DeLong on Deficits and Politics

Since at least 1825—when Britain’s canal speculation-driven bubble collapsed...governments have responded to such collapses in risk tolerance. Households feel poor and stop spending and businesses stop investing and shrink operations because risky asset prices have collapsed as investors scramble for safety. The government tries to fix the situation by making more safe assets and expanding the demand for risky ones:

• Guarantee private debt to turn risky assets into safe ones.
• Nationalize troubled institutions to turn dodgy liabilities into gilt-edged ones.
• Buy long-duration and other risky assets for cash.
• Reduce the demand for safe assets by eliminating any expectations of nominal deflation.
• Print up a huge honking extra tranche of new safe assets—government bonds—by bringing forward in time government spending and postponing taxes.

There are limits to these policies. The feckless bankers who caused the problem have leveraged positions in risky assets—and benefit enormously from policies that raise their prices. Knowledge that there was a Bernanke put last time will encourage future irrational exuberance. Governments that buy up so many assets that they own banks and companies are unlikely to run them well. ...

With that as background, I have two things to say. First: we need bigger deficits now. Unemployment is at 10%. The U.S. government can borrow for thirty years at an expected real rate of 2.12% while leaving bondholders holding 100% of inflation risk. Over the past 30 months the private market has swallowed an extra $2.9 trillion in U.S. Treasury debt—from $4.9 to $7.8 trillion—without that extra debt having moved Treasury interest rates up at all. Commit $1 of real cash flow to debt amortization and you can raise $40 today if you are the U.S. government selling into the Treasury market—and only $15 if you are an S&P 500 company. If you have any trust in price signals at all, right now they are yelling at us that the government should be raising more money on financial markets and spending it.

And there is no sign in financial markets that we are close to the edge of America’s debt capacity right now. And our reserve army of the unemployed is larger than the U.S. armed forces at their World War II peak.

Second, we need smaller deficits later for a value of “later” equal to “soon,” as in “before 2015.” CBPP wants to stabilize the debt-to-GDP ratio in normal times. But we have to do better. We need the debt capacity to run large deficits in extraordinary times: World Wars II, Marshall Plans, bribing the Chinese to build nuclear rather than coal-fired greenhouse gas-emitting power plants, paying to move the population of Bangladesh to Alberta and build them places to live there, and fighting depressions are all things that all for large deficits, and if your debt-to-GDP ratio is stable in normal times you won’t have the debt capacity to do so.

For thirty years we have by and large been unable to make these decisions. Our governance structure has been broken: the unbalanced Reagan (as opposed to Ford) Republicans—some thinking that large unfunded tax cuts would force spending discipline on congress, some thinking that large unfunded tax cuts would unleash a huge economic boom, rather more thinking that promising lower taxes and more spending would get them jobs and après nous le deluge. The round-the-bend Gingrich (as opposed to Darman) Republicans, who developed the strategy of create-gridlock-and-blame-the-other-party and rode it to power. And now, as a health care bill that is Mitt Romney’s plan moved to the right attracts zero Republican votes...

At the moment our health care system spends twice as much as other countries for worse outcomes. We have a 6.9% of GDP CBO baseline fiscal gap. And virtually everybody expects the members of congress to decry our fiscal future and then turn around and vote overwelmingly to reject PAYGO and increase the fiscal gap by an extra 2.5% of GDP...

---Brad Delong's blog, 1/18