Building a Stairway to Heaven

By Dec 16, 2012, 10:24 AM Author's Blog  

In the early 2000s Paul Krugman was outraged by the Bush administration’s fiscal deficits, and rightly so.  Bush ran sizable deficits during the 2001 recession, which is appropriate.  And those deficits raised the ratio of public debt to GDP, which is also appropriate.  But what Bush failed to do is pay off those debts during the goods years that followed (2004-07).  The debt ratio merely leveled off during the expansion.  Then the debt ratio rose again during the 2008-09 recession, and the subsequent sluggish recovery.  With this sort of fiscal policy the ratio of debt to GDP looks like a sort of staircase stairway to heaven; flat stretches during good years, followed by steep increases during recessions.   You need to offset the increases in the debt ratio during bad years, with declines during good years.  Otherwise you end up like Japan, with an ever-increasing debt ratio.  Instead the US and Europe seem to be edging toward the Japanese model.

Here’s Paul Krugman on the current situation:

So, in fiscal 2012 (which ended September 30) we did in fact have a federal deficit of $1.1 trillion (pdf). The question is, however, whether this deficit represents, as everyone claims, a fundamental mismatch between what we want and what we’re willing to pay for — or whether it’s mainly just a reflection of the depressed state of the economy.

For starters, we need to be aware that we don’t need a balanced budget to have a stable fiscal situation; all we need is for debt to grow no faster than GDP. At the beginning of fiscal 2012, federal debt in the hands of the public was $10 trillion. Meanwhile, most estimates of long-run growth and inflation put them at a bit more than 2 and 2 respectively; so we can reasonably say that nominal GDP growth can be expected to be more than 4 percent per year. If debt grew at 4 percent, it would grow by $400 billion. So the deficit should be scaled down by that much.

I’d say it is a fundamental mismatch, partly because I am less optimistic than Krugman that programs like food stamps, unemployment compensation and disability will ever return to normal (I hope I am wrong.)  But mostly because I’m afraid we may become complacent if we eventually get to a stable debt/GDP ratio, with a $400b deficit.  Most likely that will occur many years into the recovery, and our “success” will be almost immediately followed by another recession, and another increase in the debt/GDP ratio.

Just to clarify, this isn’t so much a critique of Krugman’s overall views as a warning that we shouldn’t become complacent.  It’s true that some level of deficits are sustainable if NGDP is rising.  Ironically the country that this argument is most applicable to is Australia, as they seem to have decided not to have recessions.  (They lack our Puritanism.)  Yet they have a tiny national debt.  Nor do I disagree with Krugman’s view that the current budget deficit is not the big issue; it’s a lack of AD on the one hand, and a looming medical/demographic problem on the other.  And I’d add that I expect real interest rates to stay very low for many years to come.

On the other hand I expect countries with low national debts (Australia, Singapore, Switzerland, some of the Nordic countries) to do much better in future years than places like Japan and Italy, which have very large debts.  So we shouldn’t become complacent about a fiscal policy that barely reaches a stable debt/GDP ratio at the peak of the business cycle.

In conclusion, I’d rather not “scale down” the deficit by $400 billion, but rather work very hard to eliminate even that deficit, so that we can again see a falling debt to GDP ratio.  The best way of doing so?  Fiscal austerity plus a much higher NGDP target, level targeting.

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