Qs & As

July 15th, 2011 at 11:43 pm

Q: How can we –Rs and Ds alike – now be assuming that deep cuts are what this economy needs? Are people assuming spending cuts will be expansionary? Is there any sound economics backing this up? Or is it just confidence fairy stuff?

A: For some it’s confidence fairy dust, but for others, there are a few academic papers that claim evidence in support of the idea that spending cuts are expansionary.  But the evidence is very weak and certainly doesn’t apply to the current conditions here in the US.

Here’s my review of an excellent paper challenging this idea of expansionary contractions (EC…sounds like giving birth).  Note the figure which shows that in the past, any spending cuts associated with growth occurred in economies that were pretty much back to full strength.

The nation’s premiere expert on the fallacy of EC is my CBPP Chad Stone.  See his testimony before Congress and why this qualifies as the new voodoo economics.

I always come back to the fact that GDP equals private consumption and investment, plus net exports, plus gov’t spending.  In the full employment economy, you can tell more complicated stories about gov’t spending crowding out private borrowing.  But in today’s economy and that of the near future, the private sector components of that equation aren’t helping much.  Cut G (gov’t spending), and I guarantee you, nothing good will come of it.

It’s really that simple.

Q: Why, during the financial crisis, were Treasury and the Fed adamant about protecting debt holders?

A: Not all debt holders.  Lehman failed and creditors lost money, and bond holders in the GM and Chrysler also “took haircuts” during the government take over.

But in general, debt holders were held relatively harmless for two reasons.  One, to avoid generating high risk premia on loans.  If creditors think there’s a chance they’ll get stiffed, they’ll want protection and we did not want to see interest rates spike then anymore then we do now.

But more important is fear of contagion.  This is certainly the case in Europe right now, where rather than address what looks to me like Greek insolvency, the bankers of Europe are calling it a liquidity crisis, pumping in loans, and protecting lenders.  Well, those banks hold a lot of Greek debt (about 50% of it) and some of their books could look pretty thin if they took writedowns.

I’m not saying I agree.  There are times when it’s better to rip off the band aid and accept that defaults and restructurings are part of life under capitalism.  But I will say, with hindsight, I think the evidence supports the view that Geithner played it correctly.

But I’m not nearly so sure that’s the right play with Greece.

Q: What confuses me is the idea that we first take care of the deficit and then we can focus on jobs. But wouldn’t any effective Keynesian jobs program call for more deficit spending?

A: That’s confusing because it’s backwards.  In the short term, i.e., now, the economy is practically on its knees, begging us for short term stimulus to boost job growth.  And yes, it would call for more spending.

That spending would be temporary, and thus would have virtually no impact on the medium or long-term deficit, nor would it add anything to the growth of the debt.  The Recovery Act was $800 billion of deficit spending, and look how its impact on the deficit becomes de minimis by 2013.

That doesn’t mean we ignore the fact that the current budget path is unsustainable, meaning that even with a recovered economy, what we take in and what we spend are so misaligned that each year, debt would still be rising as a share of GDP (i.e., “structural” deficits).

But the key is to get the sequencing right on this.  Plot the sustainable path now but don’t start down it until the economic recovery truly takes hold.

BTW, Greg Sargent has an interesting analysis of the President views on this question from his press conference today.   Obama’s analysis is more political or optical then Keynesian—basically, he’s saying that generating some serious deficit savings gains you the trust you need with the public to do some stimulus.

Sargent points out there may be something to that approach:

“Once Clinton restored his credibility with the middle of the country…he was able to pick (and win) major fights over the proper role of government and the safety net that set back the GOP drive to dismantle government for a decade.”

I agree but again…sequencing.  This is demonstrably NOT the time to show you can whack away at the near term deficit.

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7 comments in reply to "Qs & As"

  1. Mitchell Freedman says:

    Greg Sargent is as wrong as the president. The public, if we read the specifics in polling data, supports exactly what Jared Bernstein and Paul Krugman and so many others want: Stop spending on silly wars in Iraq and Afghanistan. Raise the income tax and capital gains taxes on those making more than $250K a year (at least to Clinton levels for goodness sakes!). Don’t touch Social Security. Don’t touch Medicare or Medicaid.

    And let’s put people to work re-building and building infrastructure.

    Greg Sargent fails Political Science 101 because people don’t vote out incumbents who spend more money than the revenue that comes in. They vote out incumbents who don’t do anything to help lower unemployment.

    The beauty of what Jared and others call for is that it is not only sound public policy. The public also endorses it. Obama is being stubborn, ignorant and politically tone deaf, a trifecta of a losing candidate. His only way to victory is if the Republicans nominate someone like Michelle Bachmann, Rick Perry or one of the other creepy candidates.

  2. foosion says:

    As Mitchell says, there’s considerable public support for doing the right thing.

    The public strongly opposed extending the Bush tax cuts for those making over $250,000, yet the Republicans insisted on it. The public cares deeply about Social Security, Medicare and Medicaid, because it affects them directly, yet Obama is prepared to gut it.

    At the end of the day, the public cares about results on them personally. The deficit has no direct effect. Unemployment and wage growth have a direct effect. Entitlement programs have a direct effect.

    Stimulus now, deficit reduction once unemployment is lower and growth higher. Alas, Obama has bought into the Republican’s political framing, which likely makes rational policy impossible. That doesn’t mean Obama has to make things worse, by going for larger cuts.

    The notion that we must cut now so that we might be able to increase later is insane. Economically, the cuts are likely to have the paradoxical effect of increasing the deficit by cutting growth. All a smaller deficit might do is allow the Republicans to cut tax rates once they return to power.

  3. comma1 says:

    I realize that part of being taken seriously in DC requires pretending that Clinton was a successful Democrat/president — but really? Obama should pretend it’s 1995 again — as if that went well for progressives, or centrist democrats or centrist republicans or anybody without a tech degree or enough free cash to take advantage of the tech bubble. Besides Obama is too busy pretending it’s 1984.

    As always, political thought says “build more to the right, then they will come.” 1) It is laughable that Clinton’s “restoration” with the “middle of the country” had any impact at all. Clinton had the dumb luck to be president during the largest shift in technology in a century, if not millenia. So what is more likely, that Clinton “carved out room” by doing exactly what conservatives wanted him to do, or he “carved out room” because of the tech revolution and bubble that had high-schoolers getting paid 20$ an hour to install AOL on computers?

    2) Clinton didn’t have an argument over the size and role of government. He did the opposite, he conceded the ideas that Reagan began. He deregulated Wall St. He did nothing about clean energy. He dismantled welfare. He was impeached and got nothing in return out of it. If anything, president Clinton should be held accountable for being the first president to let this creep to the right continue under Democratic rule — this is his real failure.

    3) The GOP drive to dismantle the government was not “stopped for a decade.” The GOP was in power for a decade, how is that “stopping for a decade?” Only in these stupid political circles could that be considered a success. By that definition Obama is shaping up to be a historic success too!

    4) Who cares how Obama “feels” about Keynes? If he is going to rule with voodoo, it is a moot. I don’t care what he thinks if he isn’t going to back up such thoughts with action. So far his penchant for saying, or thinking, one thing and doing the opposite is his only consistency. Oh yeah, that and contempt for the people who go him elected. What a joke. I just hope that this 8th term of conservative dogma does not put the final nail in the coffin of the American dream — cause that’s where we are. Furthermore, you’re kowtowing to people claiming Clinton was a success, (even if you are in DC) does nothing but send this country backward — 1996, or 1980, or 1800′s.

  4. David Kaib says:

    The best way to have credibility to protect wildly popular programs is to boldly argue in favor of them. Why would one need credibility on something the public doesn’t care that much about in order to achieve something that they do care a great deal about?

    More importantly, the public never realized that deficits were eliminated under Clinton. Sorry – I can’t find the link that shows this, but polling showed that the public was unaware of this development. In general, any argument that says X will happen in Washington, where X is some abstract thing that does not directly affect their lives (unlike, say immediate changes in SS, which lots of regular people would experience), then the public will respond by adopting Y, is flawed unless you can prove the public knew X happened. Odds are, they don’t. (No, this doesn’t mean the public is stupid, it means there is a wide ago between the concerns of elites and non-elites, and that the media and political system do a terrible job of informing non-elites of the things those people say matter.) The general argument for this can be found here: http://www.brynmawr.edu/socialwork/GSSW/schram/sossschramapsr.pdf

  5. Taryn H. says:

    Professor Bernstein:

    First off, thank you so much for answering my question (mine was the first question) and for providing the links to your review and Chad Stone’s testimony. Very clear, very helpful explanation and precisely the links I was looking for.

    I have a related follow-up question (although I completely understand if you don’t answer it).

    My last question was essentially whether expansionary austerity had any academic support.

    The next related question is whether attempting to cut the budget deficit when we’re in a liquidity trap can actually hurt our longer-run debt position?

    Richard Koo has unequivocally argued that when you’re in a liquidity trap (which he refers to as a “balance sheet recession”), attempting to reduce the deficit will actually increase debt. This week, Brad DeLong suggested austerity would “probably” increase long-run debt and he supported the argument with some rough calculations. Paul Krugman, being slightly more cautious, stated that austerity “may” actually increase long-run debt.

    Koo: http://www.economist.com/economics/by-invitation/guest-contributions/austerity_fails_after_balance_sheet_recession

    Brad DeLong: http://delong.typepad.com/sdj/2011/07/right-now-contractionary-fiscal-policy-probably-makes-the-long-run-debt-problem-worse.html

    PK: http://krugman.blogs.nytimes.com/2011/07/15/the-wrong-perversity/

    Why are DeLong and Krugman saying “probably” and “maybe”? Don’t we have enough data on austerity during a liquidity trap to know what happens to debt? There’s US 1937, Japan 1997, Japan 2001 and now there’s austerity all over Europe. Koo has some general numbers on this (cited above), but has no one looked closely at this? Can’t we get Chad Stone on it or something?

    Also, if this turns out to be true and doesn’t already have a name, I nominate the “paradox of austerity”: In a liquidity trap, trying to reduce deficits increases debt.

    Alright, that’s way too many questions and way probably way too technical, but if anyone wants to give it a go or link me to anyone talking about this, it’s always appreciated. Thanks again for answering my question and keep doing your best to save the country.

  6. Taryn H. says:

    I’m sorry it’s Dr. Bernstein – not Professor Bernstein.

  7. Lex says:

    With all due respect to Sargent, what planet is he living on?

    When Clinton’s budget passed Congress in ’93, it did so with nary a single Republican vote, and Al Gore had to break the tie in the Senate, right? And because Congressional Republicans have gotten SO MUCH MORE RESPONSIBLE NOW than in ’93, we’re supposed to believe that Democrats showing Republicans that they’re serious about deficit reduction will convince them to do what’s best for the country (which ALSO happens to be, as other commenters observe, what a large majority of the country wants)?

    No, I think not. Congressional Republicans are looney tunes and have demonstrated time and time again that their agenda is not creating jobs or otherwise working toward the public good, it’s opposing Obama and cutting taxes for rich people, period, the end. Obama needs to do what he said last week he would do: go over the heads of Congressional Republicans to the American people.

    Problem is, he’s not going to do that, and the reason is that right now what he wants is not what the American people want. You can speculate as to the reasons for that, but the phenomenon itself is pretty damned obvious.

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