Secular stagnation, secular exhilaration and fiscal policy

Paul Krugman is right: secular stagnation has historically always referred to a situation of persistent low demand, which, according to my old 1971 Samuelson and Scott textbook, renders it inappropriate for governments to attempt to balance the budget over the business cycle (as per the principle of countercyclical compensation).

While in a secular stagnation (Is the shorthand 'SecStag' catching on?), Samuelson and Scott suggest that constant or near-constant government budget deficits are needed to sustain an adequate level of demand to achieve full employment, as shown here:

Samuelson and Scott (1971:437)

The policy stance required during secular stagnation contrasts with the stance needed during periods of so-called "secular exhilaration" (with high demand), during which the right policy is running budget surpluses as a way to avoid overheating the economy and reduce inflationary pressures.

It's true that sustained deficits will increase public debt; however, the low cost of borrowing that usually comes with secular stagnation should help to ensure public debt levels won't get out of hand.

But hasn't the experience of Japan in the 1990s taught us that big deficits don't work to stimulate a stagnant economy, you might ask?

The answer is no. Kenneth Kuttner and Adam Posen demonstrated in "Passive Savers and Policy Effectiveness in Japan" that low tax revenues caused by a weak economy were to blame for the rising debt levels, not expansionary fiscal policy.

Of course, it's important that the spending be directed toward productive use.

I can think of two ways to achieve this goal. First, governments should invest in early childhood learning, an investment that's well known to pay-off in the long-run. Second, investing in infrastructure is also a good bet, as demonstrated several years ago by David Aschauer and Alicia Munnell, and as recently recommended by the IMF.

References

Aschauer, D., 1989, "Is Public Expenditure Productive", Journal of Monetary Economics, Vol. 23, pp. 177-200.

IMF, "Is it time for an infrastructure push? The macroeconomic effects of public investments", Chapter 3, October 2014.

Kuttner, K. and A. Posen, "Passive Savers and Policy Effectiveness in Japan", Institute for International Economics, 2001.

Munnell, A., 1990, "Why has productivity declined? Productivity and Public Investment" New England Economic Review, Federal Reserve Bank of Boston, January/February issue, pp. 3-22.

Samuelson and Scott, Economics, 3rd Canadian Edition, McGraw-Hill, 1971.

Deficit, Deficit, Who's got the Deficit? (Secular stagnation edition)

Over 50 years ago, James Tobin wrote an article for the New Republic entitled "Deficit, Deficit, Who's got the Deficit" (1963) that explains why the US federal government almost always needs to run a budget deficit.

The article is a gem. It has everything a good macroeconomics article should have: lots of debunking, all the relevant data, and a good dose of policy recommendations.

Unfortunately, the article is nowhere to be found on the internet. This post seeks to fix that by providing some key excerpts. Another purpose of this post is to use Tobin's analytical framework in that article and apply it to today's economic environment in the US.

Tobin on US Sectoral Financial Balances, circa 1963

The article starts off by describing the fundamental (iron?) law of financial balances:

For every buyer there must be a seller, and for every lender a borrower. One man's expenditure is another's receipt. My debts are your assets, my deficits your surplus. 

If each of us was consistently "neither borrower nor lender," as Polonius advised, no one would ever need to violate the revered wisdom of Mr. Micawber. But if the prudent among us insist on running and lending surpluses, some of the rest of us are willy-nilly going to borrow to finance budget deficits. 

In the United States today one budget that is usually left holding a deficit is that of the federal government. When no one else borrows the surpluses of the thrifty, the Treasury ends up doing so. Since the role of debtor and borrower is thought to be particularly unbecoming to the federal government , the nation feels frustated and guilty. 

Unhappily, crucial decisions of economic policy too often reflect blind reactions to these feelings. The truisms that borrowing is the counterpart of lending and deficits the counterpart of surpluses are overlooked in popular and Congressional discussions of government budgets and taxes. Both guilt feelings and policy are based serious misunderstanding of the origin of federal budget and surpluses. (1963:10)

Tobin then goes on to explain that both the household and financial sectors were running large financial surpluses (worth $20 billion combined in 1963):

American households and financial institutions consistently run financial surpluses. They have money to lend, beyond their own needs to borrow. As a group American households and non-profit institutions have in recent years shown a net financial surplus averaging about $15 billion a year -- that is, households are ready to lend, or to put into equity investments...more than they are ready to borrow. [...] In addition, financial institutions regularly generate a lendable surplus, now of the order of $5 billion a year. For the most part these institutions -- banks, saving and loans associations, insurance companies, pension funds, and like -- are simply intermediaries which borrow and relend the public's money. Their surpluses result from the fact that they earn more their lending operations than they distribute or credit to their depositors, shareowners, and policyholders. [...]

The article goes on to list the sectors of the economy that must borrow the $20 billion in surplus funds available from households and financial institutions:

State and local governments as a group have been averaging $3-4 billion a year of net borrowing...Unincorporated businesses, including farms, absorb another 3-4 billion a year. To the rest of the world we can lend perhaps $2 billion a year. We cannot lend abroad -- net -- more than the surplus of our exports over our imports of goods and services, and some of that surplus we give away in foreign aid. [...]

The remainder -- some $10-12 billion -- must be used either by nonfinancial corporate business or by the federal government. Only if corporations as a group take $10-12 billion of external funds, by borrowing or issuing new equities, can the federal government expect to break even. [...]

Tobin then follows into a discussion about the policy implications of these lending and borrowing dynamics:

The moral is inescapable, if startling. If you would like the federal deficit to be smaller, the deficits of business must be bigger. Would you like the federal government to run a surplus and reduce its debt? Then the business deficits must be big enough to absorb that surplus as well as the funds available from households and financial institutions. 

That does not mean business must run at a loss -- quite the contrary. Sometimes, it is true, unprofitable business are forced to borrow or to spend financial reserves just to stay afloat; this was a major reason for business deficits in the depths of the Great Depression. But normally it is business with good profits and good prospects that borrow and sell new shares of stock, in order to finance expansion and modernization...The incurring of financial deficits by business firms -- or by households and governments for that matter -- does not usually mean that such institutions are living beyond their means and consuming their capital. Financial deficits are typically the means of accumulating nonfinancial assets -- real property in the form of inventories, buildings and equipment. 

When does business run big deficits? When do corporations draw heavily on the capital markets? The record is clear: when business is very good, when sales are pressing hard on capacity, when businessmen see further expansion ahead. Though corporations' internal funds -- depreciation allowances and plowed-back profits -- are large during boom times, their investment programs are even larger. [...]

Recession, idle capacity, unemployment, economic slack -- these are the enemies of the balanced government budget. When the economy is faltering, households have more surpluses available to lend, and business firms are less inclined to borrow them. (1963:11)

The Corporate Sector: From Deficits to Large Surpluses

Of course, at the time Tobin wrote this article, US financial balances weren't exactly the same as they are today. Households as a group were running financial surpluses, the US was mostly a net lendor to the rest of the world, and the corporate sector was a net borrower of funds. Essentially, three things have changed since the mid-1980s with respect to financial balances (see charts below, double-click to enlarge).

First, starting in the mid-1980s, the US has become a net borrower to the rest of the world. Second, since the early 1990s and until the financial crisis, households were net borrowers to other sectors; since 2007, the household sector has returned to its traditional role of being a net lender. Finally, since the 1990s, the corporate sector has been at different times either a net lender or net borrower. However, since 2009, the corporate sector has been running a very large net financial surplus.*

What is the main policy implication to take-away from this state of affairs?

I would venture that the main take-away is that it's unlikely the US federal government will balance its budget any time soon unless households and/or firms start spending again.

In a recent article for an IMF publication entitled "Secular Stagnation: Affluent Economies Stuck in Neutral", economist Robert Solow (MIT) discussed the business sector's net lending position as a possible sign that there may be a "shortage of investment opportunities yielding a rate of return acceptable to investors" or, stated differently, that the "real rate of interest compatible with full utilization is negative, and not consistently achievable", a situation associated with the notion of "secular stagnation":

In the United States, at least, business investment has recovered only partially from the recession, although corporate profits have been very strong. The result, as pointed out in an unpublished paper by Brookings Institution Senior Fellows Martin Baily and Barry Bosworth, is that business saving has exceeded business investment since 2009. The corporate sector, normally a net borrower, became a net lender to the rest of the economy. This does smell rather like a reaction to an expected fall in the rate of return on investment, as the stagnation hypothesis suggests. (see chart below)

Source: Baily and Bosworth, 2013

Secular Stagnation

So what can be done? Paul Samuelson and Anthony Scott asked a similar question in the 1971 Canadian edition of their Economics textbook:

What if our continental economy is in for what Harvard's Alvin Hansen called "secular stagnation"? - which means a long period in which slowing population increase, [...], high corporate saving, the vast piling up of capital goods, and a bias toward capital-saving inventions will imply depressed investment schedules relative to saving schedules? Will not active fiscal policy designed to wipe out such deflationary gaps then result in running a deficit most of the time, leading to a secular growth in the public debt? The modern answer is "Under these conditions, yes; and over the decades the budget should not necessarily be balanced." (1971:436-7)

In my next post, I'll write more about secular stagnation and policy responses to address its possible eventuality.

* This post by Brian Romanchuk contains many useful charts and information on financial balances, as well as discusses secular stagnation from a stock-flow consistent perspective.

Update: I added charts on 2014-10-14, following a comment by Ramanan.

References

Baily, M. N., B. Bosworth, "The United States Economy: Why such a weak recovery", September 11, 2013, Brookings Institution, Washington DC.

Samuelson and Scott, Economics, 3rd Canadian Edition, McGraw-Hill, 1971

Solow, R., "Secular Stagnation: Affluent Economies Stuck in Neutral", in Looming Ahead, Finance and Development, vol. 51 , no.3. September 2014.

Tobin, J., "Deficit, Deficit, Who's got the Deficit?", New Republic, January 19, 1963

Deficit spending got the US out of the Great Depression: Paul Samuelson on helicopter money

Paul Samuelson, circa 2008 (see here at 1:31):

I'm full of sensible heresies. How do you think we got out -- in Roosevelt's time -- got out of that depression? How do you think the pernicious Adolf Hitler -- inheriting about the same, at least one third unemployment -- got out of it? And both of us got out of it in about the same number of years as you are getting to 1939. If you look at Mrs Schwartz's analysis of that, it's completely remote from the truth. 

This is not how it happened, but this is equivalent to how it happened: somebody invented helicopters. And somebody went to the printing press and printed-off millions and billions of legal tender. And then those helicopters flew over the poorer rural regions and the slums of the city. And it wasn't a problem of whether the money was going to be saved or wasn't going to be spent. It had nothing to do with pump-priming...It had nothing to do with jump-starting. [...] It was not a Federal Reserve operation.[...] 

Now, Mrs Schwartz and her collaborator, who's name I forgot at this moment [laughter], would say "well that helped to keep the M up". That's a joke! [The banker] didn't go out and start making new loans. He acquired more Treasury certificates, which had a yield of essentially zero. 

So we never got out of the Great Depression? Yes, we did. We did it essentially by deficit spending [...] 

The rest of this excellent discussion is well worth a careful listen.

Addendum : An ingenious reader has created a direct link to this excerpt on You Tube (see here). 2013-11-07

Which unconventional monetary policies hold most promise?

Kudos to Biagio Bossone, Chairman of the Group of Lecce and former central banker (and circuit theorist par excellence), for his first-rate analysis (see here: part 1 and part 2) of the different types of unconventional monetary policy measures that have been implemented and proposed in the last few years!

Bossone's piece does a fantastic job of presenting the different policy proposals into six distinct categories based on their implied transmission channel and the degree of cooperation between the fiscal and monetary authorities that is required in order to implement the proposed measures.

The main take-away from the analysis is that Bossone finds the proposals that aim to boost aggregate demand via fiscal actions are the most promising. According to Bossone, the benefits of fiscal measures (with or without actions by the monetary authority) are that their effect is more direct than policy measures such as quantitative easing (which works indirectly via its impact on interest rates) or forward guidance (which works indirectly via its effect on the public's expectations on future interest rates).

In the concluding paragraph, Bossone writes,

...this result vindicates the proposed measures to expand the money supply via overt monetary financing or neo-chartalism, which aims to inject new money independently of central banks' interest-rate policies, especially if these are limited by the zero lower bound.

Reference

Bossone, B., Unconventional monetary policies revisited, Part 1 and Part 2, Vox, October 2013

Impact of the US Payroll tax cut...and tax hike

This is a very informative (and short) piece by economists at the NY Fed on the effect of the 2011 US payroll tax cut and its recent expiration.

Here's a good summary:

Overall, our analysis suggests that the payroll tax cut during 2011-12 led to a substantial increase in consumer spending and facilitated the consumer deleveraging process. Based on consumers’ responses to our recent survey, expiration of the tax cuts is likely to lead to a substantial reduction in spending as well as contribute to a slowdown or possibly a reversal in the paydown of consumer debt. These effects are also likely to be heterogeneous, with groups that are more credit and liquidity constrained more likely to be adversely affected. Such nuances may be lost in the aggregate macroeconomic statistics, but they’re important for policymakers to consider as they debate fiscal policy.

Reference

Zafar, B., van der Klaauw, W., My Two (Per)cents: How are American Workers dealing with the Payroll Tax Hike, Federal Bank of New Work, Liberty Street Blog.

Are investors seeing the writing on the wall?

John Carney reports that Wall Street is now showing signs of turning against fiscal austerity.

Apparently, the Reinhart-Rogoff fiasco has something to do with it. Perhaps.

Or is it the realization that the narrowing US federal budget deficit since the start of the sequester in early March may signal the end of bountiful corporate profits?

As I've explained before, contrary to conventional wisdom, business profits are actually positively impacted by government budget deficits. Here is my take from a macro accounting standpoint:

Proof of this direct, positive relationship between government deficits and business profits is best demonstrated by manipulating the basic national income accounting identity in a manner consistent with the approach of economists John Maynard Keynes and Michal Kalecki. The following arithmetic demonstrates that government deficits have a positive effect on business profits.

Let Y=Total Output; C=Consumption; I=Investment; G=Government Expenditures; X=Exports; M=Imports; T=Taxes; R=Retained Earnings by Firms; Hs=Household Net Savings

Let the combination of the above (X - M) = Current Account Balance or Net Exports; (G - T) = Government Deficit; (Hs + R) = (Y - T - C) = Total Net Private Savings

To start off, here is the basic national income identity, as taught in all macroeconomic textbooks:
Y = C + I + G + (X - M)

Subtract taxes (from both sides of the equation) to achieve an equation "net" of taxes:
Y - T = C + I + G + (X - M) - T

Rearrange the equation to isolate total net private savings on the left side and to subtract taxes from government expenditures:
Y - T - C = I + (G - T) + (X - M)

Since (Y - T - C) can be broken down into household net savings (Hs) and retained earnings by firms (R), the equation can be stated as follows (see Krugman, 1994:313):
(Hs + R) = I + (G + T) + (X - M) 

...and can be rearranged as such:
R = (I - Hs) + (G - T) + (X - M)

In plain English, this translates into:
Firms' Retained Earnings = Investment - Household Savings + Government Deficits + Net Exports

The above equation clearly demonstrates that business profits are positively impacted by government deficits, net exports and private sector investment.* Household net savings, on the other hand, have the effect of reducing firms' retained earnings. Similarly, balanced budgets and government surpluses have either no impact on profits or have the effect of reducing them.

Now, it's true that under normal circumstances other factors such as household consumption and saving behavior and trade flows can significantly affect how these variables interact. However, in the current context where household spending has been largely subdued by deleveraging concerns, and exports weakened by sluggish growth in Europe, the UK and elsewhere around the world, the budget deficit consists of an important source of demand and (from a national accounts perspective) of corporate profits.

Is there a trade-off between employment and the household sector financial balance?

As Canadian policymakers try to get the household sector out of its financial deficit position, it's important to keep in mind that households are the sector that has been doing a lot of the heavy lifting in terms of boosting demand in recent decades.

Policymakers can attempt to get households to borrow less, but unless they can think of a way for another sector to offset the resulting reduced demand, it seems unlikely that the unemployment rate will remain at current low levels once households decide to reduce their net borrowing.

I posted these charts before but it's worth posting them again:

As household net borrowing increases, the rate of unemployment declines

A closer view of recent years

Is there a moral aspect to economic policy?

From Ed Luce of the Financial Times (a good article):

Mr Bernanke’s grounding has given him the authority to dismiss those who view the meltdown through a moral lens and want to purge society for its excesses. Had he embraced this popular intuition, the US would now be following the UK into triple-dip recession. As Mr Bernanke noted in Texas shortly after Rick Perry, its governor, had all but threatened him with a lynch mob: “I am not a believer in the Old Testament theory of the business cycle.”

As a general rule, any argument pushing for less government intervention on moral grounds in a weak economy should be viewed with suspicion. "Less is more" can be an acceptable rule for making decisions of a personal nature but in the realm of economic policy, it's often just bad advice. This is largely because of the two-sided nature of any monetary transaction: your spending is my income, public sector spending is private sector income.

A few years ago, economist Ben Friedman examined how morality intersects with economics and public policy. His view is that government intervention, in terms of its impact on the lives of citizens through its role in fostering economic growth, 'less' is definitely 'less':

A commonly held view is that government policy should try, insofar as it can, to avoid interfering with private economic initiative: the expectation of greater profits is ample incentive for a firm to expand production, or build a new factory, while the prospect of higher wages is likewise sufficient to encourage workers to seek out training or invest in their own education...The best that government can do (so the story goes) is minimize taxes, or safety regulations...The "right" pace of economic growth is whatever the market - that is, the aggregate of all private decisions - would deliver on its own.

But this familiar view too is seriously incomplete. To the extent that economic growth brings not only higher private incomes but also greater openness, tolerance, and democracy -- benefits we value but that the market does not price -- and to the extent that these unpriced benefits outweigh any unpriced harm that might ensue, market forces alone will systematically provide too little growth. Calling for government to stand aside while the market determines our economic growth ignores the vital role of public policy: the right rate of economic growth is greater than the purely market-determined rate, and the role of government policy is to foster it. (2005:14)

The point here is that public policy positively influences a society's moral character when it helps to raise living standards, which in turn affect the attitude of people toward themselves and encourages greater openness and tolerance.

Also, on a separate yet related point, it's really hard to believe there's any good to be found in the popular view that government action should be avoided because it (allegedly) stifles private sector initiative. On this point, I think Bill White of the Bank for International Settlements makes a good point:

...faced with serious deflationary tendencies, all of the weapons in the macroeconomic arsenal should be used to their full effect to ensure that aggregate demand is maintained. The concept of "creative destruction" has a certain intuitive appeal, but it should be remembered that the phrase was coined well before the onset of the Great Depression.

Reference

Friedman, B., The moral consequences of economic growth, 2005, New York, Knopf

Helicopter money: an operational view

Much has been written about Adair's Turner suggestion that central banks should consider financing public spending but I thought this short exchange between Adair Turner and economist Mario Seccareccia at an INET conference in 2011 is worth pointing out.

Here's Adair Turner's question:

[About Japan]...why wouldn't it been better still to do what Friedman said was the correct policy post facto in the 1930s, which is "helicopter money". Why wouldn't a better policy had been for the Japanese government to simply run fully, overtly, monetized deficits so that the last [inaudible] percent of GDP was not in the form of a debt contract held by the Japanese private sector but was in the form of absolute, categoric fiat money? (at 2:30 here)

This is Mario Seccareccia's response:

[About the] issue which had been raised about fiscal policy and the "helicopter drop" [vs conventional deficit spending]. That's a false dichotomy. I mean, deficit spending is -- in a sense -- monetization all the time. [Bond issuance is] how the central bank then behaves to clear or sterilize -- so to speak -- those reserves in the system in order to meet its interest rate policy. Period. There is no such thing as a "helicopter" doing this. It's always done through deficit spending fundamentally, I would argue. (at 9:00 here)

The point to remember when thinking about a central bank's ability to inject exogenous increases in reserve balances is that in a monetary regime such as Japan (and the UK for that matter) where the central bank targets an interest rate and the remuneration rate on reserves balances isn't set at the same level as its target interest rate, the central bank can't conduct offensive open market operations aimed at increasing the amount of reserve balances without simultaneously frustrating its goal of keeping its benchmark interest rate on target. Under such a regime the central bank's ability to control money growth is essentially limited to conducting defensive open market operations aimed at keeping its interest rate on target.

UPDATE: A very detailed look at the "helicopter drop" issue is found in Scott Fullwiler's article "Helicopter drops are fiscal operations" (2010). For a general discussion on offensive vs defensive open market operations, see Lombra, Herendeen and Torto, Money and the Financial System, page 425, 1980.

Fiscal austerity: A solution looking for a problem

Since the release earlier this month of the paper by IMF economists Olivier Blanchard and Daniel Leigh, I've noticed a lot of comments on blogs and news websites suggesting that the IMF economists and their inability to properly measure the size of the fiscal multiplier earlier are to blame for making political leaders believe that fiscal austerity could be expansionary and for misleading them into enacting austerity measures within their respective nations.

That's nonsense.  As if the decision to go down the road of austerity depended on a technical detail such as the potency of the fiscal multiplier.  Such a statement is as implausible as suggesting that some of the ill-advised military interventions in the Middle East during the last decade would have been prevented had those leaders who decided to enter those wars had been provided better intelligence.

Those looking to blame someone for the current disaster created by fiscal austerity should instead turn to the real culprits, the politicians themselves, as well as their horde of political aides who recommended a course of action that flies in the face of both common sense and empirical evidence.

As I discussed in an earlier post, the case against expansionary austerity was well established even before nations decided to enact austerity measures.  And amazingly, the empirical evidence against expansionary fiscal austerity stems from one of the most highly circulated economics papers of 2009, which, ironically, was branded as supporting the case for expansionary fiscal austerity.

This paper is the study by Alberto Alesina and Sylvia Ardagna, which found that the combination of austerity and growth occurred in 25 percent of the relevant episodes recorded by the OECD between 1970 and 2007 (2009, Data Appendix:Table A2).

In other words, the study demonstrated that the odds of successfully reducing public debt levels and achieving increased growth through austerity were 1 in 4.  As far as empirical support in favor of expansionary fiscal austerity goes, that's pretty weak.  With such information available, going ahead with austerity was tantamount to someone deciding to intentionally leave their umbrella at home knowing that there is a 75 percent chance of rain that day.  So much for the theory of the rational decision-maker!

And now economists are to blame?

The bottom line is that the disaster of austerity is not about economists getting it wrong.  Rather, it is a typical example of a policy-making failure: policymakers making decisions without regard for the facts.  But, more importantly, fiscal austerity was a prepackaged "solution to a problem" that fits with today's dominant policy-making ideology, which holds that governments have little or no purpose other than catering to financial interests and leaving the path clear for free-market actors to find solutions to every problem facing society.

To conclude, fiscal austerity is simply another example of a "solution looking for a problem", an empty and empirically ineffectual idea with no clear rationale other than giving the appearance that "something is being done".  In this sense, fiscal austerity joins the list of other well-known solutions looking for problems that have been tried and failed in the last thirty years such as deregulation, privatization, supply-side economics and so on.

References

Alesina, A and Ardagna, S., "Large Changes in Fiscal Policy: Taxes vs Spending", NBER Working Paper No. 15438, October 2009

Blanchard, O. and D. Leigh, "Growth Forecast Errors and Fiscal Multiplier", IMF Working Paper WP/13/1, January 2013

Evsey Domar's "On Deficits and Debt": A survival guide for making sense of today's economic challenges

As I look back to 2012, I'm reminded about how relevant the work of economist Evsey Domar, the late Professor of Economics at MIT and previously a Federal Reserve staff economist, is for making sense of the predicament facing the US and the world economies today.  Three news stories during the last year provided a good backdrop for presenting Domar’s views on public debt, budget deficits and economic growth.

First, there was the surprising about face during the summer months when European leaders switched from advocating austerity to voicing their support for actions that promote growth.  Professor Domar would have most likely approved of this change of heart by Europe’s ruling elite given that, many decades ago, Domar authored “The Burden of the Debt and National Income” (1944), a paper which argues that “the problem of the burden of the debt is a problem of achieving a growing national income” rather than one associated with the size of the budget deficit or national debt.

E. Domar

Specifically, in his paper, Domar demonstrated that, in the long run, the ratio of debt to GDP will gradually approach the ratio of the fraction of GDP borrowed each year to the rate of growth of GDP.  So, for instance, the US federal government borrowed approximately 7 percent of GDP in 2012.  If the borrowing continued at the same rate and the GDP (in money terms) grows at 2 percent per year, the ratio of debt to GDP will approach 3.5; with a 3 percent growth, it will be 2.3.

Thus, Domar showed that "less attention should be devoted to the problem of the debt and more to finding ways of achieving a growing national income" (1945:415)

According to Domar, attempting to reduce the public debt by cutting government expenditures (thus removing a significant source of income and growth from the economy) is largely self-defeating and exactly the wrong course of action if undertaken when the economy is struggling.

Then, in the fall, there was the debate among economists and bloggers about the intergenerational burden of the public debt.  Had he been around, Professor Domar would have probably been disappointed to learn that issues addressed (and, for many, put to rest) decades ago are still being debated.

And now we're facing the so-called ‘fiscal cliff’, a metaphor depicting the slowdown facing the US economy as a result of the expiry of tax breaks enacted at a time when the US federal fiscal budget situation was in better shape.  In the face of such a situation, Domar would have understood that the last thing policymakers should do when the economy is weak is to increase taxes which take away purchasing power from the economy.

As we enter a New Year, it is worth remembering Domar’s views on these and other related issues.  And nowhere are these matters best addressed than in his short, three-page article “On Deficits and Debt” published in 1993.  In this article, Domar challenges many of the widely held beliefs about debt and deficits. 

First, the article begins by taking on the popular view that considers the US federal government debt as analogous to household debt:

Our old puritanical injunctions against running into debt remain valid when applied to a private person. He or she can disregard them only at his or her peril.  A large corporation has more leeway: it can borrow by issuing bonds, and replace them with new ones when they fall due. If many large corporations simultaneously decided to pay off their debts, our economy would collapse: it is based on credit, the inverse of debt. Still any corporation, however large can go bankrupt...But, the Federal government is in a class by itself: so long as its debt is expressed in dollars (which fortunately is the case), it can always print as many dollars as it needs to pay the interest, though nowadays it would issue bonds, sell them in the market and, if necessary, have the Federal Reserve repurchase them. The Federal government, the creator of the Federal Reserve System, is its own banker.

Then, Domar describes the merits of a budget deficit:

By definition, a budget deficit means that the government spends more money then it receives, or, in other words, that it creates more purchasing power by its expenditures than it destroys through taxes.  Is this good or bad? It depends. If the economy is working to capacity, the creation of extra purchasing power will do little good and much harm: it will cause an inflation, which is easy to start and hard to stop. But when the economy has plenty of unused resources, the additional purchasing power is welcome. At such a time, we should rebuild our physical infrastructure, improve our education, health, and environment, and intensify our scientific and industrial research efforts, without raising taxes and without reducing or eliminating other needed services, always keeping a watchful eye on economic barometers to make sure that we do not overdo it.

All this sounds nice and easy, perhaps too easy to avoid suspicion. Are we to get something for nothing, as the old saying goes? Is there such a thing as a free lunch, after all? The offer of a free lunch is strictly temporary; it lasts only so long as unused resources, and particularly unemployed labor, are available, because they can be put to use with little, if any, social cost. But one they are gone government expenditures, however, desirable, must be matched with revenue.

Later in the article, Domar explains that the true burden of the national debt is distributional in that it involves a transfer of resources from one group to another group within the economy:

Some early proponents of fiscal policy argued that the size of the debt and of interest payments on it are not important because “ we owe it to ourselves”...There is some truth in this argument, but it should not be exaggerated. Even if all the Federal bonds were owned by Americans and all interest on the debt received by them, problems created by the existence of a large debt and by the need to transfer [billions of dollars] from the taxpayers to the bondholders would remain...

On the other hand, this does not mean that the...interest paid on the debt represents a net loss to the country...[T]hat interest go to other Americans, directly or not and that much of it is subject to Federal income taxes. President Eisenhower, who disliked deficits and debts, is reported to have said, shortly before he left the White House, that every American baby born at the time carried on its neck a tag indicating its share of the Federal debt. Perhaps it did; but it must have also borne a second tag showing its share of the value of the Federal bonds.

The article then presents some interesting views about whether the country’s ratio of debt to GDP is an appropriate indicator of the state of the economy:

Does the ratio of the debt to GNP matter? Yes, it does. Other things being equal, I would prefer a smaller rather than larger ratio...Other things are not equal. There are times and conditions calling for a deficit. Without it, unemployment may rise and the GNP may fall, thus raising, rather than lowering the debt burden.

The article concludes with a comment on how to best address the “debt problem”:

The proper solution of the debt problem lies not in tying ourselves into a financial straight-jacket, but in achieving faster growth of the GNP, a result which is, of course, desirable by itself. To the Republican and other politicians who are hell-bent on reducing the deficit and even repaying the debt, I would like to address a very short and simple question: Why? Are we suffering from an excess of purchasing power now?

As we head into the New Year and get ready to face many of the same concerns as in 2012, I think it would be a good idea to keep in mind these points.

On that note, I wish all readers of this blog a very Happy New Year!

UPDATE: The third paragraph was revised on January 12, 2013.  It originally indicated that Domar demonstrated in his 1944 paper that the ratio of deficit to GDP would equal the ratio of the fraction of GDP borrowed each year to the rate of growth of the economy.  Rather, Domar focused on the ratio of debt to GDP.  I also added a subsequent paragraph (after paragraph 3) which includes a reference to Domar's article "The Burden of the Debt: A Rejoinder" (1945).

References

Domar, E., "The Burden of the Debt and the National Income", American Economic Review, 34(4), December 1944

Domar, E., "The Burden of the Debt: A Rejoinder", American Economic Review, 35(3), June 1945, pp. 414-418.

Domar, E., "On Deficits and Debt", American Journal of Economics and Sociology, 52(4), October 1993, 475-478.

Myths about the burden of the welfare state: Insights from Harold Wilensky's new book

It's not uncommon these days to hear that the problems affecting the public finances of European nations are linked to the high welfare standards that are characteristic of European public administration.  According to this view, the cost of welfare programs, including social security and other forms of government-protected minimum standards, are simply too expensive and must be cut dramatically if Euro countries such as Greece, Spain and Portugal are to "regain control" of their public finances.

A related claim also suggests that the high level of taxation required to support welfare state systems stifles growth and undermines a nation's commercial competitiveness.  Accordingly, cutting social programs is viewed as a necessary first step toward lowering corporate tax rates and, ultimately, attracting businesses and promoting growth.  One commentator recently summed up this view as follows: "To thrive, Euro countries must cut the welfare state".

In my opinion, there are several problems with this line of reasoning.  The first is that viewing the European sovereign debt crisis as a consequence of the degree of generosity of welfare state policies completely disregards the fact that several Europeans nations with elaborate welfare systems are not suffering the same problems as, for instance, Greece and Spain.  Kurt Huebner has summarized the problem of linking the European debt default crisis to the costs of welfare state entitlements succinctly in a recent policy note:

If too high entitlements, in other words high welfare state standards, have caused the sovereign debt default crises, we would expect that societies with the highest and most generous welfare states would be top-ranked in the group of sovereign debt default economies. According to general prejudice this would be Sweden, Denmark, Norway, Finland and Germany, Austria and the Netherlands. The last time I checked nearly all of those economies were ranked in the top – but in the group of economic high-achievers and not high debtors. In other words: making a causal link between sovereign debt crises and welfare state entitlements is not confirmed by empirical data.

As for the claim that the high levels of taxation that is required to support welfare state systems is detrimental to economic growth, this too is unfounded.  In a recent blog post, Martin Wolf refuted the argument that lower taxes are the principal route toward better economic performance.  On the contrary, Wolf demonstrates that, not only are today’s most solvent countries highly taxed, but also that the level of taxation has no incidence on economic growth.  For this reason, Wolf suggests that the current focus among policymakers and commentators on reducing the tax burden is misguided:

Indeed, among the eurozone countries shown, crisis-hit Ireland, Spain and Italy had relatively low average tax rates. (They also had fiscal surpluses or negligible fiscal deficits, prior to the crisis. But that is a topic for another occasion.) The heavily taxed eurozone countries on the right hand side of the chart (from Germany on up) are all now relatively crisis-free.

The conclusion to be drawn is that a tax burden (within the range of 30 per cent to 55 per cent of GDP) tells one nothing about a country’s economic performance. It is far more a reflection of different social preferences about the role of the state. What matters far more are culture, quality of institutions, including law, levels of education, quality of businesses, openness to trade, strength of competition and so forth.

But what about the impact of welfare policies as a whole on a nation's economic performance?  Surely, one would assume that high welfare standards would be a net cost to the economy and society?  Again, as with the claim that a high tax burden is detrimental to growth, this too is a misguided assumption.

The most comprehensive explanation of why the welfare state is not a drag on economic performance is found in the work of the late Harold Wilensky, Professor Emeritus of Political Science at UCLA, Berkeley.  Wilensky's most recent book entitled American Political Economy in Global Perspective (2012) provides a highly detailed and up-to-date analysis on the political economy of the welfare state.

In this book, Wilensky presents findings stemming from over 40 years of in-depth research on 19 rich democracies that, among other things, support the view that modern welfare policies do not have adverse effects on productivity and national income.  The book points to empirical evidence that supports this conclusion and lays out in a clear and convincing manner the argument that welfare systems are not a drag on economic performance (2012:7-14; 46-55). 

According to Wilensky, there are two main reasons why the welfare state is not detrimental to a nation's economy.  First, Wilensky argues that many sectors of social policy are simply productivity enhancing.  The following excerpt from the book summarizes this point quite well:

Mass access to medical care and health education via schools, clinics, and child care facilities reduces long-term medical costs and in some measure enhances real health and lifetime productivity; preventative occupational health and safety programs in the workplace reduce absenteeism and turnover and other labor costs; active labor market policies supplement and in some countries reduce reliance on passive unemployment insurance and public assistance and improve the quality of labor; innovative family policies reduce the cost of both mayhem and poverty, they also reduce income inequality and gender inequality, which are a drag on economic growth.  These are substantial offsets for the costs of welfare-state benefits to the nonworking poor, handicapped, and the aged.  The net economic effect of all the programs labeled the "welfare state" is therefore either positive (before 1974) or neutral (since 1974). (Wilensky, 2012:6)

As for the second explanation of why high welfare standards are not detrimental to economic performance, Wilensky argues that nations with highly developed welfare state systems are also nations with institutional structures and legal frameworks that foster the habit of consensual bargaining among the government, businesses, unions, interest groups and other social partners, whether it be through public institutions (e.g., legislative assemblies, intergovernmental relations) or private institutions  (e.g., governance boards, conflict resolution committees).  More specifically, nations with these types of institutional structures and bargaining arrangements in place (e.g., Norway, Sweden, Finland, Denmark, Netherlands) promote coalition-building among political and societal groups, as well as effective labor relations.  In addition, these institutional structures and bargaining arrangements foment a politics of moderation that minimizes confrontation between social actors, as well as reduces both policy paralysis (i.e., inaction by government even though there is strong support for certain policies by citizens and dominant social actors) and political brinkmanship between partisan groups.

In sum, nations with consensual bargaining arrangements in place encourage the development of public policies that are more reflective of the aspirations of the electorate and, as a consequence, that are less apt to fall prey to polarizing partisanship or result in costly citizen backlash and/or rollback, as is common in more confrontational democracies such as the US (e.g., tax-welfare backlash).

According to Wilensky, the most significant economic benefit flowing from this consensual form of political bargaining is that it facilitates productive trade-offs among the government, political parties, businesses and unions, many of which have positive impacts on productivity and economic performance.  The trade-offs favorable to good economic performance and typical of consensual democracies include the following:

• Labor embraces restraint on nominal wages in return for social security and related programs based on social rights and modest increases in real wages;
• Employers provide job protection in return for wage restraint, labor peace and sometimes tax concessions (e.g., lower taxes on corporations and capital gains);
• Employers provide participatory democracy in the workplace or community in return for labor peace and wage constraint;
• In return for all of the above, the government improves its tax-extraction capacity (i.e., capacity to increase taxation with minimal backlash from public), thus enabling it to offer more generous and popular social programs;
• Faced with strong unions and with the habit of making such trade-offs, management tends to cooperate with labor in return for the implementation of a wide range of government policies, including less intrusive regulations and more effective implementation of laws and executive orders. (Wilensky, 2012:46-49).

In addition to these trade-offs, Wilensky points out that consensual democracies benefit from lower strike rates, a higher rate of gross fixed capital investment and wage restraint during economic shock periods (2012:51).  According to Wilensky, the higher rate of capital investment and lower strike rate are the main causes of good economic performance for these nations.  Also, these nations benefit from less confrontation between social and political actors and strong countervailing sources of consensus where, for instance, the dominant influence of big business is matched by the power of big labor.  Finally, as a result of the greater degree of cooperation that exists between social partners in consensual nations, policy paralysis is more easily overcome and economic shocks are more quickly and effectively addressed and mitigated.

Now, I should emphasize that Wilensky is not suggesting that nations with consensual bargaining arrangements have stronger economies than nations with more "confrontational" bargaining arrangements (e.g., US, Canada, UK, etc).  On the contrary, Wilensky makes it clear that during the last four decades there has been "two roads" to good economic performance; nations with consensual bargaining arrangements (i.e., "high road" strategy) and nations with more confrontational bargaining arrangements (i.e., "low road" strategy) have performed equally well when examined from a purely economic standpoint.  The difference is that nations that have adopted the metaphorical "high road" do much better in terms of social and political performance (e.g., income and gender inequality, health, job security and education).  In other words, according to Wilensky,

[e]ither [road] can at various times and places result in good economic performance.  The sharp contrasts appear in social and political performance.  The choice is a matter of one's values. (Wilensky, 2012:190).

Before concluding, I should address one common objection that is often made by critics of the view presented above, which is that recent global developments such as increased immigration, international competition, the spread of multinational corporations (MNCs), and the deregulation of labor markets, to name but a few, pose significant challenges to the viability of the consensual bargaining model of governance and undermine the economic base that enables the trade-offs above to materialize.  In other words, the critique suggests that this model is outdated and no longer adapted to the modern world economy.  However, according to Wilensky, such developments have only had a moderate to small influence on consensual bargaining.  For instance, on the impact of MNCs, Wilensky notes that there is little evidence that MNCs have undermined the nation's capacity to accommodate the conflicting interest of social partners by means of consensual bargaining.

That said, Wilensky argues that there is one recent development that does threaten the survival of consensus-enabling arrangements and institutional structures that help sustain effective welfare state systems: the increasing power and ideology of central banks and the internationalization of finance.  Wilensky's view on this issue is highlighted in the following excerpt:

Perhaps one recent trend does undermine the capacity of modern democracies to shape their economic destinies: unregulated internationalization of finance and the increasing independence of central banks, a clear threat to collaborative relations among labor, industry, and the state and to flexible use of fiscal policy (taxes and spending).  Reinforcing this trend is the flow of recently ascendant American economic doctrines across national boundaries: a blend of 19th century liberalism (unmodified free markets, private property, minimum government), Reaganomics, and monetarist ideology.  This was the ideological base for the deregulation of the financial sector at the root of the meltdown and Great Recession. (2012:151) (my emphasis)

A word on the Eurozone crisis and the need for a countervailing force to the ECB

Although American Political Economy in Global Perspective does not address the current European sovereign debt crisis, my impression is that Wilensky would have given preference to a solution that would not only directly address the financial problem facing the periphery Euro nations (either through the creation of "Eurobonds" or the ECB purchase of periphery nation debt) but also promote the emergence of a countervailing force that would match the influence of the ECB.

In my view, two sets of proposals could help to achieve such a result, namely, the creation of stronger EU institutions (including a democratically elected EU president, see Charles Goodhart's recommendations here)*, as well as the proposal to implement European-wide wage-setting (see Andrew Watt's article here), a proposal that I think could give rise to a stronger, more centralized labor presence at the EU level.

Here are the relevant sections of the book relating to the concept of countervailing power and central bank independence and influence:

The German labor movement for decades remained a major countervailing force to the Bundesbank...[T]he postwar record of low inflation with only medium unemployment is a product not only of the Bundesbank's autonomy but of a labor movement that has traded off wage restraint and industrial peace for social benefits and worker participation.[...] The consensual bargaining between labor, government, and industry eases the Bundesbank's task of controlling inflation without greatly reducing employment.  The ascendance of the European Central Bank, however, changed all that.[...] (Wilensky, 2012:128)

That several of the countries whose central banks had limited autonomy before 1990 (Japan, Austria, Norway, or Belgium, 1965-1974, 1985-1989) outperformed countries with more independent central banks (Canada, Netherlands, Denmark, or the US before 1980) should give pause to those who adopted the "Bundesbank model" for the European Central Bank without the German labor, management, state, political, education and training and other institutions that made it work.  Unfortunately, the European Union has neither the offsetting institutions to constrain such a bank's behavior nor the European-wide welfare state and job creation antidotes to its strong deflationary medicine. (Wilensky, 2012:132) (my emphasis)

* Paul McCulley has also suggested that the ECB president "needs a boss" to whom he or she would be directly accountable. I very much agree.

References

Huebner, Kurt, Political Exploitation of the Crisis of the Eurozone, Policy Brief, Institute for European Studies, University of British Columbia, February 2, 2012

Wilensky, Harold, "Trade-Offs in Public Finance: Comparing the Well-Being of Big Spenders and Lean Spenders", International Political Science Review, Vol. 27, No. 4, 333-358, 2006 (to view an earlier version of this article, see here)

Wilensky, Harold, American Political Economy in Global Perspective, Cambridge: Cambridge University Press, 2012

Wilensky, Harold, Rich Democracies: Political Economy, Public Policy and Performance, Berkeley: UCLA Press, 2002