order to restore these confidences. On the other hand, however, taxes should be raised, as the increase in taxes would allow the government to repay its depth and would therefore also result in a small increase in investors’ confidence.

    In my eyes, a second stimulus package will have desirable effect of increasing investors’ confidence, as on one hand the economy will be stimulated for a limited time, however nation's depth even grew with this second package and there is no guarantee for success, which further decreases investors’ confidence.

  8. Philippaon 16 Aug 2011 at 10:50 pm

    In brief, the significant difference between the two proposed arguments is that the demand-side (Krugman) suggests that increasing government spending through fiscal stimulus will lead to a decrease in unemployment, leading to income growth making it more feasible for the private sector to pay off the debt. However, the supply-side (Rugoff) want to tackle debt first, before embarking in more government spending. This side's view is that the debt would worsen with fiscal stimulus due to reluctance to invest and consumers' suspicion, leading to a reduce in growth.

    I agree with Cedric that there is no guarantee that the debt will be paid off due to investors' uneasy response to a government with an even greater debt. However, as Thomas said, cutting government programs to balance its budget will not reduce the debt in the long-run. The most effective would be to begin with the supply-side's view on reducing debt. Once the debt is reduced, fiscal stimulus can commence, as the firms' and households' uncertainties will not be so great therefore investing will begin, increasing growth. With this policy, the private sector's debt will particularly be reduced which Krugman establishes as the 'thing that's holding [the USA] back'.

    The issue of "digging ditches and filling them in" is based on the Keynes principle of injecting government spending into the economy on projects which will create jobs, increasing income and tax revenue regardless of the productiveness of the task. Krugman largely agrees with this principle, but Rugoff sees it as 'common sense' that "digging a ditch and filling it in" leads to unproductive work and an increase in debt. He states that Keynes may not have always been right and that his policies may not fit with this particular 'debt overhang'. In this situation, I agree with Rugoff; the government spending on whatever policies or projects needs to be productive as well as provide a decrease in unemployment and an increase in tax revenue.

  9. Davidon 17 Aug 2011 at 8:11 am

    I personally agree with Alexandre that there is too much spending of the governments and with Tim that the consumer confidence needs to be reestablished. As the debts of the government decreases all throughout the world but especially in the USA and Europe the people would be more confident in spending and investing money. I also agree that the taxes need to be raised but like people mentioned already before it will not be a long term solution. This is due to the fact that the rich people have the opportunity and the money to move to different countries if the taxes put on them are too high in their opinion. So if the government would increases taxes each year, there will be certainly a point in which many wealthy people of the country will move away. Than there is even greater losses of tax revenues. I also agree with Tommy that there should be a mix of the two sides to solve this problem, but the main goal should be to raise the peoples confidence.

  10. Saugata Mittraon 17 Aug 2011 at 10:44 am

    What is the fundamental difference between the two arguments being debated above? Both agree that the national debt is a problem, but where do the two economists differ on how to deal with the debt?

    The fundamental differences between the two arguments being debated entail a differing understanding and perspective of the problems at hand – Paul Krugman argues that a reduced amount of spending in the economy is the largest and most easily rectified reason for this "double dip" in the economy, whereas Kenneth Rogoff argues that the debt in the economy is the biggest problem and that households will expect future tax raises, and therefore, will save their money now, rather than spend.

    The issue of "digging ditches and filling them in" comes into play in Paul Krugman's 'demand-side-policies.' Paul Krugman believes that increasing income and increasing employment is a feasible solution to the slump in the economy, and therefore, the government should spend money to employ the unemployed. Kenneth Rogoff however, argues that "digging ditches and filling them in" will do nothing to get the US out of their slump.

    In my opinion however, the US government should pursue a second stimulus program to directly try to stimulate employment and income. The historically well-cited example of the Great Depression in the 1930s and the government's handling of the situation should be clear enough an example to incentivize the government's stimulus program. For example, if employment goes down and the average income of a nation goes up, the people, in general, are much better off. Thus, as you mentioned above, "if I owe you $98 and I only earn $100, then that $98 is a BIG DEAL. But if my income increases to $110 and my debt grows to $100, that is not as big a deal. Yes, I owe you more money, but I am also earning more money, so the debt burden has actually decreased." Therefore, I believe that the US government should increase its spending to increase household spending. This, in the long term, will also decrease the debt burden the citizens of the US will have to pay.

  11. Markelon 17 Aug 2011 at 8:32 pm

    I strongly believe that a stimulus package would help the economy by focusing on reducing the large amount of debt. A combination of the two theories however, would be the most helpful and efficient for fixing the economy. It is imperative that the US government spends money, aimed at reducing the unemployment rate and raising the national income, as it is very likely that an increase in GDP will aid in paying off the debt. As Rogoff said: "if the government invests in productive projects, the stimulus is a good idea." The only problem is getting the government to create projects which will eventually benefit the whole economy.

  12. Emmaon 17 Aug 2011 at 8:56 pm

    Krugman's demand side argument, to increase government spending and create jobs, would help the private sector pay off debt.It is currently important to decrease unemployment and getting a better income for all classes because it would instill some confidence in the consumer further raising AD.

    However, that said, the US debt is too large to be ignored. Continuing to increase government spending will cause the US debt to keep rising and rising. This is where the supply-side actions to come in. Cutting monetary spending won't make the debt disappear. It does not generate more money for the government just stops the debt growing. Therefore it has to be twinned with a policy to generate revenues to pay back the debt. The way to do this is taxes. I think taxes are a sensitive subject because increasing taxes doesn't make the government very popular with the public. Without any economic knowledge it is hard to see how increasing taxes could actually be beneficial, therefore the government has avoided it to stay popular with the public. Others have raised the valid point that taxes are not a long term solution because of the wealthy avoiding taxes. This is very true, but making some revenues from taxes is better than making nothing.

  13. The Other Philipon 17 Aug 2011 at 9:03 pm

    Should the US government pursue a second stimulus and directly try to stimulate employment and income? Or should it continue down the path to austerity, cutting government programs to try and balance its budget?

    Both arguments are opposing ones, agreed. Yet although they are opposing it doesn't mean that either one isn't as effective as the other, or that one doesn't work at all: if anything, it seems as if both programs work in their own way. What really appears to be the problem is the deadly spirit of compromise: dabble a little in the supply side of things (cut government spending) and a little in the demand side of things (don't raise taxes).. with the end result being an even larger debt and a public fear of inneffective stimulus packages.

    And so it's time for the Federal Reserve to make up their mind and stick with it for the following years, come hell or high water, although this probably make whatever party in power unpopular with the voters. Besides, two years is too early for an economy to decide that any given system "works". In addition, debt should stop being compared to a nation's GDP but to what the government raises in taxes: the difference is a pschycological barrier that's protecting the rich from increased taxing. 98% is child's play compared to the much higher number that that would be. In summary: choose one, choose one quick, and stick to it.

  14. Chris B.on 18 Aug 2011 at 8:45 am

    I have to agree with Alex and David that governments are spending too much money that they do not possess. Most of the time, this money is spent on actions that do not help the economy escape the situation it is in now. One such example is the huge amount of money the US government is spending on buying military equipment. One example of this is the F-22 fighter jet which the US bought for a unit price around $412 million. Imagine the spending if you have to buy 168 units. Personally, I believe that a second stimulus plan would not be very effective as the government isn't a good allocator of money. The private sector is a much better allocator of investment as decisions are thought over twice before they are made and are most likely used for things that are needed. To encourage private sector spending, the government should not raise taxes as this would have the opposite effect. In addition, large tax increases could lead to the rich moving to countries with lower taxes. With more private sector spending, the tax revenue for the government would increase without the need for any tax raises. Looking at the arguments above, the US is facing a serious problem that can only be tackled by reducing the government spending and encouraging consumer spending. The increased tax revenue from increased could then be used to decrease the debt that has piled up. Increasing the debt limit would only postpone the problem and make the problem much worse.

  15. Matt Beattieon 20 Aug 2011 at 11:10 am

    I agree with Cedric that the increased spending in debt and new investment does not guarentee that it will be paid off. If the government were to increase their taxes resulting in an increased income this would help the debt's size reduce. Merely cutting monetary spending would not resolve the problem as the debt would still exist. Through increasing taxes the government collect a larger income and are able to both pay off the debt and still invest and spend on factors to boost the economy

  16. […] have to agree with Alex and David that governments are spending too Much money that they do not possess. Most of the time, this money is spent on actions that do not help […]

  17. […] that we would pay off the national debt by 2011, threatening the “starve the beast” plan to limit revenue in order to reduce the size of government.  So, that that summer the Bush Administration gave a good chunk of change back  with the first […]

  18. David Xuon 08 Nov 2011 at 12:18 pm

    I love the post. We just had Professor Ken Rogoff come speak at Brown last night, and it's always interesting to hear professional opinions about the "great contraction".

    As for my two-cents on our nation's debt and how the US can get out of the recession/contraction, I don't think a stimulus is the answer. Obama's first stimulus only showed about a 1% increase in GDP while ARRA and TARP combined to make a stimulus of 15% of GDP. With high consumer and national debt, the point about expectation of future taxes is crucial. Putting more money into consumer's pockets will cause them to either pay off existing debt or save the money in expectation of higher taxes in the future. Neither of these options lead to consumption which has been shown to decrease in the last quarters.

    With the government getting so involved in the mortgage market, the debt is bound to increase with more loan defaults in that particular sector. One of the hugest issues though is not even the financial crisis, but in fact, healthcare and social security. More often, the news has been reflecting local government defaults, and the lack of funds for pension plans. An aging population in addition to a massive debt only leads to more troubles. Without an adequate reform in healthcare and pensions, we will run into astronomical numbers of spending in these areas that make the fiscal stimulus look like chump change.

    Of course, we can't forget about the contagion that Greece is putting on for the Euro. Until Europe fully stabilizes along with Italy, Spain and the other borderline countries are out of the woods, the financial markets will remain shaky and investors wary globally.

  19. Jason Welkeron 09 Nov 2011 at 8:08 pm

    David Xu »

    Hi David! Welcome back to the blog! It's been a while! I am honored to have the views of an Econ major from Brown on my blog, and one who was lucky enough to hear Ken Rogoff speak in person, at that!

    Let me respond to some of your comments though. You say that Obama's first stimulus only showed a 1% increase in GDP, but that ARRA and TARP combined to make a stimulus of 15% .I think you're confused here, because Obama's first stimulus was ARRA, the American Recovery and Reinvestment Act. Neither ARRA nor TARP boosted GDP by 15% however… although the two programs combined did COST about 15% of GDP (about $1.8 trillion between them!) You're right that GDP did not grow by much as a result of these, but what most economists agree on is that both Obama's stimulus and the "bank bailout" prevented GDP from falling by as much as it would have without these fiscal and monetary measures in place, and that subsequently the doubling of unemployment that took place between 2008 and 2009 decelerated and, thankfully, unemployment peaked at 10% instead of rising to Great Depression levels of 25%, as may have happened otherwise.

    In fact, many independent economists and think tanks have estimated that without Obama's first stimulus, unemployment would have risen to around 12.5%, meaning that an additional 5 million people would be out of work today. When you think about the impact of the stimulus in that way, you may start to think that it did at least some of what it was intended to do. If it did not return unemployment to its natural rate of 5% and return the economy to a growth rate of 3-4%, it's probably not because the stimulus "failed", as Obama's critics claim, rather that it was simply not big enough, as Krugman claims.

    You say, "Putting more money into consumer’s pockets will cause them to either pay off existing debt or save the money in expectation of higher taxes in the future…" This is a fair assumption, and in fact the last two stimuluses (Obama's and Bush's) have put around $550 billion into peoples' pockets, with little "bang for the buck". It's correct that lower taxes during a recession do not lead to large increases in consumption, because of the uncertainty that already exists, and because of what Rogoff calls the "debt overhang". Tax cuts WILL go to paying off debt and towards savings! This is precisely why tax cuts, which are the primary proposal of the Republican presidential candidates, are not the answer to America's economic woes! Reducing household debt is important, but this is happening on its own, as US savings rates have risen from under 1% in 2007 to 6% today. Debt repayment is a form of savings, as it is a leakage from the nation's economy. After a few more years of 6% savings rates, Americans' household debt will be reduced and we'd expect the marginal propensity to consume to rise again.

    Regarding healthcare and social security, we must not forget that basic health care and pensions for the elderly are public goods, that without government provision or support would be under-provided by the free market. With the added burden on American's after tax incomes of paying for their own health care and retirement pensions, Americans will find themselves with less left over for consumption. In my opinion, there are two major reforms needed in social security. First, raise the income limit beyond which payroll taxes do not have to be paid. At present, only income up to $106,800 is taxes to support social security. This means that the richest Americans are paying proportionally less towards pensions than the middle class and even lowest income earners. In this way, social security taxes are regressive and place an undue burden on the lowest income earners. Raise this cap to $250,000. Secondly, Americans whose incomes average more than $250,000 during at least 5 years of their working career are not eligible to collect social security pensions. In this way, those who need it least will not receive social security pensions, while those who need them most will pay for and receive them.

    Health care, as you know, is another issue. Widen the pool of insured and reduce costs for everyone else… Obama's plan makes sense. It is how health insurance is guaranteed in Switzerland, and somehow costs are much lower here, despite the much higher costs of living in other areas.

    Europe financial woes pose an opportunity to the US right now, that it should take advantage of. Fear over the stability of the Euro has led to a flight towards US treasuries, meaning US borrowing costs are at a historic low. The government should borrow now, SPEND the money (no more tax cuts) and put the American people back to work building an economy for the future. Education, infrastructure, health care… these are basic human rights, but also the ingredients for economic growth and prosperity. All it takes is the right leadership and political will to make it happen. Unfortunately, leadership and will are two things that America's political system is in desperate short supply of.

    Take care David… please check in on the blog more often!

  20. Debt ceilingon 10 May 2014 at 9:48 am

    The economy will start again once banks want it again.