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Since I can remember I’ve loved reminding my audiences that economics is not morality play. It wasn’t until Paul Krugman started blogging that I realized that I must have picked it up from one of his early writings.

That virtue can sometimes be vice is one of the most fun lessons of economics. There is a perverse delight in explaining how foreign aid may impoverish the Third World but sweatshops would make it grow rich.

I can understand why many of my fellow economists were so eager to transport this insight to the political realm. Politics they argued was a fight between interest groups – a battle over the fiscal commons. There weren’t good guys and bad guys. There were just naturally self-interested people.

Tyler Cowen pays homage to this legacy in a recent NYT piece

James M. Buchanan, a Nobel laureate in economics — and my former colleague and now professor emeritus at George Mason University — argued that deficit spending would evolve into a permanent disconnect between spending and revenue, precisely because it brings short-term gains. We end up institutionalizing irresponsibility in the federal government, the largest and most central institution in our society. As we fail to make progress on entitlement reform with each passing year, Professor Buchanan’s essentially moral critique of deficit spending looks more prophetic.

Curiously Tyler refers to a rational actor model as a moral critique but then again he certainly knew Buchanan better than I.

Still, to borrow a phrase from another of my favorite economists, the only problem with this analysis is that it is at odds with the facts.

If we want to build a model of what the government spends money on we would be best to start this way: ask people what social obligations do they believe “society” has. Look around for the cheapest – though not necessarily most efficient – programs that could credibly – though not necessarily effectively– address those obligations. Sum the cost of those programs. That will be government spending.

Contrary to Jonah Goldberg and others who see Canada and the United States as examples of two clashing ideologies, they are actually examples of two different ethnic distributions.  The United States is not Canada because there is ethnic strife between Southern Blacks and Southern Whites. That strife reduces the sense of moral obligation on the part of the white majority and so reduces government spending.

I want to be very clear that I don’t say this to paint those against social spending as racists. From where I sit I am betting that most of the intellectuals lined up against expanding the welfare state are naively unaware that their support rests upon racial strife. Otherwise they would realize that as America integrates they are doomed. They are fighting as if they believe they have a chance of winning. Given the strong secular trend in racial harmony, they do not.

I point this out also to show why the major Republican strategy for limiting government was doomed from the start and why I am also not particularly worried about Americas fiscal future per se.

In the 1980s some conservatives believed that they might not be able to cut government but they could cut taxes and thereby starve the beast. Rising deficits would force the hand of future governments. Spending would have to be cut in order to bring the budget into balance.

Much of the current handwringing about fiscal irresponsibility is a sense of alarm not only on the right, but throughout much of the political center, that these spending cuts are not actually materializing.

But, by what theory of government did you ever believe they would? Governments don’t look at how much money they have and then decide what they want to buy. They decide what they want to buy and then they look for ways to fund those purchases.

Divorcing the two – through sustained deficits – was only going to lead to ever increasing levels of debt. This is what we got. At no point was the beast ever starved. The peace dividend lowered government spending growth somewhat, but that was undone by the war on terror. Otherwise spending hummed along, as it always will, with the government buying things the public thinks it ought to buy.

Yet, if this is causing upset stomachs among many of my fellow bloggers it calms mine. Its quite clear how this will end. Racial strife will continue to abate. The public will coalesce around the welfare state and taxes will be raised to meet the cost.

The fundamentals do not predict rising debt forevermore. The fundamentals predict a VAT.

This is not to say I am unconcerned about our economic future. Health care costs will continue to eat up more and more of our economy unless something is done. However, trying to convince people that health care is not a social obligation a fool’s errand. The best you could do is convince them we have no obligation to the other. As the other integrates this will likewise prove impossible.

No, people will ultimately believe that health care for all is a social obligation and therefore government will pay for it. There is no more analysis to be done on that part of the question.

The only part left is looking around for the cheapest program. This is where our attention should be focused. Can we lower the cost of those obligations? Can we make medicine more efficient?

If we can there will be economic room for other things. If we can’t, well just hang in there until the artificial intelligence revolution.

Paul Krugman is doubting that financial collapse was a key part of the recession

My take on the US economic crisis has increasingly been that banks were less central than many people think, while the housing bubble and household debt are the key players — which is why financial stabilization by itself wasn’t enough to produce a V-shaped recovery.

I am not sure how central people think the banks were so I am not sure how hard to push back.

My take is that household debt and the banking collapse were symbiotic in their destructive nature. At the center of the story, however, is money and credit.

Highly leveraged households meant that consumers were very sensitive to economic disruption. The danger in having a lot of leverage is that when things go bad they go really bad. The flipside of course is that when things go good they go really good. We have to have some story about how things started to go bad before household debt can be invoked to explain why things went really bad.

Debt is ultimately just a promise.  Lots of debt is precarious when there are many interlocking promises that depend crucially on one another. If one person flakes – as eventually one person will – the whole network could crashing down.

When the banking sector collapsed it created a huge flake. Lending fell dramatically. Projects and production that were dependent on a smooth supply of lending could not go through. This rocked many households who were themselves in locked into sensitive promissory positions.

Now knowing that a flake was possible we might step back and ask either “why did we allow such sensitive networks to develop” or “why were housing prices allowed to climb on top of these tightly wound promises”

However, the more fundamental mistake was thinking that the Fed was prepared to firewall this whole thing if it went bad. It wasn’t that people couldn’t see the debt or the housing bubble building. Its that they thought it didn’t matter. The phrase commonly thrown around was “the Fed doesn’t target asset prices.”

That’s a more convoluted way of saying, this business with housing and mortgages may be a house of cards, but “so what?”

I don’t want to sound like I am pointing fingers here. I was deeply sympathetic to that view. Sufficiently powerful monetary policy I thought, and honestly still believe, could offset virtually any shock.

What we wasn’t appreciated fully enough was the fact that monetary policy would not be powerful enough; that central bankers are only human and that they will be hesitant to take extreme action.

In the light of those limitations it becomes more important to manage precarious situations as they arise. However, from the point of view of understanding the economy we also need to note, as Matt Yglesias reminds us to do, what powerful monetary policy can indeed accomplish. 

I had been urging the Fed to effectively “go negative” by promising inflation. In Sweden, the central bank went literally negative.

For a world first, the announcement came with remarkably little fanfare.

But last month, the Swedish Riksbank entered uncharted territory when it became the world’s first central bank to introduce negative interest rates on bank deposits.

Even at the deepest point of Japan’s financial crisis, the country’s central bank shied away from such a measure, which is designed to encourage commercial banks to boost lending.

The result was a surging Swedish economy. Indeed, as the FT reports, the fastest growth on record. This is coming out of a worldwide economic collapse.

This is also despite a long-run price to income profile that’s not that far off from the United States and peaked around the same time


I don’t think Krugman is doing this, but it is easy to get too caught up in thinking the macroeconomy is an extension personal finance. Having bought a house you couldn’t afford seems like a really bad situation to be in, and if everyone is in that situation then it seems like that ought to be really bad for the economy.

However, keep always in the front of your mind that a recession is not simply a series of unfortunate events.  A recession is when the economy produces less. For example,  the AIDS epidemic in Botswana is a horrible event for millions of people that uprooted lives and destroyed families and promises to leave a generation of orphans.

However, Botswana’s GDP growth didn’t turn negative until Lehman Brothers went under. 


That a Global Financial Crisis could do what rampant death and disease could not, is an important indicator of the nature of recession.

A recession isn’t when bad things happen, whether that’s loosing your house to foreclosure or your parents to AIDS. A recession is when the economy produces less.

Somehow you have to make a link between the bad thing happening and the economy producing less. I maintain that, that link almost always runs through the supply of money and credit.

So two misunderstandings. One is that you have to balance the budget to reduce the debt load. Yglesias tackles that here.

With great fear of being taken out of context by Ron Paul supporters I should make clear that the debt only has to grow more slowly than the Nominal GDP, not Real GDP for the debt burden to fall.

So if our total debt is $10 Trillion and our economy is growing at 5% nominally, then any deficit less that $500 Billion will tend to shrink the debt burden. Any deficit greater than $500 Billion will tend to increase it. This is why we haven’t had many surpluses in US history but the the debt burden is usually falling.

FRED Graph

The reason its nominal GDP that counts is because interest payments are figured in as part of the deficit. Suppose we have lots of inflation. That will tend to make interest payments on the debt rise. You could think of this as the debt growing to match inflation.

However, the US Budget accounts for interest payments on the debt. So when you are comparing the deficit to the growth rate of the economy, you have already accounted for the debt growth due to inflation.

The second thing you can see from that graph is that the debt burden has been much higher in the past.

In 2009 we just broke through the Reagan-Bush peak and haven’t come close to the WWII peak. Moreover, this is dominated by the recession. The recession contributes in four ways

  1. A smaller economy means less revenue and hence a higher deficit. This amplified by our progressive tax structure
  2. A smaller economy means lower GDP, and so the debt burden is divided by a smaller number
  3. Tax cuts, spurred on by recession have brought down revenue still further
  4. Spending, automatic and planned has increased in response to the recession

As the economy improves the northward spike will abate.

In the out years we can talk about deficits that are set to accumulate. However, this represents health care costs that the government has promised to pay for but not promised to tax for. In theory either of those promises could be changed.

More importantly, however, health care takes resources away from the rest of the economy whether the government pays for it or not. Obsessing over future budget deficits because of Medicare and Medicaid but ignoring future stagnant or even falling take home pay because of private health care is silly.

We could just end any and all public financing for health care tomorrow and the budget deficit and future deficits would vanish. Woo-hoo! However, the problem of expensive health care would still be with us.

In a Times article a few days ago is this interesting quote from Laurence Meyer, a former Fed governor:

It was this impending gridlock that might have pushed Mr. Bernanke to move, said Laurence H. Meyer, a former Fed governor. “Bernanke has said that fiscal stimulus, accommodated by the Fed, is the single most powerful action the government can take for lowering the unemployment rate, when short-term rates are already at zero,” Mr. Meyer said. “He has nearly pleaded with Congress for fiscal stimulus, but he can’t count on it.”

I’m taking this as a explicit, and unshrouded nod to the concept of “money financed fiscal policy”. Or, what is lovingly referred to in the press as “monetizing debt”. This is a situation where the government draws up a plan to distribute money, whether through direct transfers or increases in government consumption/investment, has the Treasury issue debt in the amount decided upon Congressionally, which the Fed then purchases with newly-coined money (and for hysterics, this money is created “out of thin air”!).

As Karl has noted, and as concurred upon by commenter Jazzbumpa, a program such as this would inevitably “work”. And by work, I mean it would raise inflation expectations such that businesses would be induced out of cash and into consumption and capital goods. This, of course, is something that the ARRA failed to do. This is true, but it is optimal policy?

I say no. I don’t think that fiscal policy need ever enter the picture. I think that the Federal Reserve should announce an explicit target to get the growth path of nominal expenditure to the previous level from the Great Moderation, and then continue to level target a stable growth path from there. In doing so, the Fed should immediately stop sterilizing its own open market operations by paying interest on excess reserves (indeed, the interest in reserves should be slightly negative, reflecting real rates). The Fed could then move down the yield curve, and buy Treasury debt that currently resides on the balance sheets of banks, businesses, and individuals; moving the price up while moving the yield down to zero. I suspect that there is enough debt out there that it would not run out of things to buy before hitting its nominal target. However, if it does, then it can move on to other assets.

The key thing here is that there are many interest rates in the economy, and not all of them are pegged at zero. My point is that far from needing to bring fiscal policy into the picture, monetary policy could go it alone. If the SRAS curve is relatively flat, which is a prediction of macro models, then the resultant inflation expectations would produce much more real output than inflation (lets ballpark and say 5% real growth, 2% inflation), up until full employment is reached — at which point, the Fed would revert to its normal level target. I do not think that Bernanke is “pleading with Congress” for fiscal policy. Why would he? If he identifies that aggregate demand is low relative to the Fed’s own target, then by all means, he should be taking steps to move aggregate demand to where the Fed is most likely to hit their target goals.

To those who say that it is unrealistic that the Fed would do this, is it any more unrealistic than hoping for money-financed fiscal policy?

[H/T David Leonhardt]

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