One of the oldest arguments against stimulus, however, is that which says when a government borrows money to pay for such a policy, it can lead to a decrease in private investment and a decrease in future demand as the higher level of debt must be paid back in the future. Short-term stimulus, therefore, is counter-productive since any debts incurred must be paid back in the future, leading to lower levels of spending and therefore higher unemployment sometime down the road.
A recent study by two leading American economists provides an argument against this view of the crowding-out effect of fiscal policy:
In a new paper* written with Brad DeLong of the University of California, Berkeley, Mr Summers, now at Harvard after a stint as Barack Obama’s chief economic adviser, says that in the odd circumstances America faces today temporary stimulus “may actually be self-financing”…
Mr DeLong and Mr Summers are careful to say stimulus almost never pays for itself. When the economy is near full employment, deficits crowd out private spending and investment. In a recession the central bank will respond to fiscal stimulus by keeping interest rates higher than they would otherwise be. Both effects mean that in normal times the fiscal “multiplier”—the amount by which output rises for each dollar of government spending or tax cuts—is probably close to zero.
The “multiplier” referred to here is what economist refer to as the Keynesian spending multiplier, which is based on the theory that any increase in spending in an economy (say, through a new government spending package), will lead to further increases in spending (as households feel more confident and firms start to hire workers again), therefore the final change in national income resulting from a fiscal policy will be greater than the initial change in spending itself. This multiplier effect has formed the basis of the argument for expansionary fiscal policy since Keynes articulated it in the 1930’s.
The multiplier effect is explained in detail in the following video lesson:
If the multiplier is ZERO, there is no point in engaging in expansionary fiscal policies since there will be no additional increase in output as a government goes into debt to pay for a tax cut or an increase in spending. In the US today, argue Summers and Delong, the multiplier is probably not zero. Additionally, crowding-out is unlikely to occur.
Such constraints are not present now (meaning in the United States in 2012). Investment and demand are deeply depressed and the central bank, having cut interest rates to zero, is not about to raise them. The multiplier is higher than usual as a result…
Basically, Summers and Delong are trying to argue that the US government should engage in another round of fiscal stimulus, to offer additional support to the economy beyond 2009’s “Obama stimulus” and the current bill being debated in Washington, the American Jobs Act, a $470 billion tax cut and spending bill aimed at keeping unemployment from rising in America.
On one side of this debate are those like Summers and Delong who argue fiscal stimulus can pay for itself since it can leads to a larger increase in GDP than the increase in the government’s budget deficit needed to finance the stimulus. On the other side are those “deficit hawks” who believe that any increase in government debt will lead to a fall in current and future aggregate demand from the private sector, and therefore expansionary fiscal policies will just be crowded out by declining private sector spending.
By understanding the circumstances in which crowding-out is most likely and unlikely to occur, we should be able to make a more informed decision about future fiscal policy decisions. As these two economists argue, and as I have tried to present in this post and in a previous post A Closer Look at the Crowding-out Effect, today’s economy provides policy-makers with the perfect opportunity to stimulate aggregate demand by increasing the deficit and providing the US economy with the boost in demand it needs to get America back to full employment.
Why is crowding-out more likely to occur when an economy is already producing at or near its full employment level of output than when an economy is in recession?
How are the theories of crowding-out and the multiplier effect used to argue for two different sides in the debate over the use of expansionary fiscal policy?
Why might a government deficit, paid for with borrowed money, lead to an expectation of a future increase in taxes?
Do you believe the government should take action during periods of economic hardship, or should it just get out of the way and let the economy “correct itself”?
American consumers are a curious bunch. Up until 2007, the average savings rate in the United States fell as low as 1%, and during brief period was actually negative. What does negative savings actually mean? It means that Americans consume more than they actually produce.On the micro level, the only way to consume beyond ones income is to borrow from someone else to pay for the additional consumption. In other words, savings must be negative for one to consume beyond his or her income. The US is a nation of borrowers, but from whom do we borrow? China, for one…
China is a nation of “savers”, where national savings averages 50% of income. What exactly does this mean? Well, just the opposite what negative savings means; rather than consuming more than it produces, the Chinese consume only about half of what it produces. Here’s how James Fallows, a Shanghai-based journalist, explains the China/US dilemma:
Any economist will say that Americans have been living better than they should—which is by definition the case when a nation’s total consumption is greater than its total production, as America’s now is. Economists will also point out that, despite the glitter of China’s big cities and the rise of its billionaire class, China’s people have been living far worse than they could. That’s what it means when a nation consumes only half of what it produces, as China does.
What happens to the rest of China’s output? Naturally, it’s shipped overseas for Americans and others in the West to consume. The irony is that the consumption of China’s products has been kept affordable and cheap thanks to the actions the Chinese government has taken to suppress the value of the RMB, thus keeping its products cheap and attractive to American consumers.
When the dollar is strong, the following (good) things happen: the price of food, fuel, imports, manufactured goods, and just about everything else (vacations in Europe!) goes down. The value of the stock market, real estate, and just about all other American assets goes up. Interest rates go down—for mortgage loans, credit-card debt, and commercial borrowing. Tax rates can be lower, since foreign lenders hold down the cost of financing the national debt. The only problem is that American-made goods become more expensive for foreigners, so the country’s exports are hurt.
When the dollar is weak, the following (bad) things happen: the price of food, fuel, imports, and so on (no more vacations in Europe) goes up. The value of the stock market, real estate, and just about all other American assets goes down. Interest rates are higher. Tax rates can be higher, to cover the increased cost of financing the national debt. The only benefit is that American-made goods become cheaper for foreigners, which helps create new jobs and can raise the value of export-oriented American firms (winemakers in California, producers of medical devices in New England).
Clearly, a strong dollar is good for America in many ways. The dollar’s strength in the last decade can be credited partially to the Chinese, who have been buying dollar denominated assets in record numbers over the last seven years.
By 1996, China amassed its first $100 billion in foreign assets, mainly held in U.S. dollars. (China considers these holdings a state secret, so all numbers come from analyses by outside experts.) By 2001, that sum doubled to about $200 billion… Since then, it has increased more than sixfold, by well over a trillion dollars, and China’s foreign reserves are now the largest in the world.
China’s purchase of American assets keeps demand for dollars on foreign exchange markets strong, thus the value of the dollar high relative to other currencies, allowing American firms and consumers the benefits of a strong dollars described above.
A nation’s balance of payments consists of the current account, which measures the difference between a country’s expenditures on imports and its income from exports (In 2008 China had a $232 billion current account surplus with the US, meaning the US bought more Chinese goods than China bought of American goods), and the capital account, which measures the difference between the inflows of foreign money for the purchase of real and financial assets at home and the outflows of currency for the purchase of foreign assets abroad. In the financial account, China maintains a deficit (meaning China holds more American financial and real assets than America does of China’s), to off-set its current account surplus.The two accounts together, by definition, balance out… usually. Any deficit in the China’s capital account that does not cover the surplus in its current account can be held as foreign exchange reserves by the People’s Bank of China. The PBOC, however, prefers not to hold excess dollars in reserve, as the dollar’s value is continually eroded by inflation and depreciation; therefore it invests the hundreds of billions of excess dollars it receives from Americans’ purchase of Chinese goods back into the American economy, buying up American assets, with the aim of earning interest on these assets that exceed the inflation rates.
The “assets” the Chinese are using their large influx of dollars to buy are primarily US government bonds. The government issues these bonds to finance its budget deficits, and the Chinese are happy to buy these bonds for a couple of reasons: They are secure investments, meaning that unless the US government collapses, the interest on US bonds is guaranteed income for China. That’s one reason; but the primary reason is that the purchase of these bonds puts US dollars that were originally spent by American consumers on Chinese imports right back into the hands of American consumers (via government spending or tax rebates), so they can continue buying more Chinese imports.
The Chinese demand for dollar denominated financial assets, including government bonds, corporate stocks and bonds, and real assets like real estate, factories, buildings and so on, has resulted in a long period of a strong dollar. If the Chinese ever decided to stem the flow of dollars into American assets, the dollar’s value would plummet to record lows, leading to high inflation and eventually a balancing of America’s enormous current account deficit with China and the rest of the world.
However, a falling dollar is the last thing China wants to see happen, for two reasons: One, it would make Chinese imports more expensive thus less attractive to American households, thus harming Chinese manufacturers and slowing growth in China. Two, US dollars are an asset to China. Its $1.4 billion of US debt would evaporate if the dollar took a major plunge. To China, this would represent a loss of national wealth; in effect all that “savings” that makes China so unique would disappear as the dollar dived relative to the RMB. For these reasons, it seems likely that China will continue to be a willing buyer of America’s debt, thus the financier of Americans’ insanely high consumptive lifestyle.
Many people in America are terrified that the Chinese might dump their dollar holdings. What would happen to the value of the US dollar if China decided to change its foreign reserves to another currency?
Why is it very unlikely that China will do this? In other words, how does the status quo benefit China as well as the US?
How do American households benefit from China’s financing of the government’s budget deficits? In what way to they suffer from this arrangement?
Do you think America can continue to finance its budget deficits through the continued sale of debt to foreigners forever? Why or why not?
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!
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 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?
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?
Explain what Zakaria means when he describes the relationship between the US and China as “Mutually Assured Destruction (MAD)”.
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?
Harvard Economist Niall Ferguson appeared on CNN’s GPS with Fareed Zakaria over the weekend. Ferguson has stood out among mainstream economists lately in his opposition to the US fiscal stimulus package, an $880 billion experiment in expansionary Keynesian policy. While economists like Paul Krugman argue that Obama’s plan is not big enough to fill America’s “recessionary gap”, Ferguson warns that the long-run effects of current and future US budget deficits could lead the US towards economic collapse. This blog post will attempt to explain Ferguson’s views in a way that high school economics students can understand.
Government spending in the US is projected to exceed tax revenues by $1.9 trillion this year, and trillions more over the next four years. An excess of spending beyond tax revenue is known as a budget deficit, and must be paid for by government borrowing. Where does the government get the funds to finance its deficits? The bond market. The core of Ferguson’s concerns about the future stability of the United States economy is the situation in the market for US government bonds. According to Ferguson:
One consequence of this crisis has been an enormous explosion in government borrowing, and the US federal deficit… is going to be equivelant to 1.9 trillion dollars this year alone, which is equivelant to nearly 13% of GDP… this is an excessively large deficit, it can’t all be attributed to stimulus, and there’s a problem. The problem is that the bond market… is staring at an incoming tidal wave of new issuance… so the price of 10-year treasuries, the standard benchmark government bond… has taken quite a tumble in the past year, so long-term interest rates, as a result, have gone up by quite a lot. That poses a problem, since part of the project in the mind of Federal Reserve Chairman Ben Bernanke is to keep interest rates down“
There’s a lot of information in Ferguson’s statements above. To better understand him, some graphs could come in handy. Below is a graphical representation of the US bond market, which is where the US government supplies bonds, which are purchased by the public, commercial banks, and foreigners. Keep in mind, the demanders of US bonds are the lenders to the US government, which is the borrower. The price of a bond represents the amount the government receives from its lenders from the issuance of a new bond certificate. The yield on a bond represents the interest the lender receives from the government. The lower the price of a bond, the higher the yield, the more attractive bonds are to investors. Additionally, the lower the price of bonds, the greater the yield, thus the greater the amount of interest the US government must pay to attract new lenders.
Ferguson says that the price of US bonds has “taken a tumble”. The increase of supply has lowered bond prices, increasing their attractiveness to investors who earn higher interest on the now cheaper bonds. Below we can see the impact of an increase in the quantity demanded for government bonds on the market for private investment.
Financial crowding-out can occur as a result of deficit financed government spending as the nation’s financial resources are diverted out of the private sector and into the public sector. Granted, during a recession the demand for loanable funds from firms for private investment may be so low that there is no crowding out, as explained by Paul Krugman here.
But crowding out is not Ferguson’s only concern. The increase in interest rates caused by the US government’s issuance of new bonds could lead to a decrease in private investment in the US economy, inhibiting the nation’s long-run growth potential. But the bigger concern is one of America’s long-run economic stability. If the Obama administration does not put forth a viable plan for balancing its budget very soon, the demand for US government bonds could fall, which would further excacerbate the crowding-out effect, and eliminate the country’s ability to finance its government activities. In other words, such a loss of faith could plunge the United States into bankruptcy.
Fareed Zakaria asks Ferguson:
“Is it fair to say that this bad news, the fact that we can’t sell our debt as cheaply as we thought, overshadows all the good news that seems to be coming?”
The green shoots that are out there (referring to the phrase economists and politicians have been using to describe the signs of recovery in the US economy) seem like tiny little weeds in the garden, and what’s coming in terms of the fiscal crisis in the United States is a far bigger and far worse story.
Finally Fareed asks the question everyone wants to know:”What the hell do we do?”
One thing that can be done very quickly is for the president to give a speech to the American people and to the world explaining how the administration proposes to achieve stabilization of American public finance… the administration doesn’t have that long a honeymoon period, it has very little time in which it can introduce the American public to some harsh realities, particularly about entitlements and how much they are going to cost. If a signal could be sent really soon to the effect that the administration is serious about fiscal stabilization and isn’t planning on borrowing another $10 trillion between now and the end of the decade, then just conceivably markets could be reassured.
Ferguson is saying that only if the Obama administration begins taking serious steps towards balancing the US government’s budget can it hope to stave off an eventual loss of faith among America’s creditors (and thus a fall in demand for US bonds). It will be a while before tax revenues are high enough to finance the US budget. But if the country does not begin working towards such an end immediately, it may find itself unable to raise the funds to pay for such public goods as infrastructure, education, health care, national defense, medical research, as well as the wages of the millions of government employees. In other words, the US government could be bankrupt, and its downfall could mean the end of American economic power.
The power of the bond market should not be underestimated. America’s very future depends on continued faith in its financial stability and fiscal responsibility.
Why do you think the US government has such a huge budget deficit this year? ($1.9 trillion) Previously, the largest budget deficit on record was only around $400 billion.
How does the issuance of new bonds by the US government lead to less money being available to private households and firms?
Do you think investors will ever totally lose faith in US government bonds? Why or why not?
In what way is the government’s huge budget deficit a “tax on teenagers”? In other words, how will today’s teenagers end up suffering because of the federal budget deficit?
To learn more about the power of the bond market, watch Niall Ferguson’s documentary, The Ascent of Money. The section on the bond market can be viewed here:
Newsweek international edition editor Fareed Zakaria explains in clear terms the root causes of the United State’s economic hardships. Simply put, Americans have lived beyond their means for far too long.
When a household, a firm, or a national government spend more than it earns (in income or tax revenues), it must borrow to do so. The only problem with this type of deficit financed spending is that at some point “the only way people will keep lending you money is that you have to pay higher and higher interest rates…” This, according to Zakaria, is why the US economy has begun to slow down. Higher interest rates make borrowing and spending less and less attractive, while making savings more attractive.
Savings rates have started to rise in America as our debts have come due. Higher savings means less spending, less spending means weak Aggregate Demand, which means slower growth and rising unemployment. There you have it, the root cause of our economic meltdown. Americans have spent beyond their means for far too long; the question is, have we learned our lesson? Will our current hardships teach us to spend more responsibly in the future?