Progressives’ Keynesian economist in chief, Paul Krugman, has been second to none in calling out policymakers’ focus on reducing budget deficits when economies were still weak (also known as “austerity”). Given that record, his oped in today’s NYT may surprise some readers. He argued that, as the economy closes in on full employment, fiscal budget deficits could crowd out private borrowing, pushing up interest rates and slowing growth.
Paul’s argument in the oped shouldn’t actually be surprising; he has long depended on a very simple and, as the record shows, very insightful, application of the ISLM model, a diagram of how interest rates and output interact in key markets in the macroeconomy. See here for his useful discussion of how the model ticks.
But is Paul right? Despite the fact that he invariably turns out to be so–i.e., correct–I’m not nearly so worried about interest-rate crowd-out resulting from the big, wasteful tax cut team Trump and his Congressional allies will pass, I fear, sometime later this year. What I’m worried out is what their raid on the coffers of the US Treasury will do to the programs we increasingly need to meet the many challenges we face.
Let me explain.
Here at OTE, we maintain that all economic models are wrong but some are sometimes useful. For years, at the end of the ISLM section of economics courses, there’s been this little section that shows how the model changes in a particular type of recession when two things happen: demand significantly contracts and interest rates fall to around zero (the dreaded liquidity trap). At that point you get the diagram Paul put in his link above (ignore for a moment the “IS Now” line, which I plugged in there, as did Paul in a post today).
The point of the ISLM-in-recession model is that policy makers can do a lot to boost demand without worrying about crowding out private investment, inflation, or push-back from the Fed. So let the fiscal stimulus rip. The question in such moments shifts from “is the deficit too large?” to “is the deficit large enough?!”
But according to the model, you should only let it rip up until the point when the IS curve shifts enough to the right (“IS Now”) that the economy is back in a place where increased demand will invoke those negative outcomes just noted.
One implication Paul draws from these dynamics is that Republicans, motivated not by improving the economy but by bashing Obama and the D’s, inveighed against deficits when we needed them and are about to shift to not caring about them when deficits – again, according to the model – could actually do some harm.
But how reliable is this crowd-out hypothesis? It’s actually pretty hard to find a correlation between larger budget deficits and higher interest rates in the data.
There are some obvious reasons why that’s the case. Oftentimes, like in the Great Recession, a large budget deficit corresponds with demand contraction and very low rates, so that messes up the predicted correlation. The budget deficit got to -10% of GDP in 2009 and interest rates were stuck around zero. That also implies rates can’t fall as deficits have become less negative.
To see if anything jumps out, the figure plots real rates on the 10-year bond against the deficit from 1990 to 2007, years chosen because the deficit moved around a lot in those years, including into surplus at the end of the 1990s, and the Fed wasn’t nearly as much in the interest-rate setting mix as they’ve been since then. But it’s just pretty much a random plot (if you plot changes in the variables, it still looks random; same with nominal rates; same with corp bonds, etc.).
The raw data miss a potentially important expectations component often in play regarding movements in rates. Very recently, investors’ expectations of Trump-induced fiscal expansion, along with the Fed’s plans to hike rates, have pushed up inflation and interest rate expectations. But it’s not at all clear how much of that relates to the expectation that deficits will crowd out private borrowing.
So is Paul making a mistake to continue to depend on the model that has heretofore served him—and anyone else willing to listen—so well? My guess is that deficit crowd-out is not likely to be a big problem, as in posing a measurable threat to growth, anytime soon, even if deficits, which are headed up anyway according to CBO, were to rise more than expected.
The global supply of loanable funds is robust and, in recent years, rising rates have drawn in more capital (pushing out the LM curve). Larger firms have enjoyed many years of profitability without a ton of investment so they could use retained earnings (the fact of unimpressive investment at very low rates presents another challenge to this broad model). And most importantly, while we’re surely closer to full employment, there are still a lot of prime-age workers who could be drawn in to the job market if demand really did accelerate.
(This, by the way, is the only part of Paul’s rap today that I found a bit confusing. He’s a strong advocate of the secular stagnation hypothesis, wherein secular forces suppress demand and hold rates down, even in mature recoveries. His prediction today seems at odds with that view.)
And yet, I’m still really worried—profoundly so—about crowd-out, just not the interest-rate type that Paul’s worried about. What keeps me up at night is that if Republicans are able to waste a bunch of money on deficit-inducing tax cuts that go mostly to rich people, there will be too few resources to support the safety net, public goods, health care, and possibly even social insurance.
This, I’ve long maintained, is the true target of trickle-down tax cuts: force the government to shrink by cutting off its revenue oxygen. And this is a particularly damaging time to be cutting revenues; our demographics alone mean we’re going to need more, not less, revenues in coming years. And I’m not even talking about what we’ll need to address the challenges posed by climate change, inequality, poverty, our infrastructure needs, geopolitics, and Buddha-knows what else.
So I stand firmly against big, dumb wasteful tax cuts. Not because I think they’re going to raise interest rates that much (though I could be wrong and PK is typically right), but because they’re going to shut down the federal government’s ability to do what needs to be done.