The Intellectual Argument For and Against Keynesian Expansionary Fiscal Policy

Busy day, so a quick one from Brad DeLong (this is a small part of a much longer discussion):

... If we were to try to construct the intellectual argument against Keynesian expansionary fiscal policy right now, how would it go? I think it would go more-or-less like this:

1. Ignore the forecasts of future interest rates in the term structure. They are what Paul Krugman calls "Pangloss" prices--based on the marginal investor's hope that all will go well and belief that they are smarter than the average bear and will be able to liquidate their position before price fall. Accept that interest rates are going to normalize, and normalize quickly: within five years or so.

2. An economy with a high debt burden has a Reinhart-Rogoff slow-growth possible equilibrium out there: one in which fear of high debt causes real Treasury interest rates to be higher than their 3%/year average by two percentage points and in which growth lags normal potential by 1.5%/year--in the U.S., a long-run growth rate of 1%/year.

3. In order to eliminate the possibility of such a stagnation equilibrium, the debt has to be sustainable and financeable even if long-run growth is that low and interest rates are that high: debt sustainability calculations have to be capable of delivering a good outcome with a four percentage-point gap between the government's financing cost and the economy's growth rate.

4. In the U.S., at least, primary federal spending looks to be at or above some 23% of GDP for the rest of the decade.

5. At a debt-to-annual GDP ratio of 100%, sustainability in the slow-growth Reinhart-Rogoff scenario would require federal taxes to be 27% of GDP: 23% to cover primary spending, plus 4% to hold the debt-to-annual GDP ratio constant at a growth rate of 1%/year and a Treasury real rate of 5%/year.

6. There is no way that the U.S. political system can tax 27% of GDP. If we tip over to the Reinhart-Rogoff scenario, the U.S. goes to an unsustainable debt path immediately.

7. Each year that the debt-to-annual GDP ratio stays high we run the unknown risk of tipping into that equilibrium. The debt-to-annual GDP ratio needs to get on a downward trajectory as fast as possible.

To this, the Keynesian counter is: (a) that is a very implausible scenario that you are spinning, (b) in the meanwhile employment in America is something like 6% lower than it would be if the economy were functioning properly, (c ) each year of subnormal output casts in all likelihood a huge and destructive hysteresis shadow over the future, (d) we know how to restore production to potential and employment to its natural rate--print money and buy stuff--and (e) even if we start to tip over into an unsustainable debt-path scenario, we can handle it, because that is why God made financial repression.

Let me spell (e) out a little bit. If investors start to fear that the U.S. debt trajectory is truly unstable, the immediate consequence is a fall in the dollar and an export boom, with somewhat higher domestic inflation. Because the U.S. government regulates the financial system, it can set reserve requirements where it likes--it can thus use its reserve requirements to force banks to hold Treasuries, and if it doesn't like the interest rate at which banks are holding Treasuries, it can up reserve requirements some more.

No, financial repression is not ideal. But it is not a disaster like a collapse of confidence in the debt and the currency. And when you weigh a small chance of being forced into financial repression should interest rates super-normalize against the near-certainty if nothing is done of what is now looking like Lost Decades--decades, plural--it is hard to see how the benefit-cost analysis comes out in favor of doubling-down on the failed policies of austerity. ...