Economist's View

What's behind Recent Changes in Long-Term Interst Rates?

Martin Feldstein says we need to cut social programs so that we don't "weaken demand in the near term and hurt economic incentives in the long run":

The Fed must reassure markets on inflation, by Martin Feldstein, Commentary, Financial Times: The interest rate on 10-year US Treasury bonds almost doubled in six months, rising from 2.26 per cent last December to 3.98 per cent in mid-June, before decreasing slightly in recent days. This sharp rise happened despite the Federal Reserve’s ... policy aimed at lowering long-term rates by buying $300bn of Treasuries and promising to buy more than $1,000bn of mortgage securities. ...

There is no single reason for the sharp rise in rates... The simplest explanation for the higher 10-year rate is that many investors now expect inflation to rise. ... The prospective decline of the dollar is also a potential source of inflation. ...

But such an explanation is deceptively easy. ... Those scared by Lehman Brothers’ collapse wanted the safety and liquidity of ordinary Treasury bonds, causing their yields to fall sharply...

Treasury yields rose this month to their level a year earlier because improving market conditions meant investors were no longer willing to pay for the extreme liquidity of Treasuries. Inflation was thus not the only, and perhaps not even the main, reason for the rise in rates.

Why did the Fed’s massive buying of long-term Treasury bonds not hold down the bond rate? The answer is that bond markets are less impressed by the $300bn of Fed purchases than by the official projection of $10,000bn of government borrowing over the next decade... The resulting crowding out of private investment will require higher future interest rates, and that is reflected in current long-term rates.

A further reason long rates remain high is a fear that foreign buyers may not be willing to continue buying dollar bonds to finance a large US current account deficit.

In short, higher long-term interest rates reflect investors’ concern about future inflation, future fiscal deficits and the future willingness of foreign investors to purchase US bonds. ...

It would be wrong for the Obama administration and Congress to reduce the fiscal stimulus in 2009 or 2010, since there is no clear evidence of a sustained upturn. But it would be equally wrong to allow the national debt to double to 80 per cent of GDP a decade from now. Increasing taxes even more than proposed would weaken demand in the near term and hurt economic incentives in the long run. The fiscal deficit should therefore be reduced by curtailing the increases in social spending that the president advocated in his election campaign.

The Fed must also be careful not to tighten too soon. But it needs to reassure markets that it will prevent the excess reserves of the banks from financing a surge of inflationary lending when the economy begins to expand. It must make clear now that it will be willing to do so even if that involves big rises in short-term rates.

Here's (my interpretation of) Paul Krugman's argument about the source of recent movements in long-term interest rates:

There are two reasons long-term rates might rise, first more worries about the debt and inflation in the future would drive rates up, and second the prospect of better economic conditions in the future would have the same effect, rates would go up.

Suppose we receive bad news about the current state of the economy. That should cause expectations of lower output growth in the future, and hence lower tax revenues and higher spending on social programs than would exist with a stronger economy. So the bad news should cause an expectation of a larger deficit and more inflation worries, and that would drive long-term interest rates up (these worries would also make foreign central banks less likely to fund US borrowing which would reinforce the increase in long-term interest rates).

But if it is future economic conditions that are driving the changes in long-term interest rates, bad news about the economy should drive rates down.

Last week, we received bad news about the economy. If the debt/inflation/foreign lending story is correct, long-term rates should have gone up. If the state of the economy story is driving rates, rates should have fallen. What did long-term rates actually do? They fell.

The Need for Deficit Spending

As a follow up to the post Don't "Nullify" Fiscal Policy which was part of the Romer Roundtable on fiscal policy mistakes during the Great Depression, in particular the mistake made in 1937 of giving into pressure to balance the budget before the economy had recovered sufficiently causing an economy showing signs of recovery to fall back into depression, David Cay Johnston emails this explanation of the need for deficit spending after large negative shocks from his February 18, 2009 "Johnston's Take" column at Tax Notes:

In the long run we need more savings and investment, but as Keynes famously noted, in the long run we are all dead. What we need right now is money in people's pockets to pay for mortgages so more houses do not fall into foreclosure and employers stop eliminating jobs at an accelerating pace, a rate of nearly 10,000 per day last year and 20,000 per day last month.

Borrowing our way out of this is not without risk. But imagine for a moment that you just got married, bought a house, and are expecting a baby, and your cars unexpectedly broke down. Do you take on more debt by leasing or borrowing for two new cars so you can keep getting to work to pay for the mortgage and the baby crib, or do you shun new debt because it is more prudent to do so?

Mishkin: How to Get the Fed Out of Its 'Box'

Frederic Mishkin is worried about the long-run budget and how it constrains what the Fed can do:

How to Get The Fed Out Of Its 'Box', by Frederic Mishkin, Commentary, WSJ: When the Federal Open Market Committee meets this Tuesday and Wednesday, the Federal Reserve will face a serious dilemma.

Since the last committee meeting six weeks ago, the 10-year U.S. Treasury yield has risen by around ... 0.70%,... the interest rate on 30-year mortgages has risen by a similar amount. The rise in long-term interest rates ... has the potential to choke off economic recovery and lead to further deterioration in the housing market. ... Does the situation call for the Fed to expand its purchases of Treasury bonds to lower long-term interest rates?

To answer this question, we need to look at why long-term interest rates have risen. Here, there is good news and bad news. One cause ... is the more positive economic news..., particularly in financial markets. The bad news is ... the deteriorating fiscal situation, with massive budget deficits expected for the indefinite future. ...

Although an expansion of Treasury bond purchases by the Fed would have the benefit of lowering long-term interest rates temporarily to stimulate the economy, in the current environment it could be dangerous for two reasons. First, it might suggest that the Fed is willing to monetize Treasury debt. The Fed does not, and should not, ... be an enabler of fiscal irresponsibility. Second, if the Fed loses its credibility to resist pressures to monetize the debt it could cause inflation expectations to shift upward, thereby leading to a serious problem down the road.

The Fed is boxed in. The slack in the economy that is likely to persist for a very long time suggests the need for stimulative monetary policy... The fiscal situation argues against this policy action, because it would weaken the Fed's inflation-fighting credibility.

How can the Fed get out of the box and pursue the expansionary monetary policy that is needed...? The answer is that the Obama administration and Congress have to get serious about long-run fiscal sustainability. Large budget deficits naturally occur during severe recessions..., fiscal stimulus to promote economic recovery ... in a severe recession is a sensible prescription.

However, the failure to take steps to get future budgets under control is a recipe for disaster. Not only does it make it difficult for the Fed..., but it may even make the fiscal stimulus package less effective. After all, if you know that the government is issuing a lot of debt ... you can expect to pay much higher taxes in the future. With the prospect of higher taxes, you will be less likely to spend today.

How can the Obama administration and Congress help the Fed do its job and help the fiscal stimulus package work? It needs to address exploding spending on entitlements -- Social Security and particularly Medicare -- which are causing future deficit projections to be so bleak.

One possibility is to establish a nonpartisan commission on entitlement reform, along the lines of the National Commission on Social Security in the early 1980s. ... Another is taxing health-care benefits as part of any package to reform health care. Taxing health-care benefits would ... generate large amounts of revenue. It would also increase the incentive for people to lower the costs of their health care. There are surely many other ways to promote more fiscal responsibility.

The Fed can assist this process. It could indicate that implementing measures that would promote fiscal sustainability will be rewarded with Federal Reserve actions to bring long-term Treasury rates down. Deals like this have been successfully made in the past. In the current extremely difficult economic environment, we surely need such a deal now.

As has been pointed out here many times, the inflation and interest rate concerns are likely overblown, as is the worry that consumption will suffer significantly due to the expectation of taxes in the future, and hence the motivation to attack entitlements is not as strong as suggested. Also, there is also at least some question about the Fed's ability to control long-term interest rates.

But beyond that the projected increase in health care costs is the biggest problem with the long-run budget by far, and the Obama administration is trying to reform the health care system. So the administration is attempting to "address exploding spending on entitlements," at least the one that is actually exploding - there's no sense in which the projected increase in the deficit due to Social Security can be described as "exploding" - and if the Fed, Mishkin, or anyone else wants to assist with that effort with deals or op-eds that promote the necessary reform, I'm sure the administration would welcome their help.

Rogoff: America Should also Look to its Fiscal Health

Kenneth "The Hawk" Rogoff:

America should also look to its fiscal health, by Kenneth Rogoff, Commentary, Financial Times: America desperately needs a better framework for providing healthcare and Barack Obama’s administration is right to press on for change... Yet given the explosion of the federal debt, it is extremely important to craft a plan that will not excessively risk the government’s own fiscal health. The risks cannot easily be overstated.

The US government is already entering a prolonged period where it is extremely vulnerable to a loss in investor confidence from the Chinese and other main holders of its Treasury securities. Foreign investors are rightly concerned about the deeply ingrained reluctance of Americans to tax themselves. The last thing the US needs is to be viewed as one giant California, rich but unwilling to pay enough taxes to fund the services its citizens demand. A sharp rise in taxes to pay for healthcare initiatives could potentially weaken the credibility of the government’s promise to raise taxes as needed to pay off debtors. ...

[I]n principle, fixing the imbalances in the Social Security and, especially, the Medicare programmes could provide a powerful offset to the huge increase in debt burdens visited by the financial crisis.

Unfortunately, the idea that healthcare reform will alleviate debt problems rather than exacerbate them is far-fetched..., many proposed healthcare reforms are more likely to worsen the government’s budgetary health than to improve it. This should hardly be surprising, given that a main purpose of reform is to help provide better care for Americans who cannot afford insurance.

Higher taxes to pay for healthcare are also likely to reduce US growth, making it far more difficult to escape the debt trap. This comes at a time when other policy initiatives, such as tackling environmental degradation and income inequality, are also likely to imply higher tax burdens... In addition, the continuing weakness of the financial sector weighs on growth, and it is by no means clear yet when and how some semblance of normality will be restored. ...

All of these considerations appear to underscore the importance of finding ways to keep the new health plan from being overly burdensome, and to avoid unduly optimistic projections on efficiency savings. Healthcare reform is no substitute for finding a credible path to fiscal sustainability. ...

Make no mistake, the US and much of the developed world is in a frighteningly precarious fiscal state. ... It is a disgrace that the world’s richest country cannot provide reliable basic care for its poorest citizens. But if the politics of reform produces too extravagant a plan when the nation’s fiscal health is already so weak, the US may experience a form of financial crisis even more virulent than the one it is recovering from. Any healthcare plan would then be dead on arrival.

Setting the fear mongering about the future aside - and there's no evidence in long-term interest rates that financial market participants are worried about these issues - here are a few things to keep in mind when thinking about health care reform First, it is not a demographic problem. This graph is from a CBO presentation on this point, and is fairly self-explanatory:

Second, rising health care costs is not just an issue for Medicare and Medicaid, the same rise in costs is also projected to hit private sector health care. Again, from the CBO:

Projected Spending on Health Care Under an Assumption That Excess Cost Growth Continues at Historical Averages (Percentage of GDP)

Going back to the question of the effect of health care reform on the long-run budget, though expanding coverage will expand increase the total amount of medical care that is provided, and hence increase costs, there seems to be some confusion between expanding overall coverage and simply moving the dividing line between the public and private sectors upward so that the public sector expands and the private sector contracts by the same amount. Changing the dividing line, all else equal, simply changes how the bills are paid, it has no effect at all on the overall health care burden that people face (it moves the dividing line in a graph like the one above showing the public and private sectors explcitly without changing the total area). So it's hard to see why higher taxes driven by this type of a change would have the negative economic effects Rogoff is worried about.

But he is more worried that expanding the size of the public sector both by moving the dividing line up and by including more people - the latter in particular - will increase increases health care costs and add to the debt burden, which in turn would require higher taxes. Is that true? It would if the only effect of the expansion of the public sector was to increase the number of people receiving care, and his claim that costs won't fall, or at least not by much, presumes this is how it will work. But when we look at other countries that have substantially expanded the public sector we see lower costs - on the order of 50% lower - and no reduction in the quality of the care that people receive. That's a huge reduction in costs, a reduction large enough to allow a significant expansion of coverage without increasing costs at all. I don't think we'll reduce costs by that magnitude, 50% seems like a lot to hope for, but it does imply that it's possible to reform the system without compromising quality or experiencing the dire consequences Rogoff fears.

The Return of the Great Debt Scare

Robert Reich is worried that the "Great Debt Scare" will lead to a repeat of the Clinton administration's abandonment of its investment agenda due to concerns over the deficit:

The Great Debt Scare: Why Has It Returned?, by Robert Reich: It’s the kind of thing I expect to hear from deficit hawks and chicken littles -- from the self-described "fiscally responsible" right, from the scolds Ross Perot and Pete Peterson, from my former cabinet colleague Bob Rubin. But yesterday I was shown slides developed by the putatively liberal Center for American Progress intended to make the point. And today’s front page story in the New York Times, by the eminent David Leonhardt, entitled "Sea of Red Ink: How It Spread From A Puddle," puts the issue right before our progressive noses, so to speak.

The Great Debt Scare is back.

Odd that it would return right now, when the economy is still mired in the worst depression since the Great one. ...

Odder still that the Debt Scare returns at the precise moment that bills are emerging from Congress on universal health care, which, by almost everyone’s reckoning, will not increase the long-term debt one bit because universal health care has to be paid for in the budget. In fact, universal health care will reduce the deficit and cumulative debt -- especially if it includes a public option capable of negotiating lower costs from drug makers, doctors, and insurers, and thereby reducing the future costs of Medicare and Medicaid.

Even odder that the Debt Scare rears its frightening head just as the President’s stimulus is moving into high gear with more spending on infrastructure. Every expert who has looked closely at the nation’s crumbling infrastructure knows how badly it suffers from decades of deferred maintenance... These public investments are as important to the nation’s future as are private investments.

First, some background: Deficit and debt numbers ... take on meaning only in relation to ... the size of the national economy..., in particular, to the debt/GDP ratio. True, that ratio is heading in the wrong direction right now. It may reach 70 percent by the end of 2010. That’s high, but it’s not high compared to the 120 percent it was in 1946, after the ravages of Depression and war.

Over time, the basic way America has reduced the debt/GDP ratio is by growing the U.S. economy. GDP growth makes even large debts manageable. When the economy is cooking, more people have jobs and better wages. So they pay more taxes. And they require less unemployment assistance and other social insurance. That’s why it’s so important now, in the depths of depression, that government, as purchaser of last resort, steps in and runs large deficits. Without large deficits this year and next, and perhaps the year after, the economy doesn’t have a prayer of getting back on a growth path, and the debt/GDP ratio could really get ugly. ...

In this respect, national budgets are like family budgets. It’s dumb for an indebted family to borrow more money to take a world cruise. But it’s smart even for an indebted family to borrow money to send their kids to college. So too with the Obama budget. Public investments, just like family investments, build future wealth. They allow faster growth. They make the debt/GDP ratio even lower and more manageable over time.

Don't get me wrong. I'm not saying there's nothing to worry about when it comes to long-term deficit and debt projections. I'm just saying now's not the time to worry, and we ought to temper our worries by understanding the larger context.

Not every expert agrees that a deficit-driven stimulus is the best and fastest way to get the economy back on a growth track, or that public investments can speed growth. Conservative economists, Republicans, and many Wall Streeters are skeptical because they don’t think government can do anything well. But look at the record of the last seventy-five years -- look at how the nation got out of the Great Depression, and consider the critical role public investments have played since then in speeding the nation’s growth, investments such as the interstate highway system -- and you have ample evidence that the deficit hawks are wrong. They were wrong when they convinced Bill Clinton to chuck a large part of his investment agenda (the nation is now paying the price) and they're wrong now.

So, back to the mystery. Why are the ostensibly liberal Center for American Progress and New York Times participating in the Debt Scare right now? Is it possible that among the President’s top economic advisors and top ranking members of the Fed are people who agree ... with conservative Republicans...? Is it conceivable that they are quietly encouraging the Debt Scare even in traditionally liberal precincts, in order to reduce support in the Democratic base for what Obama wants to accomplish? Hmmm.

Not so sure about that, but the larger point is certainly valid. The economy needs short-term demand stimulus, and that stimulus can be from spending on infrastructure, or it could be on something with little long-run benefit such as large firework shows held throughout the nation - big extravagant events that spend millions and millions of dollars in the most depressed economic areas. In the short-run the goal is to kick start the economy, and a firework show is just as good at that task as infrastructure spending if the spending is approximately the same.

Where they differ is in the long-run. The firework show leaves only memories - and sometimes that's enough to justify an expenditure - but let's assume that for the most past the shows were nothing more than an excuse to spend money to get the local economies moving (not that there's anything wrong with that; also, perhaps a series of shows would be better so that the impulse is spread out over time and sustains the economy through the downturn, but the idea is the same). However, as Robert Reich explains above in his example of borrowing to go on a cruise versus borrowing to go to college, infrastructure spending does have long-run benefits and can help the economy grow faster.

So, to the extent that we can, we should do both - deficit spend to get the economy moving in the short-run, and spend the money on infrastructure so the spending has long-run benefits. But the main thing is to get the economy moving again through deficit spending, it doesn't have to be on infrastructure (and there are plenty of things to spend the money on in the short-run that don't necessarily help with long-run growth but are nevertheless justified, there are choices other than firework shows and cruises, but the politics work against this).

So deficit spend in the short-run and target infrastructure as much as possible - until further spending on infrastructure begins to threaten short-run goals because, for example, it can't be done fast enough - then switch to other types of spending to give aggregate demand the kick it needs.

It may seem like I disagree with Robert Reich in that he is insisting that the spending be to rebuild our physical and social infrastructure, where I am saying it doesn't matter, but that's because we need to separate two reasons for deficit spending. What I have just described is deficit spending to offset cyclical swings in the economy, so called countercyclical policy. What Robert Reich describes in his example with the family is spending that is an investment in the future. You borrow money now in the hopes of a higher return in the future (in terms of economic growth), a return that is high enough to justify the costs. Note that this type of spending is entirely justified independently of spending to offset recessionary conditions. However, because of the politics involved, and because it can be efficient in any case, combing the two types of spending - i.e. using infrastructure spending to stimulate the economy - has benefits.

But although right now deficit spending is justified by countercyclical policy and by the need for social and physical infrastructure, we also need a plan for the long-run that credibly manages the resulting debt. Not immediately, but slowly over a long period of time. Importantly, however, that plan should not threaten or compromise our ability to do what's needed to offset the effects of this recession. I wouldn't mind having the conversation about managing the long-run debt now if it didn't do exactly that, i.e. cause policymakers to be wary of deficit spending and do less than is needed to combat the recession. But it does, and as Robert Reich notes, that is likely the point of the conversation.

I want both monetary and fiscal policy to have the best possible chance for success in dealing with our present difficulties, and that requires a large sustained shock to the system both in term of Fed actions and deficit spending. But success also requires managing the long-run appropriately. When things improve we have to pay for the stimulus to the economy (i.e. pay for all of the countercyclical part plus our share of the investment in infrastructure) and take the steps necessary to bring the budget into long-run alignment. If we don't do that, the conclusion will be that we can deficit spend when times are bad without any problem, and sure, that is helpful, but we simply do not have the discipline to pay for what we borrowed when times are better. Our inability to implement countercyclical policy effectively could then mean that future generations would not have countercyclical fiscal policy at their disposal when they need it.

But for now the main thing to realize is that "This thing ain’t over yet," and we need to continue to support aggressive policy action. We do have work to do to get the long-run budget fixed, and working on health care is a large step in that direction, but for now short-run policy goals must come first.

"The Bond War"

 What is the bond market telling us?:

The Bond War, by Daniel Gross, Slate: It's fair to say that 10-year and 30-year Treasury bonds are not subjects that enthrall the American public... In the last six months, however, the state of those bonds has become the subject of feverish argument in the economic elite. The interest rate of the 10-year Treasury bond has spiked from 2.07 percent in December 2008, when the world was falling apart, to a recent high of 3.715 percent on June 1... Now factions led by economist Paul Krugman and historian Niall Ferguson are feuding bitterly about the import of these charts. In late April, Krugman and Ferguson squared off at a New York Review of Books/PEN panel, and they've continued with an op-ed war in the Financial Times and New York Times (Ferguson here and Krugman here).

In a nutshell, Ferguson and his allies believe that the rising bond yields prove that markets are worried about the inflation that will inevitably result from the fiscal policies of the Obama administration and the Fed. ... Ferguson's fears have been echoed by the planet's leading inflation-phobe German Chancellor Angela Merkel and by influential Stanford economist John Taylor. Turn on CNBC, and you're likely to hear talk about bond-market vigilantes, the mass of traders who sell bonds and push interest rates up in order to warn governments not to spend freely.

Krugman and his fellow travelers couldn't disagree more. Far from being a sign of failure and impending disaster, they say, the rising bond yields actually signal success and impending improvement. ... Clear-headed as always, Martin Wolf of the Financial Times notes: "The jump in bond rates is a desirable normalisation after a panic. Investors rushed into the dollar and government bonds. Now they are rushing out again. Welcome to the giddy world of financial markets." This line of argument makes sense...

In ... this instance, the Fergusonians lack credibility. H.L. Mencken tagged the Puritans as people possessed of the "haunting fear that someone, somewhere, may be happy." Ferguson represents a strain of intellectual Toryism bedeviled by the haunting fear that someone, somewhere may be getting social insurance. ... Their solution to the problem of large deficits always seems to be to cut entitlements and never to raise taxes.

As for the bond vigilantes, have you noticed that they seem to surface only when a Democrat is in the White House? Stanford's John Taylor didn't write many articles about the inflationary aspects of rapidly expanding deficits when the Bush administration and Congress were turning surpluses into huge deficits, massively increasing government spending, and creating a new Medicare prescription drug entitlement. He was working in the Bush Treasury Department. ...

Federal Reserve Chairman Ben Bernanke, seemed to split the difference yesterday. "However, in recent weeks, yields on longer-term Treasury securities and fixed-rate mortgages have risen," he told Congress. "These increases appear to reflect concerns about large federal deficits but also other causes, including greater optimism about the economic outlook, a reversal of flight-to-quality flows, and technical factors related to the hedging of mortgage holdings."

Global Imbalances and Future Crises

I've been trying to figure out how much danger there is of a sudden unwinding of global imbalances that could extend and potentially deepen the recession. I've been worried there is a chance this could happen, but Barry Eichengreen explains that there are "two hopes for avoiding this disastrous outcome":

Fix global imbalances to avert future crises, by Barry Eichengreen, Commentary, Project Syndicate: Future history books, depending on where they are written, will take one of two approaches to assigning blame for the world’s current financial and economic crisis.

One approach will blame lax regulation, accommodating monetary policy, and inadequate savings in the US. The other, already being pushed by former and current US officials like Alan Greenspan and Ben Bernanke, will blame the immense pool of liquidity generated by high-savings countries in East Asia and the Middle East. All that liquidity, they will argue, had to go somewhere. Its logical destination was the country with the deepest financial markets, the US, where it raised asset prices to unsustainable heights.

Note the one thing on which members of both camps agree: the global savings imbalance – low savings in the US and high savings in Chinaand other emerging markets – played a key role in the crisis... Preventing future crises similar to this one therefore requires resolving the problem of global imbalances. ...

Whether there is a permanent reduction in global imbalances will depend mainly on decisions taken outside the US, specifically in countries like China. One’s forecast of those decisions hinges, in turn, on why these other countries came to run such large surpluses in the first place.

One view is that their surpluses were a corollary of the policies favouring export-led growth that worked so well for so long. China’s leaders are understandably reluctant to abandon a tried-and-true model. They can’t restructure their economy instantaneously. ... They need time to build a social safety net capable of encouraging Chinese households to reduce their precautionary saving. If this view is correct, we can expect to see global imbalances re-emerge once the recession is over and to unwind only slowly thereafter.

The other view is that China contributed to global imbalances not through its merchandise exports, but through its capital exports. What China lacked was not demand for consumption goods, but a supply of high-quality financial assets. It found these in the US, mainly in the form  of Treasury and other government-backed securities, in turn pushing other investors into more speculative investments.

Recent events have not enhanced the stature of the US as a supplier of high-quality assets. And China, for its part, will continue to develop its financial markets and its capacity to generate high-quality financial assets internally. But doing so will take time. Meanwhile, the US still has the most liquid financial markets in the world. This interpretation again implies the re-emergence of global imbalances once the recession ends, and their very gradual unwinding thereafter.

One development that could change this forecast is if China comes to view investing in US financial assets as a money-losing proposition. US budget deficits as far as the eye can see might excite fear of losses on US Treasury bonds. A de facto policy of inflating away the debt might stoke such fears further. At that point, China would pull the plug, the dollar would crash, and the Fed would be forced to raise interest rates, plunging the US back into recession.

There are two hopes for avoiding this disastrous outcome. One is relying on Chinese goodwill to stabilise the US and world economies. The other is for the Obama administration and the Fed to provide details about how they will eliminate the budget deficit and avoid inflation once the recession ends. The second option is clearly preferable. After all, it is always better to control one’s own fate.

"Obama Budget Reduces Deficit"

The Center on Budget and Policy Priorities says that, contrary to what you may have heard, the Obama budget "would reduce federal deficits by about $900 billion over the next ten years compared to current budget policies." Note also that, relative to their "realistic baseline," the deficit is larger in the immediate short-run than the baseline projection (but by enough?), and smaller in the longer run (any truly long-run solution to the budget problem will require us to reform health care and reduce escalating costs):

Obama Budget Reduces Deficit by $900 Billion Compared to Current Budget Policies, by Kathy Ruffing and Paul N. Van de Water, CBPP: Contrary to some claims, President Obama’s 2010 budget would reduce federal deficits by about $900 billion over the next ten years compared to current budget policies.  The $900 billion is the difference between deficits over the next decade under the President’s budget, as estimated by the Congressional Budget Office (CBO), and projected deficits under a realistic assessment of current budget policies. (See figure below.)

Some critics charge that Obama’s budget is fiscally irresponsible, and they cite CBO’s estimate that, under it, deficits would total $9.3 trillion over the next decade.  They fail to note, however, that these future deficits result from the existing budget policies that Obama inherited — not those that he is proposing.  Ironically, some of these same critics supported the large tax cuts and spending increases of recent years that helped convert the surpluses of the late 1990s into the record deficits that we face today and in the coming decades.

In fact, deficits would be $900 billion higher over the next decade under current policies than in Obama’s budget.  That’s because, in the budget plan that he released in late February, the President includes a package of spending and tax proposals that reduce future deficits by that amount.

Short-Run and Long-Run Deficits

Robert Frank says its important to separate the cyclical component of the budget from its long-run trajectory, and that when evaluating deficits, how the money is spent matters:

When ‘Deficit’ Isn’t a Dirty Word, by Robert H. Frank, Commentary, NY Times: ...Because important policy decisions hinge on whether deficits matter, this is an opportune moment to take stock of what we know. The good news is that there is little disagreement among economists who have studied the issue. The consensus is that short-run deficits help end recessions, and that whether long-run deficits matter depends entirely on how government spends the borrowed money. If failure to borrow meant forgoing productive investments, bigger long-run deficits would actually be better than smaller ones. ...

Who's Responsible for the Budget Deficit?

Dean Baker:

Rogoff: Countries Risk Drowning in Red Ink

Ken Rogoff with lots of gloom and doom:

Countries are so deep in debt, they risk drowning in red ink, by Kenneth Rogoff, Project Syndicate: No one yet has any real idea about when the global financial crisis will end, but one thing is certain: Government budget deficits are headed into the stratosphere. ...

Although governments may try to cram public debt down the throats of local savers (by using, for example, rising influence over banks to force them to hold a disproportionate quantity of government paper), they eventually will find themselves having to pay much higher interest rates as well. Within a couple of years, interest rates on long-term U.S. Treasury notes could easily rise 3 per cent to 4 per cent, with interest rates on other governments' paper rising as much, or more. ...

With the credit crisis still making it difficult for many small-and medium-sized businesses to obtain even the minimal level of financing necessary to maintain inventories and conduct trade, global GDP is on a precipice in 2009. A real possibility exists that global growth will register its first contraction since the Second World War. ...

Worse, unless financial systems spring back, growth could disappoint for years to come, especially in “ground zero” countries such as the United States, Britain, Ireland and Spain. U.S. long-term growth could be particularly dismal, as the Obama administration steers the country toward more European levels of welfare assistance and income redistribution.

Countries with European-style growth rates could handle debt obligations of 60 per cent of GDP when interest rates were low. But with debts in many countries rising to 80 per cent or 90 per cent of GDP, and with today's low interest rates clearly a temporary phenomenon, trouble is brewing. ...

Many of the countries that are piling on massive quantities of debt to bail out their banks have only tepid medium-term growth prospects, raising real questions of solvency and sustainability. Italy, for example... Other countries, such as Ireland, Britain and the U.S., started with a much stronger fiscal position but may not be much better off when the smoke clears.

Exchange rates are another wild card. Asian central banks are still nervously clinging to the dollar. But with the U.S. printing debt and money like it is going out of style, it would appear the euro is set to appreciate against the dollar two or three years down the road – if the euro is still around, that is.

As debt mounts and the recession lingers, we are surely going to see a number of governments trying to lighten their load through financial repression, higher inflation, partial default, or a combination of all three. Unfortunately, the endgame to the great recession of the early 2000s will not be a pretty picture.

That's why I wrote this. As I noted, there are plenty of people who are anxious to pin our economic problems on the deficit, and going one step further, the welfare state (e.g. the "growth could be particularly dismal, as the Obama administration steers the country toward more European levels of welfare assistance and income redistribution" statement above). But government intervention is not going to make things worse for, say, the typical unemployed worker, it will make things better by improving job prospects and providing an enhanced level of support while unemployed (health care, unemployment insurance, food stamps, and similar programs). The stimulus package won't prolong the recovery period, it will shorten it by jump starting the economy in important areas and keeping it going until the private sector can take over (think of the government spending and tax cuts as a bridge over troubled assets).

So I want to emphasize one more time that stabilization policy does not have to change the size of government in the long-run (and see pgl for a debunking of some of the claims about the size of government. i.e. he notess that "Federal spending as a share of GDP was about as high in 1985 as it is projected to be for 2019").  Fiscal policy can increase the size of government, but it can also shrink the size of government (lower taxes in the downturn, then cut spending when things are better to eliminate the deficit and government will shrink). So the criticism is not about the use of stabilization policy to help people during the downturn and to give the economy a boost, instead it's a claim about the long-term political aims of the administration with respect to the size of government. However, according to pgl's calculations, the projections are that the size won't exceed what we had under that well known socialist sympathizer Ronald Reagan.

"Put Earmarks in Perspective"

Thomas Mann of the Brookings Institution says that "hyperbolic attacks on earmarks do a disservice to the public":

Put Earmarks in Perspective, by Thomas E. Mann, Senior Fellow, Brookings: It is hard to take seriously a political opposition whose major antidote to the most serious and frightening financial and economic crisis since the Great Depression is a rhetorical crusade against congressional earmarks.

Sen. John McCain took to the Senate floor Monday to unleash his fury at the 9,000 earmarks — “wasteful, disgraceful, corrupting ... pork barrel spending” — that are included in a $410 billion omnibus spending bill for the current budget year. ...

But dramatic calls for an abolition of earmarks, by law or presidential veto, are futile and counterproductive. Congress has the constitutional power of the purse and legitimately defends its authority to allocate public resources. Given the enormity of the economic and financial problems facing the country, Obama would be foolish to engage Congress in a battle over earmarks.

Earmarks constitute less than 1 percent of the federal budget. In most cases, they don’t add to federal expenditures but merely allow Congress to direct a small fraction of program funding that would otherwise be allocated by formula or grant competition. Abolishing all earmarks would therefore have a trivial effect on the level of spending and budget deficits. While earmark reform and reduction is a worthy cause, it is a relatively minor one. It would do nothing to slow the rate of federal spending or improve our long-term budget outlook. Moreover, hyperbolic attacks on earmarks do a disservice to the public, encouraging people to concentrate way too much attention and energy on a largely symbolic issue and ignore the critical decisions that we face in the months and years ahead.

In an effort to stimulate an economy threatened by deflation and severe recession, federal spending will increase dramatically over the next several years. The challenge is to see that these new funds are expended in the most responsible way possible. Beefing up our public management capacity — in contracting, financial accountability, program evaluation — and developing oversight systems are the highest priorities. Same with efforts under way to stabilize the financial markets. Then there are the daunting challenges of designing and implementing new systems to restrain the cost and increase the coverage of health care and to shift to a low-carbon economy, to say nothing of grappling with a huge, long-term fiscal imbalance.

In this most threatening and challenging policy environment, it is time for earmarks to be put in their proper perspective and for politicians in both parties to get serious with the public about what really lies ahead.

Here's a graph I made during the election illustrating the same point.

"Bogus Arguments about the Burden of the Debt"

I saw Senator McCain on CNN talking about how the stimulus package is, essentially, reaching into the pockets of future generations and transferring their wealth to the present generation. He kept talking about how much poorer future generations will be as a result of the debt the stimulus package (never mind that he voted for tax cuts that would have made the deficit much worse, e.g. "It’s 'generational theft,' said Senator John McCain, just a few days after voting for tax cuts that would, over the next decade, have cost about four times as much.").

So let's look at this and see if the generational theft charge has any foundation or, as is more likely given recent history, it is mostly scare tactics being used in an attempt to manipulate public opinion.

To begin, think about how the government finances, say, $10,000 in deficit spending. To use debt finance (as opposed to raising taxes or printing money), the government will print up a piece of paper - we call it a government bond - and write "IOU $10,000 plus interest" on it. It then trades the "IOU $10,000 plus interest at some point in the future" for $10,000 in cash. Thus, the private sector gives the government $10,000 and gets an IOU (a bond) in return.

Let's suppose the government then takes this money and spends it on a project such as a road that has benefits for a wide segment of the population. The end result, then, is that the money was borrowed from an individual and distributed through government spending (or transfer payments) to a larger segment of the population.

So far, there hasn't been any transfer of resources from the future to the present, only a transfer a resources within the current generation. What about when the bond is paid off, does that transfer resources across generations? Let's suppose it is a 30 year bond, and that the holder passes away and bequeaths it to his or her children. Thus, thirty years from now the bond comes due, and the holder cashes it in and is paid in full. But where does the money come from? The government pays it out of its tax revenue. That is, the government collects the $10,000 plus interest from the future generation, then gives taxes it collects to the bond holder.

But this is a transfer of resources within a generation, not across generations. A whole bunch of people in the future will have to pay higher taxes, and the taxes they pay will go to a smaller number of individuals holding the debt. But across the population the assets and liabilities cancel exactly, there is no net aggregate burden. Liabilities have passed to future generations, but so have the corresponding assets.

Thus, the current generation cannot use government deficits to literally reach into the pockets of future generations and steal their resources. But that doesn't mean that deficits are always harmless. There are three ways that debt can make future generations worse off, the question is whether these are important considerations right now. So let's look at three ways debt can be problematic and see if we should be worried about them in the present environment.

First, financing the debt can cause interest rates to rise. If interest rates rise, investment is lower and that can lower future economic growth. Thus, if this effect is operative and strong, there is a sense in which higher output today is traded for lower growth in the future.

This effect, commonly called crowding out, is worrisome when the economy is running at or near full employment and competition for resources is intense, but right now with interest rates as low as they are and with so much slack in the economy, this is not much of a worry. Government borrowing will not put upward pressure on interest rates, and hence private sector investment - to the extent firms are willing to undertake it in such poor conditions - won't be much affected.

Second, the collection of taxes in the future can cause distortions, and those distortions can lower economic growth. This is simply the usual supply-side economics story. This will likely bring the supply-side fanatics and ideologues out of the woodwork, but I don't believe the evidence supports the claim that these effects are large (e.g. see "Final grade on the Bush tax cuts: Failure to produce jobs"). So there's nothing much to worry about here either.

Third, if we borrow from foreigners rather than ourselves, the debt can impose a net aggregate burden within the US. To see this, use the example above where the government borrows $10,000, but this time let's suppose the money is borrowed from the foreign sector. In this case, we borrow from the foreign sector, and then at some point in the future the debt is paid off and this involves a flow of resources out of the U.S. Because resources flow out of the U.S. instead of simply being redistributed within the U.S., this imposes a net burden.

But there are two important qualifications. If we use the money to build something that provides benefits to current and future generations that exceed the value of the resources flowing out of the country, there is still a net benefit from the transaction. It depends upon what is done with the money. If it is used, for example, to build things like infrastructure and schools, then future generations get a benefit along with a bill, and it is the net effect that matters.

The second qualification is that while we borrow from foreigners, we also hold foreign assets and if you look at the net resource flow, the flow of funds outward from foreigners owning our debt, and the flow inward from our owning foreign assets, the net flow is positive. So overall these transactions do not detract from the living standards of future generations. [Update: I should have also added that these considerations are independent of countercyclical fiscal policy. The value from using countercyclical fiscal policy to enhance economic stability - something that does not necessarily require capital expenditures by the government (e.g. investment in infrastructure) - also needs to be taken into account.]

When you put all of this together, it seems very clear that the Republican opposition is misplaced and, though it's par for the courses they play on, unduly alarmist. But you may not believe me, so let me add two other sources for the same message.

Let's start with a textbook treatment from Baumol and Blinder's Macroeconomics text (9th ed.):

Bogus Arguments about the Burden of the Debt

Having gained some perspective on the facts, let us now turn to some of the arguments advanced by those who claim that budget deficits place an intolerable burden on future generations.

Argument I Our children and grandchildren will be burdened by heavy interest payments, which will necessitate higher taxes.

Answer It is certainly true that a higher debt means higher interest payments and, therefore, higher taxes on our children and grandchildren. But think who will own the bonds and therefore receive the higher interest payments as income: our children and grandchildren! Thus, one group of future Americans will be making interest payments to another group of future Americans. So we conclude that:

As long as the national debt is owned by domestic citizens, as the majority of the U.S. debt is, future interest payments transfer money from one group of Americans to another. These transfers mayor may not be desirable, but they hardly constitute a burden on the nation as a whole.

However, this argument is valid-and worrisome-for the portion of our debt that is held by foreigners, a share that has been growing rapidly and is now over 40 percent. Paying interest on this portion of the debt will burden future Americans in a concrete way: For years to come, a portion of America's GDP will have to be sent abroad to pay interest on the debts we incurred in the 1980s, 1990s, and 2000s. For this reason, many thoughtful observers are becoming concerned that the United States is borrowing too much from abroad.

Another valid element of this argument is that the taxes that will have to be raised to pay interest even to U.S. citizens may reduce the efficiency of the economy.

Argument 2 Repaying the enormous debt will ruin the nation.

Answer A first answer to this argument merely rephrases the answer to the previous one: Most of America's debt is owed to Americans. But this argument raises an even more fundamental point. Unlike a private family, the nation need never payoff its debt. Instead, each time the principal is due, the U.S. Treasury can simply "roll it over" by floating more debt. Indeed, that was done routinely for decades.

Was this a bit of chicanery? How could the U.S. government get away with making loans that it never intended to pay back? The answer lies in the fallacy of comparing the U.S. government to a family or an individual. People cannot borrow in perpetuity, because they will not live that long. Sensible lenders will not extend long-term credit to very old people because their heirs cannot be forced to pay up. But the U.S. government will never "die" - at least, we hope not! So this problem does not arise. In this respect, the government is in much the same position as a large corporation. GE never pays off its debt. It, too, rolls it over by floating new debt all the time.

Argument 3 Like any family or any business firm, a nation has a limited capacity to borrow. If it exceeds this limit, it is in danger of being unable to pay its creditors. It may go bankrupt with calamitous consequences for everyone.

Answer This is another false analogy. While private debtors and many foreign governments have to worry about defaulting on their debt, the U.S. government does not. Why not? First, because it has enormous power to raise revenues by taxation. If you had such power, you would never have to fear bankruptcy either.

But once again, the statement raises a more fundamental point - one that distinguishes the U.S. debt from that of most other nations. The American national debt is an obligation to pay U.S. dollars: Each debt certificate obligates the Treasury to pay the holder so many U.S. dollars on a prescribed date. But the U.S. government is the source of these dollars. It prints them! No nation need default on debts that call for repayment in its own currency. If worse comes to worse, it can always print whatever money it needs to pay off its creditors. This option is not open to countries whose debts call for payment in U.S. dollars, as a number of Southeast Asian countries learned in 1997 and Argentina learned in 2001.

It does not, of course, follow that acquiring more debt through budget deficits is necessarily a good idea. Sometimes it is a very bad idea. As we know, printing money to pay the debt will expand aggregate demand and cause inflation. In addition, as we will learn in Chapter 18, printing more dollars should make the international value of the dollar fall. We may not relish either of these outcomes. The point is not that budget deficits are either good or bad; they can be either under the appropriate circumstances. Rather, the point is that worrying about a possible default on the national debt is unnecessary and even foolish.

Next, Dean Baker:

Government debt can either increase or decrease the wealth of future generations. The debt itself is not a measure of the financial impact across generations. What matters is how the debt affects the strength of the economy when the government borrows the money.

It is easy to see that the national debt is not really a measure of intergenerational burden. While the taxpayers collectively can be seen as owing the debt, taxpayers (or at least some of them) also own the debt. This is not a payment across generations; it is a payment within generations.

If the United States let the debt rise to $10 trillion and then left the debt at $10 trillion for 100 years, just paying the interest, then in 2108 some of our children, grandchildren and great grandchildren would be collecting the interest on the $10 trillion, which would be paid from the taxes that the government collects.

This flow of money from taxpayers to bond holders doesn’t on net make people better or worse off 100 years from now. It is simply a redistribution from some members of future generations to other members of future generations. None of the interest is flowing to those of us alive now, since virtually all of us will have passed into history by then.

Whether or not the debt has made future generations poorer will depend on how it was incurred. If we ran up debts so that we could finance schools and colleges, and make sure that our children and grandchildren were well educated, then we probably made them richer than if we didn’t run up debt but left them illiterate. Similarly, if we ran up the debt to construct a modern physical and information infrastructure, then we probably made future generations much wealthier than if we had handed them a country that was debt free, but had no Internet and no computers.

In short, the debt is not an accurate measure of whether we have been generous to or short-changed the generations that come after us. The answer to that question depends on the economy and society that we pass on. There are many scenarios in which we would have impoverished future generations, even if we were to hand them a government that is free of debt or alternatively left them very wealthy, even if there is a substantial government debt.

There is an economic argument whereby deficits can reduce the wealth of future generations. If the economy is at its capacity (e.g. everyone who wants to work is already employed), then if we run a large deficit due to additional government spending or tax cuts, then we may be pulling people away from building up the economy’s capacity. Specifically, the government’s borrowing needs can lead to higher interest rates.

Higher interest rates can in turn lead to less investment. If businesses invest less in machinery, computers, and other investment items, then productivity will grow less rapidly. Productivity, how much workers produce in an hour of work, is the main long-run determinant of living standards. ... (Productivity almost always grows, so the issue is how fast it grows – it is almost impossible to envision a future in which workers are not substantially more productive in 20 or 30 years than they are today.)

If a deficit leads to high interest rates, which in turn reduce investment, then they will have slowed the economy’s growth and made future generations less well off than they would have been without the deficits. But it is important to remember that the way deficits can hurt future generations is not directly through the debt burden, but rather because they can reduce investment and therefore slow productivity growth.

The measure of the deficit’s impact on the living standards of future generations is not the size of the debt in dollars or even the size of the debt relative to the size of the economy. The impact of the deficit on future living standards would be reflected in the rate of productivity growth. If the deficit has actually hurt the living standards of future generations, then it would be because deficits lead to slower productivity growth than the country would have otherwise seen.

In fact, even as the economy has run up substantial deficits in recent years, productivity growth has been strong for most of the last 15 years. Productivity has grown at an average annual rate of 2.5 percent in the years from 1995 though the second quarter of 2008. This means that for each hour of work, we are getting 38.6 percent more of output today than we did in 1995. In principle if the country as a whole is spending the same percentage of its time working in 2008 as in 1995, then we can be enjoying a standard of living that is 38.6 percent higher than in 1995.

While there is an issue that a greater share of the economy’s output might be diverted to foreigners because of the foreign debt (see below), we still derive more income each year from our ownership of foreign assets than foreigners do from their ownership of U.S. assets. At the moment at least, we are still in the process of making our children much wealthier than we were, in spite of our $9 trillion debt.

"Dynamic Scoring"

I was thinking about thinking about this:

Dynamic Scoring, by Andy Harless: Suppose that, at the beginning of the fiscal year, Congress appropriates $100 billion extra for infrastructure projects. At the end of the fiscal year, how much higher will the deficit turn out to be, compared to what it otherwise would have been?

The obvious answer, and the one that usually seems to be implicitly assumed by the media and the pundits, is $100 billion. But if you think about it carefully, it should become obvious that the obvious answer is the wrong answer.

The government is going to use most of that money to hire people and to buy things. Many of the people it will hire are people who were previously unemployed. Many are leaving other jobs which will subsequently be filled by people who were unemployed. These previously unemployed people, who may have been collecting benefits, will now be paying taxes. Those taxes will reduce the deficit, as will the reduced benefit payments. Moreover, for the businesses from which the government purchases, their profits will rise, and they will pay additional taxes on those additional profits. And they may expand and hire new people, or retain people that would otherwise have been laid off. And (if you believe in a multiplier effect), all the newly employed people, as well as the owners of the businesses, will spend more money, thus providing more profits and more employment for others, who will also pay taxes and stop collecting benefits. And so on. The ultimate effect of the original expenditure on the budget deficit will be considerably smaller than $100 billion.

This is called dynamic scoring. ... In the past, dynamic scoring has met with a lot of skepticism – and with good reason. Under normal economic conditions (by which I mean those that prevailed from 1953 through 2007), it's not clear that budget changes have any significant indirect effects on revenues and expenditures. Supply-siders claimed that the incentive effect of tax cuts would increase incentives for economic activity and thereby result in increased revenues. (I mean, "increased" relative to the static estimate of the revenue loss, not increased relative to what would happen without the tax cut. The latter idea had a lot of play in the popular press, but it was seldom taken very seriously by economists.) Keynesians (the old-fashioned kind) claimed that tax cuts and expenditure increases would increase demand and thereby result in increased revenues (again, relative to the static estimate). But...

Mainstream economic analysis said they were both wrong. Many economists think there are major supply-side benefits to more efficient taxation, but most such economists think those are primarily long-run benefits (faster growth over a span of time) rather than benefits that would significantly affect revenues in the short run. The Keynesian argument would make sense if monetary policy were passive, but in fact, the Fed has its own goals, and its goals don't necessarily change in response to fiscal policy. And of course the Fed takes fiscal policy into account when deciding how to accomplish those goals. So if a tax cut or an expenditure increase were expected to create, say, a million extra jobs, then, under normal economic conditions, the Fed would simply raise interest rates enough (according to its best estimate) to destroy a million jobs. (If the Fed didn't think the demand for those million jobs would be potentially inflationary, then it would already have tried to create them.)

But today's economic conditions are not normal. The Fed, like most everyone else, is expecting the recession to be a severe one, a potentially deflationary one, but the Fed is running out of options for how to deal with it. Contrary to what happens under normal conditions, the Fed will make no attempt to offset the effects of fiscal policy; indeed, it will enthusiastically welcome the help. The old-fashioned Keynesians, whose advice about dynamic scoring was (properly, in my opinion) considered wrong or irrelevant for so long, can now dust off their computers and start giving meaningful dynamic estimates of the effects of budget changes. ...

But there has never been a consensus beforehand about how dynamic scoring should be done, or even about the direction of the effects. In the past, the only conservative approach was to use static scoring – to ignore any indirect effects that budget changes might have on the ultimate deficit.

There is still no consensus about the details. But today one can hardly doubt that the indirect effects of stimulus policies on the budget will partly (if not entirely) offset their direct effects, or that the indirect effects will be large enough to be important. In today’s environment, static scoring is not just conservative, it's fundamentally unreasonable.

The details have to be negotiated... But next time you think that an $800 billion stimulus plan will add $800 billion to the national debt, think again.

I was thinking more along the lines of the traditional supply-side argument, i.e. the dynamic effects from the higher growth rate we'd have with improved infrastructure, but as noted above, these "are primarily long-run benefits."

Update: Paul Krugman:

Bang for the buck (wonkish): Mark Thoma says he was thinking about thinking about this; I was actually thinking about it. Anyway, it’s true: the cost of an effective fiscal stimulus, in terms of adding to the government’s debt, can (and should) be much less than the headline cost.

Consider an increase in government spending; assume that the interest rate is fixed (a good assumption right now, because interest rates are up against the zero lower bound). Then textbook analysis says that if the stimulus is dG, the increase in GDP is 1/(1 - c(1-t)) where c is the marginal propensity to consume out of income and t is the marginal tax rate. Suppose c is 0.5 and t is 1/3; then the multiplier is 1.5, which is more or less the conventional wisdom right now.

But if $100 billion in spending raises GDP by $150 billion, and the marginal tax rate is 1/3, $50 billion of the spending comes back in additional revenue. So bang for the buck — increase in GDP per dollar of added debt — is 3, not 1.5. Since the main concern about stimulus is that it will add to government debt, it’s this bang for the buck measure, rather than the multiplier, that’s relevant. And 3 sounds a lot better than 1.5.

Take this a bit further: $150 billion is about 1 percent of GDP, which Romer and Bernstein say means a million jobs; so this says $50,000 per job, which is a much better number than the critics have been throwing around (plus many more workers with full-time rather than part-time jobs).

Bang for the buck also heightens the contrast between effective and ineffective stimulus policies. Stay with c = 0.5, t = 1/3, and look at the effects of a tax cut; the multiplier is 0.75, half that for public investment, but bang for the buck is 1, only 1/3 that for investment.

So thinking about how stimulus comes back via revenues is important.

"Is The Deficit A Threat To A Future Recovery?"

Jamie Galbraith responds to the question posed by the National Journal, "Is the deficit a threat to future recovery?"

James K. Galbraith, National Journal:  No. The question is grossly misconceived. Right now and for the immediate future, the budget deficit is the only source of demand that can fuel a recovery. Our present problem is not that it is too big, but that it is too small. Far too small.

In principle, economic growth can come from household consumption, business investment, government spending, or exports. This is a tautology, indisputable and known to everyone who has ever opened a textbook....

[T]he entire private sector, across the entire country and indeed the world, is pulling the economy downward at the present time. ... [A]s consumption, investment and exports decline, so will tax revenues. The government budget deficit is destined to rise, by a lot, on this account alone. This is helpful: a falling tax burden in a progressive tax structure keeps money in private pockets. But it is a weak device to promote expansion, since tax savings will be used first to try to pay down debt... A major tax cut, focused on working Americans such as by remitting the payroll tax, would help sustain after-tax incomes and provide funds to pay mortgages and buy cars. But even these effects are uncertain in a debt deflation.

In these conditions, only government spending can pull the economy out of the ditch. Government must spend. It must do so by as much as necessary in order to maintain a high level of employment. Aid to states and localities, an infrastructure fund, increased social security benefits, foreclosure relief, loans or grants to industry, a green jobs program -- all can be useful in coping with the crisis. All will, of course, add to the public budget deficit.

There is no harm in seeking out wasteful or unnecessary programs to cut as the President-elect proposes. The war in Iraq is a huge waste of money with minor benefits to employment. Missile defense is a vast waste of construction, engineering and scientific resources with no benefit to security. Bridges to nowhere and roads to the wilderness add nothing to the value of the national capital stock. But the point of cutting waste and boondoggles is not to reduce the deficit, but to release real resources for better uses. The obligation to use those resources, and to deploy the public funds necessary to ensure that they are used, remains.

Will the projected future deficit "crowd out" future private investment as so many claim? This is absolutely improbable. To the contrary, a successful program of public expenditure will create profit opportunities that will encourage private businesses, many of which will otherwise close, to stay open and eventually to expand. A general improvement of economic conditions can only lower, not raise, the presently prohibitive risk premiums on interest rates being charged private borrowers! There is no way that present or future public spending, even in very large volumes, would under these conditions raise long term interest rates generally by enough to offset the positive effects of an increase in activity and a reduction of risk. Quite the contrary! Public spending will crowd in, not crowd out, private investment.

Whether they know it or not, those who argue a "crowding out" model are working from a mental construct under which the economy is always operating at or near full employment, and under which there is a fixed supply of credit resources, a pool which government and the private sector must share. This is not the case! We are far below full use of available resources now and will certainly fall very much farther in the months ahead... And there is no fixed pool of credit! The entire purpose of the capitalist banking system under the Federal Reserve Act, ever since 1913, has been to create an "elastic currency" not subject to fixed limits to the supply of finance. With due respect to those who continue to have reservations about "crowding out", please stop. This is a moment when an unfamiliarity with the most basic economic and financial facts can be very dangerous to national well-being.

Finally, there are those who have argued, in times past, that projected future deficits might have a psychological or other effect, detectable in statistical data, on long term interest rates and therefore on private business investment. But whatever the merits of the statistical case, there is no risk under present conditions that something so remote and ethereal as a psychological fear of deficits in the distant future is going to drive up the long-term interest on public debt. We are in a full- fledged flight to safety! That is a flight to cash and to Treasury bonds and bills..., as witnessed by the rising dollar. Right now and for the foreseeable future Uncle Sam can borrow, for whatever term, on whatever scale, for practically nothing. In fact, he has suddenly become a creditor to much of the world -- notably the European Central Bank -- because of a worldwide shortage of dollar assets!

Finally, there is the question of whether it is possible to go too far. The answer is yes. Maybe my diagnosis is wrong. Maybe private credit will recover faster than I think likely. But even allowing for this possibility, action now should be on a grand scale. It is far easier to trim back tax relief in an expansion, than it will be to repeat the political effort of passing a large expansion package if the first one is too small. For this reason, the conditions call for error on the side of action, not of caution. "Wait-and-see," in an emergency, is the worst possible advice. ...

In these circumstance, large budget deficits are essential, and preoccupation with budget balance is counterproductive. ... Those who hang on to simple views of economic virtue in present times need to rethink: time is short and action is needed.

On the crowding out issue, two conditions are required for this effect to be significant. First, an increase in the supply of bonds to finance a larger deficit must cause interest rates to increase. But in a liquidity trap, or near one, changing the supply of bonds has little if any impact on interest rates (this also makes it hard for monetary authorities to reduce interest rates). But even if interest rates do change, a second step is required for crowding out to occur. Investment must be sensitive to changes in the interest rate. However, in a recession this sensitivity is very low (and again, this makes monetary policy ineffective since it relies upon investment responding to lower interest rates). As noted above, near full employment things are different, but crowding out is not a worry in big recessions.

On the question of what if the stimulus is too large, we've heard for years how sensitive upper income households are to variations in the tax rate. If these claims are correct, then a way to slow down an overheated economy is available. In any case, [the extra revenue will help with deficit worries and,] as Jamie says, scaling down is easier than scaling up and that asymmetry points to more aggressive action.

Paul Krugman: Deficits and the Future

Deficit hawks who are complaining about the stimulus package have it all wrong:

Deficits and the Future, by Paul Krugman, Commentary, NY Times: Right now there’s intense debate about how aggressive the United States government should be in its attempts to turn the economy around. Many economists, myself included, are calling for a very large fiscal expansion to keep the economy from going into free fall. Others, however, worry about the burden that large budget deficits will place on future generations.

But the deficit worriers have it all wrong...; strong fiscal expansion would actually enhance the economy’s long-run prospects.

The claim that budget deficits make the economy poorer in the long run is based on the belief that government borrowing “crowds out” private investment — that the government, by issuing lots of debt, drives up interest rates, which makes businesses unwilling to spend on new plant and equipment, and that ... reduces the economy’s long-run rate of growth. Under normal circumstances there’s a lot to this argument.

But circumstances right now are anything but normal. Consider what would happen ... if the Obama administration gave in to the deficit hawks and scaled back its fiscal plans. ... Fiscal austerity ... would reduce, not increase, private investment...: it’s exactly what happened in two important episodes in history.

The first took place in 1937, when Franklin Roosevelt mistakenly heeded the advice of his own era’s deficit worriers. He sharply reduced government spending, among other things cutting the Works Progress Administration in half, and also raised taxes. The result was a severe recession, and a steep fall in private investment.

The second episode took place ... in Japan. In 1996-97 the Japanese government tried to balance its budget, cutting spending and raising taxes. And again the recession that followed led to a steep fall in private investment.

Just to be clear, I’m not arguing that trying to reduce the budget deficit is always bad for private investment. You can make a reasonable case that Bill Clinton’s fiscal restraint in the 1990s helped fuel the great U.S. investment boom of that decade...

What made fiscal austerity such a bad idea both in Roosevelt’s America and in 1990s Japan were special circumstances: in both cases the government pulled back in ... a liquidity trap, a situation in which the monetary authority had cut interest rates as far as it could, yet the economy was still operating far below capacity.

And we’re in the same kind of trap today — which is why deficit worries are misplaced.

One more thing: Fiscal expansion will be even better for America’s future if a large part of the expansion takes the form of public investment — of building roads, repairing bridges and developing new technologies, all of which make the nation richer in the long run.

Should the government have ... permanent ... budget deficits? Of course not. Although public debt isn’t as bad a thing as many people believe — it’s basically money we owe to ourselves — in the long run the government, like private individuals, has to match its spending to its income.

But right now we have a fundamental shortfall in private spending: consumers are rediscovering the virtues of saving at the same moment that businesses ... are cutting back on investment. That gap will eventually close, but until it does, government spending must take up the slack. Otherwise, private investment, and the economy as a whole, will plunge even more.

The bottom line, then, is that people who think that fiscal expansion today is bad for future generations have got it exactly wrong. The best course of action, both for today’s workers and for their children, is to do whatever it takes to get this economy on the road to recovery.

"Deficit Hawks are Like Protectionists"

Things are different when the economy is operating inside the production possibilities curve:

Deficit Hawks are Like Protectionists, by knzn: Everybody knows that, in the aggregate, trade increases welfare. ... But protectionists argue that the redistributive effects of trade can often be bad enough to outweigh the aggregate advantage. Trade can hurt certain parties that one may wish not to hurt. The overall pie is larger, but someone’s share may be smaller.

When an economy has slack resources, as the US economy – as well as the world economy – clearly does now and likely will even more in the immediate future, there is no aggregate welfare cost to using up those resources, so any benefit society receives is, in the aggregate, free. In an aggregate welfare sense, slack resources are a free lunch, and that lunch is wasted if nobody eats it. Deficit hawks talk about the cost to taxpayers and the cost to future generations and all that. But let it be noted that fiscal stimuli during times of slack resource use make the overall pie larger, and any objections must rest on the premise that the new division of the pie leaves some particular party with a smaller slice despite the larger pie. It’s pretty much analogous to the argument for protectionism. ...

[J]ust like the protectionists, the deficit hawks must be concerned about the redistributive effects of deficits, since the aggregate effect is to increase welfare. But while the protectionists actually have a pretty good argument (at least at the national level, in developed countries) as to why the redistributive effects are bad and might be expected to outweigh the aggregate effects in terms of importance, the deficit hawks’ arguments seem pretty lame to me.

The main issue would seem to be redistribution from future generations to the current generation. Here’s a point I made a couple of years ago, but I’ll repeat it: in the history of capitalism, there has been a consistent long-term trend of increasing welfare, by pretty much any reasonable measurement. You can complain about some of the things that have gotten worse, but the fact is, the19th century really sucked for most people, and the 18th century sucked even worse. And compared to the 1990s, the 1920s sucked, too. Unless we expect the trend to suddenly reverse itself, the likelihood is that future generations will be, in the relevant sense, richer than the current generation. So the deficit is a transfer from relatively rich future generations to the relatively poor current generation. I would hope that those future generations could spare a few extra pennies for such miserable folk as we. Especially since it is our blood, sweat, and tears that will have made them so rich. It is through no merit or toil of their own that they will come of age using microprocessors that run 1000 times faster than the ones we use today. ...

Big Spender?

Was Bush a big spender? Did voters penalize Republicans for lack of fiscal discipline?:

Big Spender, by Kevin Drum: National Review editor Rich Lowry addresses the party faithful today about the reason Republicans got trounced so badly this year:

One temptation will be to say that if only Republicans had stayed truer to the faith, especially on fiscal discipline, none of this would have happened. ...

Bush ... didn't run as a strict fiscal conservative when he was elected in 2000, and he wasn't any more profligate in his second term, when he was roundly rejected by the public, than in his first term, when he was on his way to reelection.

Lowry is right, but it's actually even worse than that. Bush's big spending ways have been overdramatized by the right, but it's true that domestic spending went up during his first three years in office. So did earmarks. And his big Medicare bill was passed in 2003. Did conservatives revolt over this? It sure doesn't look like it. The next year Bush rode a triumphant conservative coalition to reelection and Republicans picked up four seats in the Senate.

Starting in 2004, in fact, Bush got fairly stingy with his domestic budgets. Result: Republicans took a shellacking in 2006, and two years later took yet another shellacking. This is not exactly great evidence for a nationwide rebellion over profligate spending. In fact, you might even conclude that Americans like profligate spending. Conservatives don't seem to mind it that much either: their rebellion against Bush mostly started after 2005, three years after the 2003 budget was put in place and lower spending was already the order of the day in the Bush White House. ...

Bottom line (so to speak): Reining in spending and cutting back earmarks might be good things to do from a conservative perspective. But was it spending and earmarks that turned the American public against the Republican Party? Not a chance. My guess is that the answer is pretty much the obvious one: a combination of policy incompetence, an unpopular war, economic dogma that didn't even pretend to take middle class wage stagnation seriously, and an increasingly hard-edged social conservatism that turned off Latinos, seculars, and the young. But big spending? Not so much.

Reminds me of Bogus Bush Bashing and Is Bush a Big Spender?.

I think it's simple. Conservatives do not have answers for today's problems. We need government intervention on a variety of fronts, and there is strong public support for government action (though there is disagreement on the details). Conservatives have tried, I think unsuccessfully, to blame government intervention in the past for today's problems. But beyond blaming government policy in the past, what cures do they have to offer? By Ricardian equivalence, fiscal policy cannot work, so no help there. They believe money is neutral, or at least neutral enough to discount it as an effective policy tool, so that rules out monetary policy. They oppose regulation, so unless you beleive that lifting regulations is the answer to our current problems, there isn't much to offer there either. I've heard conservatives say that now is not the time to adhere to strict ideological principles, or that they were wrong about markets ability to self-regulate, things like that, but that doesn't seem like much of a selling point for their economic philosophy.

Their answer is, for the most part, for the government and policymakers to get out of the way and let the economy heal itself. If you believe that is the right answer, then you should support conservatives. But I think most people have come to the conclusion that lack of regulation and oversight is the problem, not the solution, that watching economy go into a tailspin without doing anything about it on the belief that trying to help will only make things worse is the wrong approach, and that on those occasions when help is finally offered, to argue that the solution is tax cuts that help those at the top rather than help directed at those who need it most does not find much public support. We have tried that approach, and most people understand that it didn't work (and it didn't help to seriously mislead people about the ability of those tax cuts to be self-financing). Since conservatives have so little to offer in response to the current economic crisis - they have little to say if they insist on sticking to their ideas about the harm that comes from government intervention - and since past conservative policies have not lived up to the promises made when they were implemented, I don't think it's much of a mystery why conservatives are having so much trouble finding an economic message that resonates with the public.

Will the Financial Crisis Crowd Out Health Care Reform? Should It?

Ezra Klein says the financial crisis should not get in the way of health care reform. In fact, the crisis helps to clarify the need to find a way to reduce the growth in health care costs if we want to continue to have the flexibility to respond to financial and other economic crises:

You've Won! Now Don't Do Anything!, by Ezra Klein: Bloomberg lays out the case for why the financial crisis should prevent Barack Obama from doing anything about health care reform. As the argument goes, health care is the most severe fiscal threat facing the nation, so it should be allowed to fester, trash the government's long-term solvency, and ensure that we face a far more severe financial crisis a few decades into the future, and we face it without the sort of solvency that enables large-scale government intervention. Oh, wait. That's not how the argument goes. That's the part of it that is always somehow oddly left out. So rather than read the Bloomberg article, folks should listen to Peter Orszag on these matters:

While I’m on the topic of health care, I’d like to make a point related to the current turmoil in financial markets. Many observers have noted that addressing the problems in financial markets and the risks to the economy may displace health care reform on the policy agenda — and that may well be the case for some period of time. ...

Although it may not seem immediately relevant given our current difficulties, it will be crucial to address the nation’s looming fiscal gap — which is driven primarily by rising health care costs — as the economy eventually recovers from this current downturn. Indeed, our ability to address our current economic difficulties (through both financial market interventions and potential additional fiscal stimulus) would be severely impaired if investors were not so willing to invest substantial sums in Treasury securities without charging much higher interest rates. That willingness reflects the (currently accurate) view among investors that Treasury securities are extremely safe investments.

If we fail to put the nation on a sounder fiscal course over the next few decades, though, we will ultimately reach a point where investors would lose confidence... If that were to occur, we would lack the kind of maneuvering room that we currently enjoy to address problems in the financial markets and the economy. So if you think the current economic crisis is serious, and it is, imagine what it would be like if we didn’t have the ability to undertake aggressive and innovative policy interventions because creditors were effectively unwilling to lend substantial additional sums to the Federal government…

Orszag, of course, is head of the Congressional Budget Office and one of the individuals who has been most immersed in the impact of the financial crisis on federal priorities. And he speaks the truth. Leaving our health care problem to worsen is the height of fiscal irresponsibility. It cannot be said more clearly than that.

Update: See also What Should Obama Do First? Health Care Reform by Andrew Samwick.

The Financial Crisis and Short-Run Stabilization Policy

Short-run stabilization policy for the economy during a downturn involves either cutting taxes to stimulate consumption and investment (and sometimes net exports), or increasing government spending. Which of these is used and the specific policy adopted has important implications for the effectiveness of policy, but no matter how it is done it will raise the deficit, and the increase in the deficit is often used to oppose the policy.

Theoretically, however, there is no reason at all why short-run stabilization policy ought to impact the long-run budget picture. Ideally, the deficits that accumulate during bad times are paid for by raising taxes or cutting spending during the good times so that there is no net change in the budget in the long-run.

Historically, we have been pretty good at spending money in bad times, but not so good at paying for the spending when times are better. But if we are serious about stabilization, that's what we need to do. When output is below the long-run sustainable rate we increase economic activity by deficit spending, and when output exceeds the long-run sustainable rate, we decrease activity by running a surplus. Doing this fills the troughs with the shaved peaks from the booms and keeps the economy closer to the long-run trend value.

I've been wondering if the current crisis will change our attitude about paying for stabilization policy, i.e. if it will make us more willing to raise taxes and cut spending when times are good. One of the problems with the last two boom-bust cycles was unchecked exuberance. Any calls to raise taxes or interest rates were met with howls about how it would cut off the boom, and who would want to do that? But tempering the boom might have helped to reduce the size of the meltdown we are experiencing now and left us much better off.

When the next boom develops, will we be more willing to raise taxes, cut spending, and tighten Fed policy? Will we remember what happened when the previous two booms ended and be more willing to step in and slow down the booming economy, will we be less susceptible to the argument that doing so will eliminate creative and productive innovation (as opposed to misdirecting resources during the mania phase)? This doesn't mean creating a recession or slamming on the brakes so hard we hit our heads, it doesn't mean ending innovative activity, it simply means what it says, bringing the growth rate down to its sustainable rate, and attenuating the exuberance that leads to housing and dot.com bubbles. Will we be more willing to take the necessary steps the next time the economy begins to boom?

I doubt it.

And the problem is that if we aren't willing to pay our bills during the good times, then it will be much harder to spend the money we need to spend when times are bad -- our hands will be tied when it comes to stabilization policy.

So perhaps a business cycle version of Paygo is needed. Legislation could be clearly identified as a countercyclical measure, and it would contain both the deficit spending to address the downturn along with an explicit plan to pay for the policy when times get better. That is, the legislation would contain a specific trigger saying that when the recession is over and GDP growth, employment growth, etc. exceed some predefined amount (e.g. two quarters of strong growth), taxes would go up or spending would be cut by enough to pay for the stabilization package.

My concern is that worries over the deficit will prevent us from taking the countercyclical policy steps we need to take to protect people who are vulnerable to job loss, etc. in a downturn. Thus, the goal here is to find a way to ease the long-run budget worries so that we don't hesitate to do what's needed to stabilize the economy. I'm not sure if a business cycle version of Paygo is the answer, it may be just as hard to promise to raise taxes in the future as it is at any other time (though perhaps this would be easier if it returned rates to old levels), and the triggers would be hard to define, but somehow we need to learn to pay for the policies we put in place so that they will still be there the next time we need them.

A better answer would be a legislature that does this on its own without the need for mechanisms such as Paygo to force them to do what is best for the economy over the long-run, but that hasn't worked. Maybe we''l get a better class of legislators in the future, but I'm not counting on that.

Finally, this is separate from spending on infrastructure, health care, etc., and whether we can afford it. I think we can afford it, and that we should invest in infrastructure to enhance future productivity, that we should take on health care (our biggest long-run budget worry), and that we should make other investments in our future, but that is a different discussion. They can be connected - short-run stabilization can be directed a longer-run problems when it's feasible to do so - but the case for short-run stabilization can be made independent of whether or not it contributes to solving longer run issues. If it does, so much the better.

Reich: Saved by the Deficit?

Robert Reich is worried "that we are about to have a rerun of 1993":

Saved by the Deficit?, by Robert Reich, Commentary, NY Times: Both presidential candidates have been criticized for failing ... to name any ... plans they’re going to have to scrap because of the bailout and the failing economy. That criticism is unwarranted. The assumption that we are about to have a rerun of 1993 — when Bill Clinton, newly installed as president, was forced to jettison much of his agenda because of a surging budget deficit — may well be mistaken.

At first glance, January 2009 is starting to look a lot like January 1993. Then, the federal deficit was running at roughly ... 5 percent of gross domestic product, way too high for comfort. By contrast, the deficit for the 2009 fiscal year is now projected to be ... about 3.3 percent of gross domestic product. That’s not too worrying. But if the Treasury shovels out the full $700 billion of bailout money next year, the deficit could balloon to more than 6 percent of gross domestic product... And if the nation plunges into a deeper recession, with tax revenues dropping..., the deficit will be even larger...

Yet all is not what it seems. First, the $700 billion bailout is ... like ... a temporary loan or investment. The Treasury will take on Wall Street’s bad ... securities for which there’s no market right now — and ... hope it ... will be able to resell the securities for at least as much as it paid, if not for a profit. And if there is a shortfall, the bailout bill allows the president to impose a fee on Wall Street to fill it.

Another difference is that in 1993, the nation was emerging from a recession. ... Under these circumstances, the deficit Bill Clinton inherited threatened to overheat the economy. He had no choice but to trim it, a point that the Federal Reserve chairman, Alan Greenspan, was not reluctant to emphasize. ...

Next year, however, is likely to be quite different. All economic indicators are now pointing toward a deepening recession. ... Under these circumstances,... the government will probably have to run deficits to keep the economy going anywhere near capacity...

Finally, not all deficits are equal. As every family knows, going into debt in order to send a child to college is fundamentally different from going into debt to take an ocean cruise. Deficits that finance investments in the nation’s future are not the same as deficits that maintain the current standard of living.

...[W]ithout adequate public investment [in infrastructure, education, healthcare, and the environment], the vast majority of Americans will be condemned to a lower standard of living for themselves and their children. The top 1 percent now takes home about 20 percent of total national income. As recently as 1980, it took home 8 percent. Although the economy has grown considerably since 1980, the middle class’s share has shrunk. That’s a problem not just because it strikes so many as being unfair, but also because it’s starting to limit the capacity of most Americans to buy the goods and services we produce without going deep into debt. ...

Perhaps it should not be surprising, then, that the Wall Street bailout has generated so much anger among middle-class Americans. Let’s not compound the problem by needlessly letting it prevent the government from spending what it must to lift the prospects of Main Street.

John McCain's "Big" Economic Plans

Here's John McCain's big plan for the budget: make a whole lot of noise about eliminating of the piece of the budget pie representing earmarks (and remember that most earmarks simply mandate where monies will be spent, they don't create any new spending):

[Note: The OMB estimates earmarks to be 16.9 billion in 2008. Current federal expenditures for 2008 are not yet available, so the chart uses the 2007 value of 2880.5 billion from the BEA (the ratio is approximately one half percent, i.e. 0.59%). Since federal expenditures for 2008 will exceed those of 2007, this means that the area for earmarks shown in the diagram is overestimated, i.e. it is larger than the true value. The NY Times also notes that "earmarks ... make up less than 1% of the federal budget."].

All the recent controversy over McCain lying about Palin's earmark requests, as he did most recently on The View, is noteworthy for what is says about McCain's (lack of) character, but more generally it is misdirecting us from more important issues. Earmarks are only a minor part of the overall budget, and issues such as health care reform are much more important since rising health care costs will absolutely dwarf any savings from earmarks.

Here's the centerpiece of McCain's economic plan: drill for oil, then pretend like it will help at the pump:

[via]

I can't even see the sliver of yellow until after 2015, and even after that it's not much of a contribution. That's supposed to lower gas prices?

With such a solid foundation for the polcy porposals - a couple of slivers of pie - I can't imagine why the McCain campaign would resort to lies, deceptions, misdirection, and misleading characterizations to sell these "big" plans.

Update: Brad Delong has a slightly more detailed version of the first graph here (scroll down).

"Yes, Bush's Economic Policies Are a Failure"

Tax cuts paying for themselves, or not:

Yes, Bush's Economic Policies Are a Failure, by Brad DeLong: Rex Nutting of Marketwatch:

Budget outlook worsens on war, economy - MarketWatch: With the economy weakening and spending on the war rising, the federal budget outlook has deteriorated in both the short-run and the medium-term, the Congressional Budget Office said Tuesday. In its summer budget update, the nonpartisan budget office said the federal deficit would likely double this year compared with last year, and remain at about 3% of gross domestic product for the next two years. ...

Unlike the February update, which showed the budget roughly in balance through 2018 under favorable assumptions, the September projection now sees deficits totaling $2.3 trillion over the next 10 years. Those projections assume that the 2001 and 2003 tax cuts expire and that the alternative minimum tax is not changed. If the tax cuts are extended as the White House and the McCain-Palin ticket want, the deficits over the next 10 years would be $4.2 trillion higher than now projected, CBO said.

The reason McCain-Palin want to continue these policies is that they believe suggestions that the policies haven't worked for the majority of Americans can be attributed to whining. So, if you want to continue being berated for whining about the obvious problems you face, McCain-Palin is the ticket for you.

"Bush Midsession Budget: Profound Sadness"

Stan Collender is feeling down:

Bush Midsession Budget: Profound Sadness, by Stan Collender: It says more about me than I should probably admit, but back in 2000 I found the  prospect of paying off the national debt to be very exciting.

To me, the pledge to do that, which Bill Clinton made towards the end of his presidency and George W. Bush made as his years in the White House were just beginning, was absolutely thrilling. Because of the lower annual interest payments that would result, no other change then being seriously talked about had the potential to alter the long-term federal budget outlook as positively and permanently.

That's why I found the mid-session review of the budget released yesterday to be so depressing.  It was the official notice that the pledge, and all the good things that would come from it, would not be fulfilled. It was also time to admit that the budget politics, economics, and limits of the past decade would continue...and continue...and continue.

That's just not a happy occasion for anyone but those of us who blog, write, and talk about the budget. Business will be booming.

None of this was a surprise, of course. The prospects for paying down the national debt firmly ended back in the first year of the Bush administration. And the close to $490 billion deficit that OMB projected for 2009 has long been assumed or leaked.

Nevertheless, the release of the midsession review on July 28, 2008 should be noted as the official date when the dream of a very different budget debate and fiscal policy opportunities died.

I'll have more about the following shortly.  But other observations:

The bad news absolutely is understated. The $482 billion projected fiscal 2009 deficit will actually be closer to $600 billion before the year is over.

The much-ballyhooed Bush administration pledge to cut the deficit in half was a gimmick. There clearly was no commitment to do it more than once (that is, if there really ever was a commitment to do it even once).

From a budget, deficit, debt, interest rate, and fiscal policy perspective, the Bush administration is leaving the country so much worse off than it found it that it will likely hamstring the next president and Congress in ways that aren't yet fully understood.

Based on what we now know for sure about next year's budget, none of the presidential candidates' promises should be taken seriously. Unless they, the country, and those lending us money are willing to tolerate much higher nominal deficits and a larger debt than has so far been imaginable, the next president's options will be severely limited.

More to come.

How should Democrats respond? Recall Brad Delong's thoughts:

[S]hould Barack Obama become president. Those of us who served in the Clinton administration and worked hard to ... turn deficits into surpluses are keenly aware that, after eight years of the George W. Bush administration, things look worse than when we started back in 1993. All of our work was undone by our successors in their quest to win the class war by making America’s income distribution more unequal.

A chain is only as strong as its weakest link, and it seems pointless to work to strengthen the Democratic links of the chain of fiscal advice when the Republican links are not just weak but absent. Political advisers to future Democratic administrations may argue that the only way to tie the Republicans’ hands and keep them from launching another wealth-polarizing offensive is to widen the deficit enough that even they are scared of it.

They might be right. The surplus-creating fiscal policies established by Robert Rubin and company in the Clinton administration would have been very good for America had the Clinton administration been followed by a normal successor. But what is the right fiscal policy for a future Democratic administration to follow when there is no guarantee that any Republican successors will ever be “normal” again? That’s a hard question, and I don’t know the answer.

Fear of a deficit didn't stop the Republicans from putting their agenda into place, should Democrats take the same approach? Medicare, Social Security, and other programs for the elderly aren't going away, not with an aging population that will have considerable political power, so the question is how we pay for these programs. 

The current budget problem is mainly from tax cuts and increases in military and domestic security expenditures, but the problem going forward is mainly health care costs. We can't cut enough out of the budget or raise taxes high enough to meet projections if the current health care system is unchanged, so this comes down to one question, how do we reign in health care costs?

I don't mean that health care spending shouldn't grow as a percentage of GDP as we get wealthier. It is quite reasonable for us to devote new income from growth toward health care spending. But even so, current projections are that growth in health care costs will need to be lowered to be sustainable.

All of the focus on getting the budget in shape in the short-run is necessary, though we should recognize that as a percentage of GDP deficits have been much higher in the past without disastrous consequences, so there's no need for drastic cuts in programs to make ends meet and tax increases are probably out of the question (and actual fat should not be eliminated from the budget, but there's not much there). This would be easier if Republicans hadn't squandered the surplus they inherited. But focusing on the immediate problems brought about by tax cuts and military spending should not divert us from the more formidable problem of solving the escalating health cost problem. If Obama wins and tries to institute some form of universal care, it will be opposed as a budget breaker (and for other reasons), but I think universal care will help a lot in bringing down health care cost growth. But whatever we do, it's time to get started.

The Spending Spree Myth

I stopped reading the Washington Times for the most part (why doesn't it come under more scrutiny for the things it publishes?), so I haven't read this article. Fortunately I don't have to:

Talk about cash money, money, Sadly No!: The Washington Times ... shows it’s the go-to place for fine analysis of all budget and deficit-related matters. Especially when William F. Shughart II, the F.A.P. Barnard Distinguished Professor of Economics ... is writing.

In February, the $175.6 billion deficit was a single-month record, 46 percent higher than the previous single month high (in February 2007), and nearly $14 billion more than the deficit for all of fiscal 2007, which ended last Sept. 30.

We’ve seen a lot of nonsense written about the deficit, but this is the first time we remember someone going on about the monthly deficit. Because once you start doing that, hilarity ensues. Such as us commenting that the government’s finances are in great shape because it ran a surplus of $159 billion in April. Why — that pretty much cancels out February’s deficit! Hooray!

Peterson's One Billion Dollar Debt Crusade

Wow, here's what's coming (from here):

From the NY Times:

Spending $1 Billion to Restore Fiscal Sanity, by John Harwood, NY Times: Gaffes have commanded presidential campaign headlines lately... Peter G. Peterson wants people to focus on what he considers real news: the nation is going broke.

Because he wasn’t born yesterday, Mr. Peterson, co-founder of the Blackstone Group and a secretary of commerce under President Richard M. Nixon, will spend $1 billion in an effort to get the public’s attention. The money ... will finance a media blitz, starting with a documentary, “I.O.U.S.A.”

The film aims to startle voters and politicians alike, and summon them to the task of closing the long-term imbalance between what the government will take in and what it has promised to pay out, most notably through Social Security and Medicare.

Mr. Peterson, 82, says he yearns for the can-do spirit that helped politicians forged by the Depression finance the G.I. Bill of Rights, the Interstate highway system and the Marshall Plan from the ashes of World War II. ...

“Has something fundamental happened to the character of our people or our societal structure, or has no one stepped up to provide the leadership?” Mr. Peterson asked. “We’re not going to know that until we try.” ...

Though Mr. Peterson has endorsed Mr. McCain, his efforts to control debt are bipartisan, and he has enlisted Robert E. Rubin, President Bill Clinton’s treasury secretary, to make his case. The foundation does not expect the candidates to propose comprehensive solutions while chasing votes; instead, it will pursue the more limited goal of dissuading the candidates from ruling out potential solutions.

Money Talks

At the center of Mr. Peterson’s plan lies “I.O.U.S.A.,” which will be screened for the news media in Washington on Monday and opens in 400 theaters next month. ... “I.O.U.S.A.” hopes to give as much cachet to long-term fiscal policy as “An Inconvenient Truth” gave to environmentalism.

Mr. Peterson’s foundation is planning an active Internet strategy, tapping bloggers and social networks to reach young voters, who typically pay little heed to far-off fiscal obligations. In early 2009, as the new president takes office, the foundation will try to draw attention with programming on public television, and possibly television advertisements and infomercials.

The effort resembles those of public policy advocacy groups, with a big exception: the money Mr. Peterson has put behind it. ... “You can buy a lot of airtime” with $1 billion, Mr. Peterson said. “People are going to hear from us.”

At some point we do have to face budget realities, and if we are going to deal with this problem, which is mainly a problem with rising health care costs (and that will be a problem whether it's paid for publicly or privately), I'd rather have it happen with a Democrats in charge. That way, the process is less likely to result in large cuts to necessary social programs (and we'd be more likely to get universal health care, something that could also help with the health care cost problem).

I haven't seen the movie, so I don't know for sure how the problem is presented, but the little bits shown above lead me to worry that this will create unnecessary fear about the budget in areas where such fear is unwarranted (e.g. Social Security, a place Peterson has focused in the past). The problem is that this can lead to solutions that satisfy ideological or political goals, but don't deal with the major problem. In any case, it looks like the budget hawks are about to become more vocal and aggressive.

McCain's Continuous Flip-Flopping

At first, John McCain said he'd balance the budget by the end of his first term. But when pressed last April, he changed his stance:

Sen. McCain has backed off his earlier promise to eliminate the budget deficit by the end of his first term and now says it may take two terms.

Today his stance changed again:

Mr. McCain is now pledging once again to balance the budget by the end of his first term in 2013, his advisers said Monday. In doing so, they were reverting to an earlier pledge that Mr. McCain had abandoned in April, when he proposed a series of costly tax cuts and said, citing the ailing economy, that it might take two terms to balance the budget.

Funny thing is, he's flip-flopping between promises to balance the budget that, given his other pledges, are not credible. Brad DeLong:

To John McCain's promises to (a) wage more wars abroad and (b) cut taxes for the rich while (c) limiting domestic spending cuts to waste, fraud, and abuse he has now added a promise to balance the budget by 2013--a promise that his substantive policy advisors had been trying to keep him from making all winter and spring. Their view was that George H.W. Bush's promise in 1988 not to raise taxes had brought him little short run political gain and had done so at the price of making his presidency a failure (cf Richard Ben Cramer, What It Takes).

Why might McCain do this?:

Mr. McCain’s tax cut proposals have won over some of his erstwhile supply-side critics. Last year the Club for Growth, a prominent group that advocates tax cuts, issued a paper headlined “John McCain is No Supply-Sider”... Now Pat Toomey, the president of the group, said that Mr. McCain’s recent tax cut proposals indicate that supply-siders are getting the upper hand.

“Is John McCain a supply-sider in his bones?” Mr. Toomey asked. “I’m not sure he is. But I do support the positions he has been taking.”

And,

Mr. McCain, who has been dogged by his own past statements that he does not understand the economy as well as he should, has not always spoken fluently about economic policy during the campaign.

When he was asked at a town hall-style meeting in Connecticut in April whether he wanted to “raise taxes, cut entitlement spending, cut defense spending, or have a deficit,” Mr. McCain spoke generally about emulating President Ronald Reagan, not mentioning that the deficit nearly tripled during the Reagan presidency.

Some statements from the McCain campaign appear to be more than just confusion. Jared Bernstein:

They're Lying: The debate over the economy swung into high gear today as both presidential candidates gave speeches on the topic. That's as it should be: let this critical debate begin.

What's not okay is that one candidate -- John McCain -- and his team are making up damaging stuff that directly contradicts policies Obama has been crystal clear about. ...

McCain and Obama have very different economic plans, particularly regarding tax policy... They have every right to go forth and build support for their plans and attack the other guy's. But this is not the way to do it. If McCain and his staff persist in twisting the truth like this, there can be no decent debate. It's a terrible disservice to the electorate and an abrogation of anything resembling straight talk.

Giving in to the "tax cuts pay for themselves" crowd, not understanding economic principles enough to see the consequences of the economic policies he supports, and the tactics he is using are all worrisome. McCain doesn't get economics, he's willing to take positions of convenience rather than principle, and he's willing to use distortions of the truth to sell his policies. That's a bad combination.

Updates: Robert Reich:

George W. Bush took the largest budget surplus in history and transformed it into a giant deficit. McCain's economic plan, announced today, will do even worse. McCain says he’s going to balance the budget by the end of his first term (actually, he didn’t literally say that – he just “demanded” it – implying that a Democratically-controlled Congress would be ultimately responsible if it didn't happen). And then McCain came up with numbers that will blow the deficit into the stratosphere. ...

The big question is how he proposes to fill the giant budget hole he’s dug for himself, over and above the $443 billion already there. Answer: He doesn’t say. He calls for $160 billion in unspecified spending cuts, and unspecified “reform” of entitlements. Whaaaa?

Supply-side economics is one of those unfortunate half-brained theories actually to have been tried in practice, and failed miserably. Now we have a candidate for president of the United States who says to the American people, in effect: I know you know supply-side economics is a crock. Well, I’m going to do the biggest supply-side tax cut in history, mostly for corporations and the well-to-do. And I’m going to tell you I’ll balance the budget. If you believe this, you’ll believe anything.

Brad DeLong:

Cr--! Robert Pear of the New York Times called, looking for a soundbite on McCain's budget policy. I blathered on, while the perfect soundbite was waiting in my email inbox, unread.

It was:

Underpants Gnomes.

You all remember the plan of the Underpants Gnomes from South Park:

1. Collect underpants.
2. ?
3. Profit!

That's the perfect analogy for John McCain's budget policy:

1. Cut taxes and spend more on the military.
2. ?
3. Balanced budget!!

Memo to self: read email from persons known to be witty before talking to reporters, not after...

Economist Mom:

...[I]t doesn’t take long to go through the document... A few initial reactions... The most annoying passage is found in the so-called “Bi-partisan Fiscal Discipline” section on page 5...:

Bi-partisan Fiscal Discipline: A McCain Administration will provide the leadership to achieve bipartisan spending restraint equivalent to that in the 1997 Balanced Budget Agreement between a GOP Congress and a Democratic President.

• In 1997, President Clinton and the GOP Congress agreed to balance the budget by restraining the growth in spending and cutting taxes over a ten-year period.
• With the same bipartisan effort today ... we could keep taxes low and still balance the budget by holding overall spending growth to 2.4 percent. Unlike Congress and the Executive branch in recent years, a McCain Administration will enforce the spending restraint to balance the budget and keep it balanced.
• A McCain Administration would perform a comprehensive review of all programs, projects and activities of the federal government, and then propose a plan to modernize, streamline, consolidate, reprioritize and, where needed, terminate individual programs. ...
• A McCain Administration will review all special spending provisions to end subsidies to high-income individuals and corporations.

First, the Clinton Administration did not achieve fiscal discipline by restraining spending and “cutting taxes.” The Clinton Administration made the tough choices (and earlier than 1997) to restrain spending and raise taxes in order to achieve meaningful deficit reduction through both the spending and revenues side of the budget.

Second, how is it “bipartisan” to continue to take the hard line that all the fiscal restraint has to come from the spending side of the budget? ...

Third, ... the tax proposals don’t provide for revenue-neutral, efficiency-enhancing tax changes (the types of changes characteristic of fundamental tax reforms), only revenue-losing, deficit-increasing ones–i.e., a continuation of Bush Administration tax policy.

Yet curiously, nowhere in their economic document does the McCain campaign specifically mention”permanent extension of the Bush tax cuts”–which we know to be a key part of their economic platform, at least as constantly explained to their “base,” if not spelled out to the general public here (wink wink). Could it be that they don’t want to call attention to the fact that the “meat” of the McCain economic plan,when you get past the fluff (distractions?) of the waste, fraud, and abuse-type spending cuts (that don’t amount to “beans”),is really just continuing the Bush tax cuts?

There’s now a list of economistswho endorse the McCain economic plan up on the Jobs for America website–including at least a couple whom I greatly respect. I would love for any of them to explain to me how they believe this plan realistically, and wisely,would eliminate the budget deficit in four years, and how any of them who might be less than thrilled with theBush Administration’s record onfiscal policy can read between the lines (and fluff) of this McCain plan and see anything substantially different.

Brad DeLong: The Democrats' Line in the Sand

Brad DeLong says it might be correct that the only way for Democrats "to tie the Republicans’ hands and keep them from launching another wealth-polarizing offensive is to widen the deficit enough that even they are scared of it." If so, then there's a line that Democrats cannot cross:

The Democrats' line in the Sand, by J. Bradford DeLong, Project Syndicate: ...[I]f an economy as a whole is under-saving and under-investing, the government ought to help to correct this problem by running surpluses, not make it worse by running deficits that drain the pool of private savings available to fund investment. This is why most economists are deficit hawks.

Of course, governments need to run deficits in depressions in order to stimulate demand and stem rising unemployment. Moreover, a lot of emergency government spending on current items is really best seen as national savings and investment. ...

But the rule is that governments should run surpluses and not deficits, so various American presidents’ economic advisers have been advocates of aiming for budget surpluses except in times of slack demand and threatening depression. This was certainly true of Eisenhower’s, Nixon’s, and Ford’s economic advisors, and of George H.W. Bush’s and Bill Clinton’s economic advisers.

It was true of Reagan’s economic advisers as well. Some of Reagan’s advisers sincerely did not believe that the tax cuts of the early 1980’s would generate the large deficits that they did (Beryl Sprinkel and Lawrence Kudlow come to mind). Others, like Martin Feldstein and Murray Weidenbaum, understood the consequences of the Reagan tax cuts and were bitter bureaucratic opponents, even if they did not speak out publicly.

In fact, since WWII, only George W. Bush’s economic advisers have broken with this consensus. A few have done so because they are making careers as party-line Republicans, so their priority is to tell Republican politicians what they want to hear (Josh Bolton and Mitch Daniels come to mind here). As for the rest, their reasons for supporting the Bush administration’s savings-draining policies remain mysterious. It is not as though they were angling for lifetime White House cafeteria privileges, or that having said “yes” to George W. Bush will open any doors for them in the future.

But their failings do pose a dilemma for Democratic deficit-hawk economists trying to determine ... economic policies ... should Barack Obama become president. Those of us who served in the Clinton administration and worked hard to ... turn deficits into surpluses are keenly aware that, after eight years of the George W. Bush administration, things look worse than when we started back in 1993. All of our work was undone by our successors in their quest to win the class war by making America’s income distribution more unequal.

A chain is only as strong as its weakest link, and it seems pointless to work to strengthen the Democratic links of the chain of fiscal advice when the Republican links are not just weak but absent. Political advisers to future Democratic administrations may argue that the only way to tie the Republicans’ hands and keep them from launching another wealth-polarizing offensive is to widen the deficit enough that even they are scared of it.

They might be right. The surplus-creating fiscal policies established by Robert Rubin and company in the Clinton administration would have been very good for America had the Clinton administration been followed by a normal successor. But what is the right fiscal policy for a future Democratic administration to follow when there is no guarantee that any Republican successors will ever be “normal” again? That’s a hard question, and I don’t know the answer.

There is, however, one fiscal principle that must be respected. Fiscal deficits so large that they put the debt-to-GDP ratio on an explosive upward trend do not merely act as a drag on long-term economic growth; they also create the possibility that at any moment the economy might face an immediate macroeconomic and financial disaster. A more hawkish fiscal stance may no longer be possible in future Democratic administrations, and might not be good policy if it were, given the likely complexion of successor administrations. Stabilizing the debt-to-GDP ratio is thus the line in the sand that must not be crossed.

Taxes During Wars

What do you think of this? It's the Introduction to a book from the Urban Institute, War and Taxes. The argument is that in criticizing the Bush administration for its policies regarding financing the war, "we should be careful not to compare today’s policies to some cardboard cutout version of an imagined past."

Brad DeLong: McCain and the Decline of US

Brad DeLong says America will be much poorer if John McCain is elected president:

McCain and the decline of US, by J Bradford DeLong, Project Syndicate: Back in 1981, America’s Republican Party gave up all belief that the government’s budget ought to be balanced. The idea took hold that tax cuts should be undertaken all the time, at every opportunity, because reducing taxes supposedly raised revenue. ...

John McCain – who once criticised George W Bush’s tax cuts as imprudent and refused to vote for them – has succumbed to this potion. He appears to be proposing further tax cuts that promise to cost the US Treasury some $300bn a year, to “offset” them with cuts in earmarked spending accounted for at $3bn a year, and somehow to balance the budget.

We know the consequences: McCain’s fiscal policy is likely to be standard Republican fiscal policy – and since 1981, standard Republican fiscal policy has increased the ratio of gross federal debt to GDP by nearly 2% per year. By contrast, a typical post-WWII Democratic administration has reduced the debt-to-GDP ratio by more than 1% per year. This is one of the issues at stake in this year’s presidential election.

Policies that ignore the level of government debt lead to the currency’s collapse, depression (due to the resulting disruption of the sectoral division of labour), and high inflation – perhaps hyperinflation. Often, the guilty blame the economic catastrophe on the sinister manipulations of foreigners like the “gnomes of Zurich” or the IMF. The US is far from that point. But even in the shorter run – over the next two presidential terms, say – the costs of a high deficit and rapid debt growth would be substantial.

A growing debt-to-GDP ratio would ... crowd out investment, as resources that would otherwise go to fund productive investment instead support private or public consumption.

Since 1981, the US has been lucky in that inflows of capital from abroad financed the growth of government debt. At some point, this will stop, and increases in deficits will trigger capital flight from the US.

Suppose that over the next eight years larger deficits trigger neither extra capital inflows nor capital outflows, and suppose that a lower-investment America is a poorer America, with a gross social return on investment of 15% per year.

By 2016, America’s productive potential would be smaller by an amount that would reduce real GDP by 3.6%..., or roughly $3,000 per worker. In a poorer America, fewer businesses would find it worthwhile to entice ... workers ... into the labor force, and perhaps 500,000 net jobs would disappear.

In getting from here to there over the next eight years, a higher-debt America would see productivity growth slow by perhaps a third of a percentage point per year. Average unemployment would then ... rise... The gross correlations between productivity growth and average unemployment found in the 1970’s, 1980’s, 1990’s, and 2000’s would increase the economy’s natural rate of unemployment by about one-fifth of a percentage point, costing an additional 500,000 jobs.

And a higher-debt America is one in which savers and lenders would have a justified greater fear that the government would resort to inflation in order to repudiate part of its outstanding debt.

The Federal Reserve would then have to fight inflation – putting upward pressure on unemployment – in order to reassure savers and lenders of its willingness to guard price stability. There are not even crude gross correlation-based estimates of the size of this effect, but economists believe that it is very real. Would it cost a negligible number of jobs? A quarter-million? A million?

Add it all up, and you can reckon on an America that in 2016 that will be much poorer if McCain rather than Barack Obama or Hillary Rodham Clinton is elected president. ... [U]nder McCain, the wedge between public spending and taxes would be larger, Americans would feel richer, and they would spend more at the expense of “posterity” eight years down the road. Ronald Reagan might have approved. After all, as he put it: “Why should I do anything for posterity? What has posterity ever done for me?” Or was that Groucho Marx?

Paul Krugman: Bush Made Permanent

The Pander Bear Express:

Bush Made Permanent, by Paul Krugman, Commentary, NY Times: As the designated political heir of a deeply unpopular president — according to Gallup, President Bush has the highest disapproval rating recorded in 70 years of polling — John McCain should have little hope of winning in November. In fact, however, current polls show him roughly tied with either Democrat.

In part this may reflect the Democrats’ problems. For the most part, however, it probably reflects the perception, eagerly propagated by Mr. McCain’s many admirers in the news media, that he’s very different from Mr. Bush — a responsible guy, a straight talker.

But is this perception at all true? During the 2000 campaign people said much the same thing about Mr. Bush; those of us who looked hard at his policy proposals, especially on taxes, saw the shape of things to come.

And a look at what Mr. McCain says about taxes shows the same combination of irresponsibility and double-talk that, back in 2000, foreshadowed the character of the Bush administration. ...

According to the nonpartisan Tax Policy Center, the overall effect of the McCain tax plan would ... reduce federal revenue by more than $5 trillion over 10 years. That’s ... enough to pose big problems for the government’s solvency.

But before I get to that, let’s look at what I found truly revealing: the McCain campaign’s response to the Tax Policy Center’s assessment. The response, written by Douglas Holtz-Eakin,... former head of the Congressional Budget Office, criticizes the center for adopting “unrealistic Congressional budgeting conventions.” What’s that about?

Well, Congress “scores” tax legislation by comparing estimates of the revenue that would be collected if the legislation passed with estimates of the revenue that would be collected under current law. In this case that means comparing the McCain plan with what would happen if the Bush tax cuts expired on schedule.

Mr. Holtz-Eakin wants the McCain plan compared, instead, with “current policy” — which he says means maintaining tax rates at today’s levels.

But here’s the thing: ...the Bush administration engaged in a game of deception. It put an expiration date on the tax cuts, which it never intended to honor,... to hide those tax cuts’ true cost. ... Mr. Holtz-Eakin is saying, in effect, “We’re not engaged in any new irresponsibility — we’re just perpetuating the Bush administration’s irresponsibility. That doesn’t count.”

It’s the sort of fiscal double-talk that has been a Bush administration hallmark. ...

And Mr. McCain has said nothing realistic about how he would close the giant budget gap his tax cuts would produce — a gap so large that eliminating it would require cutting Social Security benefits by three-quarters, eliminating Medicare, or something equivalently drastic. Talking, as Mr. Holtz-Eakin does, about fighting waste and reforming procurement doesn’t cut it.

Now, Mr. McCain isn’t unique in making promises he has no way to pay for — the same can be said, to some extent, of the Democratic candidates. But Mr. McCain’s plan is far more irresponsible... Mr. McCain’s budget talk simply doesn’t make sense.

So what are Mr. McCain’s real intentions?

If truth be told, the McCain tax plan doesn’t seem to embody any coherent policy agenda. Instead, it looks like a giant exercise in pandering — an attempt to mollify the G.O.P.’s right wing, and never mind if it makes any sense.

The impression that Mr. McCain’s tax talk is all about pandering is reinforced by his proposal for a summer gas tax holiday — a measure that would, in fact, do little to help consumers, although it would boost oil industry profits.

More and more, Mr. McCain sounds like a man who will say anything to become president.

McCain's Budget Plan

Douglas Holtz-Eakin, John McCain's top economic advisor, says not to worry about the fact that John McCain's budget plan is out of balance by hundreds of billions of dollars, they have a plan to increase revenues and take care of the problem:

As Mr. McCain’s plan currently stands, The Economist magazine concluded that it “will not come anywhere close to paying for the tax cuts.” Most telling, I spoke over the past week with several other economists who admire Mr. McCain and have advised him over the years. None would defend his current fiscal package (or be quoted).

Mr. Holtz-Eakin says the mistake that people are making is treating the McCain platform as if it were a finished piece of work. “It’s April,” he said. “We have until November.” The campaign will later unveil “base broadeners” in the corporate tax code — that is, loopholes it will eliminate — that will pay for the faster investment write-offs, for example.

If you weren't paying a tax before, but you are paying a tax now because McCain broadened the base, that's a new tax. Isn't it? It's a new tax for somebody, even if taxes are lowered elsewhere. Wonder what happened to:

Republican John McCain says there will be no new taxes during his administration if he is elected president.

"No new taxes," the likely GOP presidential nominee said during a taped interview broadcast Sunday.

O.K., in a technical sense, it's a tax shift, a tax cut one place, and a tax increase in another, and some shifts are desirable, others aren't. But does anyone doubt that Republicans would call this proposal a new tax if it came from Democrats? Cue the deep, scary voice: "Democrats have a plan to impose new taxes to pay for their wasteful spending. Instead of making the hard decisions and cutting spending, they want to take money out of your pockets -- they want to raise taxes on businesses, and that costs jobs and lowers economic growth. Republicans understand that, as times get tougher, Washington shouldn't be imposing new taxes that make it harder for people to keep afloat in this economy."

Here's more from the article:

Weighing a McCain Economist, by David Leonhardt, NY Times: When Douglas Holtz-Eakin took over in 2003 as the director of the Congressional Budget Office ... he walked right into a firestorm.

For years, Republicans had been pushing the budget office to change the way it estimated the cost of a tax cut. Rather than looking only at the revenue lost, they argued, the office should also consider how tax cuts would change behavior. With lower tax rates, businesses would invest more, workers would work more — and the government would thus get a tax windfall. This, in a nutshell, is supply-side economics. ...

Mr. Holtz-Eakin ... did indeed begin using dynamic analysis... Yet he used it as it should be used. What the budget office found, as study after study has shown, was that any new revenue that tax cuts brought in paled in comparison with their cost. This is why the deficit jumped under the last two tax-cutting presidents (Ronald Reagan and George W. Bush) and fell under the last two tax-raising presidents (George H. W. Bush and Bill Clinton).

As Mr. Holtz-Eakin told Congress in 2003, a dynamic analysis of the White House’s tax and spending proposals made essentially no difference. ...

Today, Mr. Holtz-Eakin again finds himself in a firestorm. He is the top economic adviser to John McCain’s presidential campaign, and some fiscal conservatives have begun wondering what happened to ... the John McCain who was a fiscal conservative...

“We’ve been taking some hits,” Mr. Holtz-Eakin acknowledged.

Last week, Senator McCain laid out his economic vision... He talked about wasteful spending, but the newest, most detailed part of the speech dealt with a package of tax cuts that would cost about $300 billion a year. They would come on top of $350 billion a year in Bush tax cuts that Mr. McCain wants to make permanent. To put these numbers in perspective, the Iraq war has been costing roughly $200 billion a year. ...

To deal with the deficit, Mr. McCain has said that he will get tough on year-to-year spending, both in military programs and domestic ones. Then he will try to remake Medicare and Medicaid...

The problem is that the campaign has been far, far more detailed about its tax cuts ... than its spending cuts... Mr. McCain has proposed the elimination of the alternative minimum tax (at a cost of $60 billion a year), new child tax deductions ($65 billion), a corporate tax cut ($100 billion) and faster write-offs for corporate investments in new equipment ($50 billion to $75 billion). ...

It’s easy to imagine how Mr. McCain could be laying the groundwork to run as a true fiscal conservative, now that he has locked up the Republican nomination. He could present himself as the one candidate who believes that the nation can afford neither Mr. Bush’s endless tax cuts nor the Democrats’ big new government programs. He has the perfect adviser to help him make that case.

But it’s not the case he’s making, at least not yet. Instead, when you add up the numbers that have been released so far, you’re left wondering...

I have a question. At first, John McCain was promising to balance the budget his first year in office, he said it was straight talk, so I guess he meant it. But then he said he really didn't mean it, now it's at the end of his second year [Update: I can't read, apparently - a year is not a term]:

Sen. McCain has backed off his earlier promise to eliminate the budget deficit by the end of his first term and now says it may take two terms.

Here's the question. If we are heading into or already in an economic recession, what kind of economic plan is it to cut spending and/or raise taxes by hundreds and hundreds of billions of dollars? How is that supposed to help the economy recover from its troubles? He can talk about short-term economic stimulus packages all the wants, but if he plans to balance the budget over a two year time-frame, with some of that surely coming in the first year, the talk of short-term stimulus is meaningless. The economy is not stimulated when spending is cut or new taxes are imposed, and that's what he says he plans to do. [continuing the update, the question, then, is whether he will increase the deficit his first year to stimulate the economy. If he does, it won't be on the spending side, he plans a one year moratorium on new spending which is a cut in real terms. And the talk of base broadeners, etc., is a way of denying that they plan to increase the deficit through tax cuts, though that denial is part of the reason the plan is not viewed as being credible.]

Of course, his promises aren't possible even in the best of times. He won't be able to cut as much from government programs as he says he will, and he claims he won't raise taxes. I can't think of any credible analyst who thinks his plan comes anywhere close to adding up. But he says it anyway, with his supposed straight talk, in the face of a potential recession, and nobody seems to mind, nobody seems willing to think hard about what this says about his character. After all, it's just the economy, it's not something important like only eating half your waffle.

Update: More from pgl and Brendan Nyhan.

Update: The Economist's blog, Free Exchange, adds:

Now, it's possible that Mr McCain thinks his critics are wrong, and that supply-side orthodoxy holding that tax cuts always raise revenues is correct. Whether or not this is what Mr McCain thinks, it's absolutely what he says. Brendan Nyhan has collected a long list of statements to this effect.

Of course, as Mark Thoma points out, now might not be the best time to seek a balanced budget. By the time Mr McCain gets around to crafting his first budget, economic conditions may be quite a bit different, but for now, at least, a package of tax increases and spending cuts is not what the economy needs.

Whatever is going on inside Mr McCain's head, it would be very helpful if he could begin elucidating one clear message, so that the public can weigh it against alternative proposals. As things stand, with the candidate preaching supply-side voo-doo to partisan audiences while his economic advisor maintains that it's all an election ploy or an episode of "misspeak," it's impossible to determine how good or bad an economic leader he might be.

And pity the economic advisor, whose official role is now seemingly to tell the world that his candidate is lying to get elected, and all will be well once he's safely ensconced in the oval office.

I wish I'd made the last point in reference to the character issue.

Budgetary Bait and Switch

Bruce Bartlett and I disagree about the size of government. He would starve the beast, I would want it healthy and thriving, but I have no disagreement with his view of the general lack of character Republicans have displayed on the budget issue:

The GOP's bait-and-switch tax strategy, by Bruce Bartlett, Commentary, LA Times:  It is an article of faith among Republicans that tax cuts are the cure for every problem the economy faces, and that tax increases are the equivalent of economic poison. Any hint by Democrats that the current administration's tax cuts should be revisited in light of changing economic or fiscal conditions is met with charges that they are proposing the largest tax increase in history.

The truth is that President Bush's tax cuts didn't do much good for the economy; they were mostly giveaways to GOP political constituencies and were little different conceptually from pork-barrel spending...

The fact is that the massive tax increase Republicans claim the Democrats are proposing is entirely the result of the GOP's ... policies. Rather than expend the effort to make their tax cuts permanent in the first place, they attached expiration dates to every major provision. ... The alleged tax increase that would result is simply a consequence of the tax system returning to what it was before 2001...

In other words, no one is proposing new taxes... It is simply a matter of allowing the law that Republicans enacted to follow the course that they chose in the first place.

Republicans respond that they ... didn't have the votes to enact permanent tax cuts, so it was temporary cuts or nothing. This is not true. They could have made them permanent, but that would have required bipartisanship and more political capital than Republicans were willing to spend. So they took the easy way out, figuring that Democrats wouldn't dare oppose extending the tax cuts when the time came, lest they be accused of favoring a vast tax increase.

But this isn't even the worst of the Republican dishonesty. That goes to projections from the Congressional Budget Office showing a sharp reduction in budget deficits after 2010. But these lower deficits result largely from the expiration of the tax cuts and the higher revenues that would result. Thus, Republicans are trying to ... blame Democrats for advocating higher taxes while implicitly using those higher taxes to make future deficits smaller.

This sort of political game may be fun for Republicans who think that they have boxed Democrats into a corner. But this game has had real economic consequences. Because the tax cuts are not permanent, their economic impact has been severely diminished. All economists know that permanent tax changes have far more effect than temporary ones because people won't change their behavior significantly unless they have some assurance that the tax regime will be in effect for the long term. ...

There is little doubt that the economy would have been stronger with permanent tax cuts. But that would have meant fewer tax cuts and thus fewer opportunities to buy votes. It also would have forced Republicans to deal with the true budgetary consequences of their actions. ...

Tax policy is an important campaign issue, and it would be good to get agreement on the post-2010 tax code as soon as possible. Current law makes it impossible to plan for the future with regard to taxes. Whatever is done should be done permanently to the greatest extent possible.

He believes tax cuts promote economic growth to a much larger degree than I do, but there is some common ground. He wants taxes to be efficient, i.e. to promote maximum growth given the size of government that taxes must support, and I do too. Thus, to the extent that we can make the tax code more efficient through budget neutral tax changes without compromising equity, we shouldn't resist doing so. A budget neutral shift in taxes can promote economic growth in the same way that a tax cut does if the shift eliminates or substantially reduces economic distortions, though as I noted above tax changes are not the first place I would look if enhanced growth was the goal.

What this means is that instead of letting all the Bush tax cuts expire, there is the possibility of retaining some of the existing tax cuts while enacting new ones to replace them so that the revenue implications are the same, but the economic and equity properties are the same or better. However, given that this would be played as Democrats enacting new taxes, the politics that are involved make such a shift in taxes unlikely even though it would bring about the very thing Republicans claim they want, higher economic growth. I think Bruce Bartlett is honest in his belief that permanently lowering taxes has a significant effect on economic growth and that this belief corresponds to his small government philosophy, my difference on this issue is over the magnitude of the growth effect relative to what you must give up in terms of key government programs when taxes are cut. But for many Republicans, it seems as though the growth argument is merely an excuse to attain their real goal, smaller government, and their support of pretty much any tax cut that is proposed is evidence that growth is not the primary concern. Paul Krugman puts it this way:

Since the 1970's, conservatives have used two theories to justify cutting taxes. One theory, supply-side economics, has always been hokum for the yokels. Conservative insiders adopted the supply-siders as mascots because they were useful to the cause, but never took them seriously. The insiders' theory - what we might call the true tax-cut theory - was memorably described by David Stockman, Ronald Reagan's budget director, as "starving the beast." ... Starve-the-beasters believe that budget deficits will lead to spending cuts that will eventually achieve their true aim: shrinking the government's role back to what it was under Calvin Coolidge.

And when taxes have been cut recently, who has benefited most from what is "little different conceptually from pork-barrel spending" is worth thinking about as well.

War and the Economy

Are wars good for the economy?

America’s War-Torn Economy, by Joseph E. Stiglitz, Project Syndicate: ...It used to be thought that wars were good for the economy. After all, World War II is widely thought to have helped lift the global economy out of the Great Depression. But, at least since Keynes, we know how to stimulate the economy more effectively, and in ways that increase long-term productivity and enhance living standards.

This war, in particular, has not been good for the economy, for three reasons. First, it has contributed to rising oil prices. ... Higher oil prices mean that Americans (and Europeans and Japanese) are paying hundreds of millions of dollars to Middle East oil dictators and oil exporters elsewhere in the world rather than spending it at home.

Moreover, money spent on the Iraq war does not stimulate the economy today as much as money spent at home on roads, hospitals, or schools, and it doesn’t contribute as much to long-term growth. Economists talk about “bang for the buck” – how much economic stimulus is provided by each dollar of spending. It’s hard to imagine less bang than from bucks spent on a Nepalese contractor working in Iraq.

With so many dollars going abroad, the American economy should have been in a much weaker shape than it appeared. But, much as the Bush administration tried to hide the true costs of the war by incomplete and misleading accounting, the economy’s flaws were covered up by a flood of liquidity from the Federal Reserve and by lax financial regulation. ...

In a sense, the strategy worked: a housing bubble fed a consumption boom, as savings rates plummeted to zero. The economic weaknesses were simply being postponed to some future date; the Bush administration hoped that the day of reckoning would come after November 2008. Instead, things began to unravel in August 2007.

Now it has responded, with a stimulus package that is too little, too late, and badly designed. ...

With home prices falling (and set to continue to fall), and with banks uncertain of their financial position, lenders will not lend and households will not borrow. So, while the additional liquidity injected into the financial system by the Fed may have prevented a meltdown, it won’t stimulate much consumption or investment. Instead, much of it will find its way abroad. China, for example, is worried that the Fed’s stimulus will increase its domestic inflation.

There is a third reason that this war is economically bad for America. Not only has America already spent a great deal on this war – $12 billion a month, and counting – but much of the bill remains to be paid, such as compensation and health care for the 40% of veterans who are returning with disabilities, many of which are very serious.

Moreover, this war has been funded differently from any other war in America’s history... Normally, countries ask for shared sacrifice, as they ask their young men and women to risk their lives. Taxes are raised. There is a discussion of how much of the burden to pass on to future generations. In this war, there was no such discussion. When America went to war, there was a deficit. Yet remarkably, Bush asked for, and got, a reckless tax cut for the rich. That means that every dollar of war spending has in effect been borrowed.

For the first time since the Revolutionary War, two centuries ago, America has had to turn to foreigners for financing, because US households have been saving nothing . The numbers are hard to believe. The national debt has increased by 50% in eight years, with almost $1 trillion of this increase due to the war – an amount likely to more than double within ten years.

Who would have believed that one administration could do so much damage so quickly? America, and the world, will be paying to repair it for decades to come.

Recall that an increase in government spending can be paid for in one of three ways, we can raise taxes, we can borrow the money, or we can print the money needed to finance the spending. (In a given year, the government budget constraint is Government spending + Interest on debt- Taxes = Change in money supply plus Change in bond supply). This administration didn't raise taxes to pay for the war - taxes were lowered - so that means that changes in the money supply and changes in borrowing needed to make up the $1 trillion spent on the war plus the hundreds of billions of revenue lost due to the tax cuts.

Normally, an increase in borrowing (government debt) has two costs, First, it raises interest rates because the government competes with private investors and other governments for available funds, and that increases the price of borrowing. The increase in interest rates causes investment to be lower, that in turn lowers growth, and that means output will be lower in future time periods. In effect, output has been shifted from the future to the present through borrowing. Second, the interest payments themselves are a cost to the US if they are made to people living outside the US (payments made within the US redistribute income, but they are not a net cost to US citizens). Since recent borrowing was from foreigners, all the interest paid on the debt will flow out of the US and represent a cost to US citizens.

One of these costs, interest payments flowing outside of the US, has occurred and will continue to occur, but the other, an increase in interest rates brought about by competition from the government for saving has not. Why? One reason is the "savings glut" in the world that allowed us to borrow money from the foreign sector without pushing up interest rates. But a second reason is Federal Reserve interest rate targeting. With a constant interest rate target, deficit spending that puts upward pressure on interest rates is automatically "monetized," i.e. the Fed buys up the debt and replaces it with money to keep the interest rate on target, and the increase in the money supply holds down interest rates. But there is a cost here too, by increasing the money supply to hold down interest rates, inflation pressure is created, and inflation acts as a hidden tax by lowering the value of money.

I think the spending on the war and low-interest rates that have been brought about by Fed policy and the savings glut have helped to keep our economy from sputtering, but it has not been costless. First, as noted above, spending on the war may have some had stimulative effect, but if that is the goal, there are much better ways to do this. So, relative to spending the money domestically on, say, infrastructure, we have not gotten as much for our money as we might have otherwise.

Second, increases in the money supply and the influx of funds from foreigners to finance debt kept interest rates low and financed a housing bubble, but the result was a misallocation of resources to the housing sector. We stimulated the economy with low interest rates and a housing bubble, but we built things that didn't need to be built and are now sitting idle wasting resources. That is a cost to the economy, and we'd be better off now if some of that spending had been in other sectors.

Third, the interest costs. As noted above, we have borrowed from foreigners to pay for the war, so the interest on the debt will be a net drain to the US economy.

Fourth, inflation. Keeping interest rates low is inflationary, and inflation imposes a cost. I'm not sure how much of the $1 trillion has been financed by printing money, but to the extent that it has been financed in this way, the consequence is potentially higher inflation in the future.

Fifth, the increase in the price of oil as detailed above.

There are also the human costs, and the costs to the Iraqis, which are not included in these figures.

Because we have paid for the war by borrowing and printing money, and because of delays in the appearance of many of the costs associated with the war, e.g. the cost of paying for permanently disabled soldiers will come largely in the future, inflation only appears with a long lag, interest payment to foreigners will be ongoing, etc., many of the costs are not evident yet. But the costs are there and they will need to be paid.

Are there any costs that I've overlooked, misstated, or forgotten?

"False Budget Comparisons"

In a commentary in the Wall Street Journal ("The Coming Tax Bomb"), John Cogan and Glenn Hubbard argue that we shouldn't let the Bush tax cuts expire. Andrew Samwick isn't much impressed with their arguments:

More False Budget Comparisons, by Andrew Samwick: ...I object to many parts of the op-ed, but two in particular. First, the expiration of tax cuts that were legislated to be temporary is now described as:

This would be the largest increase in personal income taxes since World War II.

How might such a change in taxes have been avoided?  Perhaps by not ramming through such budget-busting tax cuts in the first place. Perhaps by not letting them persist for so long, running up deficits during business cycle peaks in the intervening years. Until Hubbard and Cogan are willing to commit to a responsible budget policy, of which tax policy is one component, it is impossible to take an op-ed like this seriously. ...

Second, picking up on Stan's point about the problems in using historical comparisons, the following statement from the op-ed completely undermines any responsible action on entitlement reform:

By historical standards, federal revenues relative to GDP, at 18.8% last year, are high. In the past 25 years, this level was only exceeded during the five years from 1996 to 2000.

Note that the 18.8% includes the Social Security surplus.  So according to Hubbard and Cogan, that money is available to be spent on current government expenditures, rather than used to repurchase government debt, which would make the Social Security Trust Fund a legitimate savings vehicle. (Yes, this is the same Cogan who laments that Trust Fund accounting doesn't work because the government just spends the money.  I wonder whose op-eds they use to justify their reckless behavior.) 

Returning to Stan's point, we should have a higher tax/GDP ratio today because we should be using the Social Security surplus to prefund a portion of the retirement benefits of the Baby Boom generation. ... [Update: More here.]

Bruce Bartlett: Stop Those Checks

Bruce Bartlett says we should cancel the rebate checks and use the money in other ways:

Stop Those Checks, by Bruce Bartlett, Commentary, NY Times: With unusual speed and cooperation last month, George W. Bush and Democrats in Congress agreed to a tax rebate set to be paid out beginning in May. Families will get checks for $300 to $1200 or more, and it is assumed that they will all rush out to spend this money immediately, giving retailers a boost that will raise economic growth.

Despite the bipartisan support for the rebate, few economists have supported the idea. They note that we have tried rebates in the past — most recently in 2001 — and there is no evidence that they have meaningfully stimulated either consumption or growth. By and large, people saved the money they received or paid bills...; very few used their rebates to increase spending.

The true reason why the current rebate has been so popular in Washington is that giving away free money in an election year is good for politicians of both parties. Superficially, it looks as if Washington is responding to a real problem with decisive action. ...

But in the almost six weeks since the rebate legislation was signed into law, the economic situation has changed. The meltdown in financial markets is much more serious than it looked in February. ...

The solution, therefore, is not to drop $100 bills from helicopters — which is essentially what the rebate would do. Rather, what we need is a mortgage Superfund that can clean up the toxic waste. If we can cleanse the financial system of at least some of the bad debts, it will do far more to restore the economy to health than anything that could be accomplished by the rebate...

We all know that the government is eventually going to get stuck with a lot of the bad debts... At the same time, there are increasing demands for targeted relief for homeowners facing foreclosure. It looks to many people as if Washington cares more about fat-cat bankers than working families in hard times. At some point, Congress is going to respond with additional aid for people caught in the mortgage mess, and this relief will come on top of the $117 billion cost of the rebate.

We need to stop and ask whether we can afford to spend $117 billion that the Treasury Department does not have on a program of dubious effectiveness. It simply makes no sense to send out checks to people who have no need for it as some kind of election-year bribe to vote for incumbents of both parties. That money would go a long way toward cleaning up the mortgages that are poisoning the financial sector.

Congress should immediately repeal the rebate and redirect the money that has been budgeted into a package of measures that would help the housing sector and those people who actually need assistance. The Treasury might use some of the money, for example, to enable Fannie Mae and Freddie Mac ... to buy up some of the bad mortgages, get them off bank balance sheets and help homeowners refinance them.

My gut tells me that the vast majority of Americans would happily give up their rebate if they knew that the money would be used instead to help families in need and start the process of cleaning up the bad debts in the housing sector. Everyone knows that we will have to spend the money eventually...

This is a proposal that both Republicans and Democrats should embrace. It involves no increase in the deficit. We would simply redirect already appropriated money...

The checks haven’t gone out yet so no one has to give anything back. Congress could pass a repeal bill in a day if it wanted to. At a minimum, hearings should be held on this proposal in light of the country’s deteriorating financial situation.

Some people may have already purchased goods on credit and are planning to pay it back with the rebate, so the fact that the checks haven't gone out yet does not imply the rebates have not yet altered people's plans. Breaking promises now is a bad idea.

However, if we were to do this, instead of repealing everyone's rebate, how about leaving the rebates in place for households with incomes under a certain amount, households that are likely to spend the money rather than save it, and repeal it for households with higher incomes? I don't object to any of the spending because it increases the deficit, that's how the economy is stimulated (and you pay for the rebates when times are better helping to deflate or prevent bubbles), but there's no reason for the rebates to go to households who are unlikely to use the money to stimulate the economy, particularly when we might use the money more productively in other ways, e.g. on programs to prevent foreclosures.

But we can wish all we want, the rebates are in place, the machinery is rolling forward, and nothing will stop them now (and since they have already been promised, nothing should stop them). The rebates are water under the bridge. We could have structured the fiscal policy response in a much more productive way, but we didn't. Now we need to devote our attention to preventing further troubles rather than wasting effort trying to change what has already been done. If enabling "Fannie Mae and Freddie Mac ... to buy up some of the bad mortgages, get them off bank balance sheets and help homeowners refinance them" is the best policy to pursue - and a policy along those lines would help if we could do it quickly enough - then what are we waiting for? Whether we have rebates or not doesn't matter, we should do what is needed to get the mortgage repurchase program into place as soon as we can.

But the politics make me doubt that we will be able to craft an effective fiscal policy response to deal with the foreclosure problem. I hope politicians prove me wrong, that they will move as fast to help struggling homeowners as they would if tax cuts were on the table, but that seems unlikely. For that reason, the burden may remain largely with the Fed, and they will need to consider the full array of both conventional and unconventional policy responses if conditions continue to deteriorate. And if the Fed does succeed in bailing us out of this mess, it will be in spite of rather than in conjunction with fiscal policy. The rebates might help a little, but the rebates are not enough. Politicians will tout their responsiveness in time of need by citing the rebates voters received, but the truth is that the response has been inadequate, and voters ought to ask what politicians have done to help stem foreclosures, and what additional measures they have taken or plan to take in response to the crisis, for example on the regulatory front. Let's hope the Fed can pull this off.

"War Costs and Costs and Costs"

Joseph Stiglitz on the cost of the war:

War costs and costs and costs, by Joseph Stiglitz,Project Syndicate: ...In our new book The Three Trillion Dollar War, Harvard's Linda Bilmes and I conservatively estimate the economic cost of the war to the US to be $3 trillion, and the costs to the rest of the world to be another $3tn - far higher than the Bush administration's estimates before the war. The Bush team not only misled the world about the war's possible costs, but has also sought to obscure the costs as the war has gone on.

This is not surprising. After all, the Bush administration lied about everything else, from Saddam Hussein's weapons of mass destruction to his supposed link with al-Qaida. Indeed, only after the US-led invasion did Iraq become a breeding ground for terrorists.

The Bush administration said the war would cost $50bn. The US now spends that amount in Iraq every three months. To put that number in context: for one-sixth of the cost of the war, the US could put its social security system on a sound footing for more than a half-century, without cutting benefits or raising contributions.

Moreover, the Bush administration cut taxes for the rich as it went to war, despite running a budget deficit. As a result, it has had to use deficit spending - much of it financed from abroad - to pay for the war. This is the first war in American history that has not demanded some sacrifice from citizens through higher taxes; instead, the entire cost is being passed onto future generations. Unless things change, the US national debt ... will be $2tn higher because of the war (in addition to the $800bn increase under Bush before the war).

Was this incompetence or dishonesty? Almost surely both. ...

The war has had only two winners: oil companies and defence contractors. The stock price of Halliburton, vice-president Dick Cheney's old company, has soared. But even as the government turned increasingly to contractors, it reduced its oversight.

The largest cost of this mismanaged war has been borne by Iraq. Half of Iraq's doctors have been killed or have left the country, unemployment stands at 25%, and, five years after the war's start, Baghdad still has less than eight hours of electricity a day. Out of Iraq's total population of around 28 million, 4 million are displaced and 2 million have fled the country.

The thousands of violent deaths have inured most westerners to what is going on: a bomb blast that kills 25 hardly seems newsworthy anymore. But statistical studies of death rates before and after the invasion tell some of the grim reality. They suggest additional deaths from a low of around 450,000 in the first 40 months of the war (150,000 of them violent deaths) to 600,000.

With so many people in Iraq suffering so much in so many ways, it may seem callous to discuss the economic costs. And it may seem particularly self-absorbed to focus on the economic costs to America, which embarked on this war in violation of international law. But the economic costs are enormous, and they go well beyond budgetary outlays. Americans like to say that there is no such thing as a free lunch. Nor is there such a thing as a free war. The US - and the world - will be paying the price for decades to come.

The "Impending Demographic Crisis"?

John Shoven argues we should raise the Social Security retirement age to solve the "impending demographic crisis":

The Truth About Aging Boomers' Effect on Our Economy, by John B. Shoven, Foreign Policy and Alternet: There is a looming catastrophe stalking the developed world. It promises to devastate the global economy, overwhelm hospitals... What is the calamity... It's the aging of the world's baby boomers, the coming tidal wave of senior citizens who will live longer, consume more, and produce less, seriously challenging societies' ability to care for their graying ranks.

At least that's how the dire warnings generally sound. Alarming forecasts bombard us about an impending demographic crisis in the United States, Europe, Japan, and even China that will reshape the way we live and work. ... The fiscal burden of supporting this rapidly expanding segment of the global population not only threatens to bankrupt national healthcare systems..., but also revolutionize electoral politics, with political clashes no longer governed by right versus left, but young versus old.

If it sounds distressing, it shouldn't. The gloomy projections are deeply flawed. The reason lies in the misleading way in which we measure age. Typically, a person's age has been determined by the number of years since his or her birth. ... Thanks to the medical revolutions of the past century, however, life expectancies have been radically prolonged. Since 1960, the average Chinese person's life span has increased by 36 years. Over roughly 40 years, South Koreans have seen their lifetimes extended by an average of 24 years, Mexicans by 17 years, and the French by nearly a decade. Given these drastic changes, our conception of what qualifies as "old" has itself become old-fashioned.

Measuring age by years since birth is just as foolish as using the dollar as a timeless unit of value. ... Just as with the dollar, it is time to introduce inflation-adjusted ages as a superior method for measuring age. The best replacement gauge is mortality risk, or the chance a person has of dying within the next year. The higher the mortality risk, the "older" a person is. It's a measurement that reflects a much more accurate picture of a person's health, likely productivity, and remaining life expectancy.

When the U.S. Social Security system was designed seven decades ago, the 65-year mark was deemed the moment when Americans moved "beyond the productive period" and into dependency. That age was chosen based on mortality risk: a 65-year-old man in 1940 could expect to live an additional 11 years, a 65-year-old woman another 15 years. But medical advances have shifted mortality risks enormously. ...

The implications are significant: The magnitude of the elderly wave that demographic forecasters have predicted is, in reality, far smaller. Forecasts today tell us that the fraction of the population over the age of 65 will grow enormously. But consider what would happen if we replaced the 65-year marker with a mortality risk measurement that governs who is considered "elderly." In 2000, 12.4 percent of the U.S. population was over the age of 65... By 2050, only ... about 15 percent of the population ... will have a mortality risk greater than 1.5 percent. That's hardly a demographic tidal wave. The global outcomes are similarly striking: A mortality-based measurement lowers the projected elderly population in 2050 in Japan, Spain, and Italy by an average of 30 percent.

Just consider the consequences of altering the age when entitlement benefits kick in or retirement becomes mandatory to these new inflation-adjusted measurements. It doesn't mean shortening retirements, just stabilizing them. In 20th-century America, the average length of retirement grew from two years to more than 19 years. As life expectancies continue to rise, retirements will continue to get longer -- and the pension bill far larger. If benefits and retirements are governed by mortality risk instead of age, the costs will be far more manageable. ...

Three comments. First, there is no guarantee that the ability to work and lead a productive life expands at the same rate as life expectancy (e.g., if most of the extension in life expectancy in the future comes from expensive interventions toward the end of life rather than improvements in health during, say, the late 60s, that make working easier then there would be no reason to extend the retirement age). It would be better to define retirement in terms of the minimum of these two concepts, the time at which the typical person can no longer be expected to work full-time on a typical job that may have physical demands, and the life expectancy adjusted retirement age discussed above. But that is not the main objection. A second issue is that Social Security is not the entitlement problem we should worry about, that title belongs to Medicare where costs are expected to increase rapidly in the future. And the problem with Medicare costs brings up the third issue, demographic change is not the driving force behind rising healthcare costs (e.g., see this article from the CBO, "The rate at which health care costs grow relative to national income—rather than the aging of the population—will be the most important determinant of future federal spending."). Most projections see large increases in health care costs in the future, but the main problem is not from the growth of the elderly population. Even if the population remained stationary, costs would still be expected to escalate rapidly.

What Caused the Increase in Federal Spending During the Bush Administration?

There is a persistent myth that the increase in federal spending during the Bush administration is due, in large part, to an increase in spending on domestic programs. But the increase in federal spending is mostly due to changes in defense expenditures, and not all of the increase is war related:

Federal Spending, 2001 through 2008: Defense Is a Rapidly Growing Share of the Budget, While Domestic Appropriations Have Shrunk, by Richard Kogan, CBPP: ...Some may think the President’s recent attempts to squeeze domestic appropriations are being made in response to an explosion of domestic discretionary funding during his Administration... But this is not correct: there has been no such funding explosion for domestic discretionary programs. Between fiscal year 2001 ... and fiscal year 2008, funding for domestic discretionary programs has ... shrunk both as a share of the budget and as a share of the economy. In contrast, appropriations for defense and other security-related programs have increased more rapidly than any other area of the budget — even more rapidly than the costs of the “big three” entitlement programs: Social Security, Medicare, and Medicaid.

Robert Reich: David Brooks is Wrong

Another one from Robert Reich:

David Brooks is Wrong: America Can Afford What Needs to be Done, by Robert Reich: The rightward New York Times columnist David Brooks warned in his column yesterday that a new Democratic president would be engulfed in the same "Reich versus Rubin" choice that faced Bill Clinton in 1993 -- either fulfill your campaign promises and add to the federal budget deficit or forget your promises and satisfy Wall Street (Brooks didn't put it exactly this way, but that's what he was getting at).

What Brooks neglects to mention is that the REASON a new Democratic president might face such a choice is that he or she will be burdened by much the same spend-thrift legacy that Bill Clinton discovered when he arrived in the Oval Office in 1993. Then, it was deficits of $300 billion as far as the eye could see. In January of 2009 it will be deficits of $400 billion as far as they eye can see. The fiscal-political strategy of Ronald Reagan and George H.W. Bush, in other words, was the same as that of George W. Bush -- "starve the beast" through irresponsible supply-side tax cuts and military buildups that make it almost impossible for any subsequent Democratic president to deal with the nation's needs.

This doesn't mean that a new Democratic president would have to break the bank, however. Where to get the additional money needed for universal health care, better schools, and crumbling infrastructure? Three sources: (1) The peace dividend from ending the Iraq War, (2) a more progressive tax, and (3) modest deficit spending to cover public investments that generate economic growth.

1. According to government figures, the wars in Iraq and Afghanistan have so far cost the United States more than half a trillion dollars. Another four years would cost significantly more, because this figure doesn't include the ever larger costs of recruitment, the cost of replacing the equipment that's been used in the war so far, or the ballooning costs of taking care of America's permanently wounded and disabled. If a Democratic president pulls out of Iraq -- even if some troops need to be deployed to Afghanistan -- it's a safe estimated that the peace dividend would be more than $100 billion a year, even including the costs of attending to our wounded.

2. Rolling back the Bush tax cuts for the wealthy will yield some $200 billion more. But the new president should not stop there because the only people who have the money necessary to reverse the nation's troubling trends are at the top. ...

Only a relatively few at the top would need to pay more. ... By my calculation, a tiny annual wealth tax of one-tenth of 1 percent on all net worth exceeding $5 million -- a tax that would affect only 50,000 households, or fewer than one-tenth of 1 percent of the nation's taxpayers -- would yield an additional $100 billion.

Remember that a progressive income tax has been a cornerstone of our fiscal system since 1913 -- and our current non-progressive and often regressive tax is the anomaly. ...

3. Finally, the next president will need to wean the public off the false notion that fiscal austerity is necessarily good for the economy. There's a crucial difference between public spending that builds the future productivity of the nation's workforce -- spending on education and infrastructure, for example -- and spending that improves today's living standards. Borrowing in order to accomplish the former is wise because it enhances the capacity of the nation to produce goods and services... 

This obvious point should be illustrated in the annual budget. Such "investments" should be segregrated from ordinary spending. Annual spending should not exceed annual revenues, but investments should be judged by their potential for growing the overall economy. If the returns to the economy in terms of economic grow are greater than the costs of such borrowing, these public investments are appropriate.

You can also think of the benefits from spending on infrastructure being spread intertemporally. If we build a piece of infrastructure that lasts 100 years, then the benefits will be spread over that entire time period. So each generation could, in principle, pay for the benefits they receive (e.g. I could still be paying something for the benefits I receive from the highways that were present when I was born, or even for WWII since I presumably benefit from the outcome). This justifies deficit spending because the current generation would only pay for the portion of the infrastructure they consume, and the remainder of the asset and liability would be pushed forward to the next generation.

But I think we should remember that when we were born, we inherited a substantial amount of public capital that had already been paid for. If we let that capital depreciate, then start sending bills to future generations for its replacement, that doesn't quite seem fair.

"Does America Have a Budget Problem?"

Free Exchange on the federal debt:

Does America have a budget problem?, Free Exchange: ...[T]here's a new federal budget proposal out with a whopper of a deficit figure--$410 billion for 2008. ... Greg Mankiw writes in the New York Times that his ... birthday wish is a world where we didn't bequeath large debts to our children. ...

He is absolutely correct that we face a rather troubling budget picture. Unfortunately, he misses the mark in describing ... the situation... Mr Mankiw's first great omission is in focusing his column entirely on entitlement spending. Mr Bush's budget increases defence spending by at least 7.5 percent (and one never knows what further appropriations may be required) to a total of $515 billion. That marks the 11th year in a row in which defence spending has increased. Perhaps ... it is time to discuss whether budget cutting zeal ought to be turned exclusively toward entitlements.

And what about that aging population? ... Mr Mankiw writes:

Because people are having fewer children and living longer than past generations, the number of working-age people supporting each elderly person has fallen and will continue to fall.

But as Bryan Caplan noted..., the fact that people are having fewer children is also a positive when considering the dependency ratio. Workers will have more retirees to support in the future, but they'll also have fewer children to support. In other words, the total number of people a worker needs to support on average should not be overly burdensome.

Mark Thoma complains that Mr Mankiw has not done enough to differentiate Social Security among the problems discussed in his piece. He hasn't... There is Social Security, for which long-term solvency is not a significant problem, and there are Medicare and Medicaid, for which growing expenses are a serious issue. ... The problem with Medicare and Medicaid isn't so much a demographic one as a per capita health expenditure one. This implies a different solution set. For one thing, whether health insurance is provided privately or publicly, costs will continue to grow. In other words, reducing government payouts isn't going to fix the problem.

What will? For those of you interested in health insurance policy, there is an interesting debate taking place on a recent paper by John Gruber comparing the use of subsidies versus mandates to achieve full coverage. Not surprisingly, mandates are cheaper from a financial standpoint, but perhaps not from a social standpoint (the act of forcing someone to enroll in a program reduces the program's cost, but imposes a social cost on the enrollee).

In general, we should recognise that the generational issues involved in the budget are substantial, but they aren't the chief challenges we face. The tough questions involve our commitment to a constantly enlarging defence budget, the growth of health care costs, and the ways in which those items ought to be balanced in a sustainable budget. Mr Mankiw skirts this formulation, but the next administration and Congress will not be able to.

Assuming that the military budget as a share of GDP will not continue expanding indefinitely, one issue in particular, health care costs, threatens the progressive agenda in the future. If we don't reign in the costs of health care somehow and/or find additional revenues, the budget will come under considerable pressure and there's no telling for sure how such pressures would be resolved or what programs would be reduced or eliminated. I'm sort of doubtful that the pressures on the health care system have mounted enough yet to bring about the necessary change during the next administration, though I hope I'm wrong about that, but if projections are correct the time will come when something will need to be done. When it does, will Democrats be ready? That's what worries me about moving too soon. If Democrats win the election and try for fundamental reform only to be shot down in flames once again, does that poison the well for the time when problems are evident and people are ready for and demanding change, or could it actually work in Democrats favor as people look back and realize they were right all along?

These Clowns Aren't Very Funny

Brad DeLong comments on the Bush Budget:

The Bush Budget Clown Show, by Brad DeLong: Roger Runningen and Brian Faler of Bloomberg report on the Bushies' proposed budget for fiscal 2009:

Bloomberg.com.S.: President George W. Bush sent Congress a $3.1 trillion federal budget that trims Medicare and health care programs, boosts military spending and projects the deficit this year and next will hit near-record levels. The spending blueprint for fiscal 2009... would slow the rate of growth in spending for entitlement programs such as Medicare for savings of $208 billion over five years. Pentagon spending would rise 7.5 percent to $515 billion, the 11th consecutive year of increases....

Bush's spending plan stands little chance of being adopted. Criticism came today from Republicans as well as Democrats. "There's a lot of games, smoke, mirrors, incomplete numbers, basically there's not much realism" in the budget, Senator Judd Gregg, the top Republican on the Budget Committee, said in an interview. "They're playing the usual games."... The budget deficit is projected to reach $410 billion this year. That is up from $162 billion in 2007, reflecting a slower economy generating fewer corporate tax receipts, the cost of a $146 billion economic stimulus measure and spending on the wars in Iraq and Afghanistan. The deficit is forecast at $407 billion in 2009... 2.9 percent of the $13.2 trillion U.S. economy....

Bush, after meeting with his Cabinet this morning at the White House, called it a "good, solid budget" that puts a priority on national security and keeps spending in check. "Congress needs to pass it," he said. Lawmakers took a different view. House Budget Committee Chairman John Spratt, a South Carolina Democrat, said it "bears all the hallmarks of the Bush legacy -- it leads to more deficits, more debt, more tax cuts, more cutbacks in critical services"...

Their reference to "near-record levels" of the deficit doesn't give a full and fair account of the magnitude of what can only be called a clown show.

Mankiw's Birthday Wish

The birthday boy points out that we have a problem with an aging population and rising health care costs. Shall we hope, at his age, that he doesn't have the wind left to blow out fifty candles and get his wish?:

My Birthday Wish: Not Burdening Our Children, by N. Gregory Mankiw, Economic View, New York Times: It's official. As of today, at 6 a.m., I am a half-century old. ... As I reach this particular milestone, it is hard not be worried about the economy. No, I am not talking about the subprime meltdown and the possible recession that looms on the horizon. I am confident that the team at the Federal Reserve can contain that problem.

Moreover, from the broad vantage point of history, the next recession, whenever it occurs, will likely be a minor blip. ... What worry me are the problems that we will bequeath to our children.

Long before I was born, Franklin D. Roosevelt established a compact among the generations. Families had long cared for their elderly members, but Roosevelt federalized that responsibility in the form of the Social Security system. Social Security is sometimes viewed as a pension plan, but it is mostly pay-as-you-go. The working-age population taxes itself to support its parents, in the hope and expectation that its children will do the same. On the day of my birth in 1958, the payroll tax to pay for this program, including both the employer and employee shares, was 4.5 percent.

Around the time I started grade school, Lyndon B. Johnson expanded the generational compact to include health care for the elderly. The Medicare system increased the payroll tax... By 1968 ... the payroll tax for both programs had risen to 8.8 percent.

Today, the payroll tax for these programs is 15.3 percent, far higher than the programs’ creators ever imagined. More worrisome is that this 15.3 percent is nowhere near enough to maintain solvency in the future. When my generation of baby boomers retires in large numbers and starts claiming benefits, spending on these programs will far outstrip revenue at the current tax rate.

Two problems are working in concert. The first is demographic. Because people are having fewer children and living longer than past generations, the number of working-age people supporting each elderly person has fallen and will continue to fall. ...

The second problem is that the cost of health care has risen significantly and is expected to continue rising.

From one perspective, these problems are really blessings. Life expectancy ... has risen by about eight years over my lifetime... Part of this improvement is attributable to technological advances in medicine, which sadly do not come cheap. But they are worth it nonetheless. ...

The big question for the green-eyeshade crowd is how to pay for these blessings. It is an issue that no presidential candidate has taken up in earnest.

Republican candidates are fond of saying we should cut tax rates because doing so would incentivize more rapid economic growth (true) and raise tax revenue (wishful thinking). But unless we figure out a politically acceptable way to reduce the benefits now promised to future retirees, taxes are going up in the coming decades. ...

Democratic candidates like to talk about expanding the social safety net with universal health insurance. But they blithely ignore the fact that the safety net we already have was bought on credit and that the bill is almost due. The Democrats claim fiscal responsibility by advocating taxes on the rich, but the numbers don’t back up the rhetoric. ...

Inside the Beltway, meanwhile, in a rare outbreak of election-year bipartisanship, checks are being prepared to send to voters nationwide. If all goes as planned, a few months before the November elections, a typical family of four will get a windfall of $1,800. Whether the economy needs a short-run fiscal stimulus is debatable. But there’s no doubt the stimulus will add to the national debt we are passing on to future generations of taxpayers.

My birthday wish is for all of us to stop asking what the government can do for us today. Instead, we should focus on what we can do together to prepare the economy for our children and grandchildren. That means getting ready to care more for ourselves in old age, perhaps by retiring later, perhaps by saving more. I hope that when I celebrate my 100th birthday in 2058, my descendants won’t look upon Grandpa and his generation as the biggest economic problem of their time.

I wish Greg would have actually said that Social Security is not the problem instead of leaving it implicit. That will surely leave some people confused on this point.

On the rebate, whatever is done to stabilize the economy now is, to use Greg's term, a "minor blip" on the long-run horizon. Fear about rising health care costs in the future is not a reason to oppose fiscal stimulus today. The problems that people have when unemployment hits their families, people who show up to work every day, work hard and make it possible for us all to have the things we have, are difficult. It's hard to even imagine what it feels like on that day when you have to go home and tell your family that you lost your job and things are going to be tough for awhile, to tell your kids that promises - both explicit and implicit - cannot be kept. These aren't people who are looking for a handout or a way to avoid working, they have been hit by an unfortunate circumstance beyond their control and suddenly those dreams such as sending their kids to a decent college are evaporating - they'll be lucky to pay the bills at all or be able to keep the house, in any case savings will be depleted. If we are worried about future generations, keeping tragedies from hitting families with children - and losing a long held job unexpectedly is a tragedy - is every bit as important as making sure the tax rate our children face is a few percentage points lower.

(I should also note that stabilization policy today, minor blip or not, will not necessarily raise the level of federal debt in the longer run - there is nothing in the economics that says this has to be true - it's a matter of having the political will to actually implement Keynesian style stabilization policy and balance the budgetary changes used to smooth the economy over the business cycle. Update: I should have also noted the extent to which expanding health care coverage is an investment in children, and an investment in the future more generally.)

The Myth of Runaway Federal Spending under Bush

Paul Krugman issues a useful reminder:

Federal spending mythology, by Paul Krugman: One thing I’ve written about a number of times, but becomes especially worth emphasizing now that John McCain is the presumptive Republican nominee, is the myth of runaway federal spending under the Bush administration. McCain has said on a number of occasions that he doesn’t know much about economics — although, straight-talker that he is, he has also denied having ever said such a thing. But one thing he thinks he knows is that the Bush administration has been spending like a drunken sailor. Has it?

Consider the actual record of spending. Never mind dollar figures, which grow because of inflation, population growth, and other normal factors. A better guide is spending as a percentage of GDP. And this has increased, from 18.5% in fiscal 2001 to 20% in fiscal 2007.

But where did that increase come from? Three words: defense, Medicare, Medicaid. That’s the whole story. Defense up from 3 to 4% of GDP; Medicare and Medicaid up from 3.4% to 4.6%, partially offset by increased payments for Part B and stuff. Aside from that, there’s been no major movement.

Behind these increases are the obvious things: the war McCain wants to fight for the next century, the general issue of excess cost growth in health care, and the prescription drug benefit.

So the next time Mr. McCain or anyone else promises to rein in runaway spending, they should be asked which of these things they intend to reverse. Are they talking about pulling out of Iraq? Denying seniors the latest medical treatments? Canceling the drug benefit? If not, what are they talking about?

Here are a two charts using data from the CBO to illustrate these points. The first is for all data available, i.e. for 1962-2007, the second for 2001-2007. These aren't all the categories of federal spending, but they cover all the major categories, and all the categories mentioned above:

"The Three Trillion Dollar War"

Good question:

Keynesian trillions, Editorial, LA Times: President Bush['s]... final State of the Union speech made clear that he intends ... to ... spend whatever it takes to secure Iraq and Afghanistan -- and his legacy.

While the president's speechwriters were tweaking his address Monday, the White House announced that Bush would ask for $70 billion more for the two wars this year. A Pentagon spokesman said combat operations were costing $12 billion a month, with $9.2 billion spent in Iraq. That's just for combat operations. Including replacing equipment that's being used up and providing medical care and disability benefits for the wounded, Iraq has already cost well over $1 trillion. Back in early 2006, when war spending was running about $5 billion a month, economists Joseph Stiglitz and Linda Bilmes were sharply criticized for a study that predicted the Iraq war would cost up to $2 trillion. Their sequel, to be released next month, is titled "The Three Trillion Dollar War."

The interesting question is why the U.S. economy, beneficiary since 9/11 of the largest military spending binge in history, now requires $150 billion more in the form of a short-term stimulus package. Why hasn't the $1 trillion in defense spending, in addition to the 2001 and 2003 tax cuts, been sufficient to keep the economic boom going? ... Does that mean the fundamentals of our economy are weaker than we thought, and a deeper slump might have occurred without all that spending? ...

The economist John Maynard Keynes taught us in the 1930s that money spent on guns -- or butter, or even digging ditches and filling them up again -- had the same stimulative effects on a slumping economy. We've developed a more nuanced view of government spending since then, but it's still worth asking: What would Keynes say about a $3-trillion war?

Update: Paul Krugman:

An Iraq recession?, Paul Krugman Blog: One thing I get asked fairly often is whether the Iraq war is responsible for our economic difficulties. The answer (with slight qualifications) is no.

Just to be clear: I yield to nobody in my outrage over the way we were lied into a disastrous, unnecessary war. But economics isn’t a morality play, in which evil deeds are always punished and good deeds rewarded.

The fact is that war is, in general, expansionary for the economy, at least in the short run. World War II, remember, ended the Great Depression. The $10 billion or so we’re spending each month in Iraq mainly goes to US-produced goods and services, which means that the war is actually supporting demand. Yes, there would be infinitely better ways to spend the money. But at a time when a shortfall of demand is the problem, the Iraq war nonetheless acts as a sort of WPA, supporting employment directly and indirectly.

There is one caveat: high oil prices are a drag on the economy, and the war has some — but probably not too much — responsibility for pricey oil. Mainly high-priced oil is the result of rising demand from China and other emerging economies, colliding with sluggish supply as the world gradually runs out of the stuff. But Iraq would be exporting more oil now if we hadn’t invaded — a million barrels a day? — and that would have kept prices down somewhat.

Overall, though, the story of America’s economic difficulties is about the bursting housing bubble, not the war.

The New Laffer Curve Logic and the Lack of Evidence for It

After being shown again and again that tax cuts don't increase revenues, those who make the Laffer curve argument stopped making the claim generally and shifted the argument to say that while it may not be true across the board, there is evidence that it is true for the very top rates. Now, as Lane Kenworthy discusses below, the argument has shifted again. But even after all of this reformulation of the argument to try and make it work somehow, somewhere, the evidence is still pretty shaky:

The New Laffer Curve Logic, by Lane Kenworthy: “When you cut the highest tax rates on the highest-income earners, government gets more money from them.”

This sounds like an argument by Arthur Laffer, probably on the Wall Street Journal op-ed page circa 1978. Actually, it is by Arthur Laffer … in the Wall Street Journal … but in 2008 rather than 1978. The piece is titled “The Tax Threat to Prosperity” (here). In it, Laffer reiterates his famous, and famously-influential, claim about the detrimental impact of tax rates on incomes and therefore on tax revenues.

But the argument has changed. The notion at the heart of the original “Laffer curve” argument was that higher marginal tax rates on those making the most money discourage them from investing, starting new businesses, and working hard. The result is less income growth, and hence lower tax revenues. Laffer now argues that the problem with high marginal tax rates is that they encourage high earners to hide and shelter their income. The “supply-side” problem now is said to be tax avoidance.

What is the evidence? Laffer notes that while the top marginal income tax rate has been significantly altered over the past generation, the effective tax rate — the amount of income actually paid in taxes — for the top 1% of households has been fairly stable. The chart below shows this. (The data on effective tax rates are from the Congressional Budget Office here. This, he says, is because when the top marginal rate is increased, high-income taxpayers reduce their taxable reported income via “tax shelters, deferrals, gifts, write-offs, cross income mobility, or any of a number of other measures.” When the top marginal rate is reduced, they increase their taxable reported income.

This is certainly plausible. But it is equally plausible that the effect on tax avoidance, while real, is quite small. Suppose the top marginal tax rate is reduced by 10 percentage points. Is it likely that most of those in the top 1% will call their accountants and instruct them to go easy on the exemptions and deductions?

If changes in the top marginal tax rate in fact have little impact on tax reporting by those with high incomes, what accounts for the fact that the effective rate on the top 1% is far less variable than the top marginal rate? Two things. First, the top marginal rate applies to only the top portion of these households’ incomes. Second, and more important, when Congress and the president have altered the top marginal rate they frequently also have changed the rules about loopholes, exemptions, deductions, and tax compliance.

There are have been four noteworthy changes in the top marginal tax rate since the late 1970s. Let’s consider them in turn.

Andrew Samwick: A Better Way to Respond to Downturns

Here's Andrew Samwick on fiscal policy. I disagree with some of this, e.g. if you wait until you know if monetary policy works then it's too late for fiscal policy. Also, it's not clear that monetary policy works faster than fiscal policy. Monetary policy can be put into place faster than fiscal policy, but once in place it takes longer to impact the economy. When you put the implementation and effectiveness lags together, there is no necessary winner between the two types of policies.

In the post below this one on the same topic, I didn't do a very good job of separating the focus of the short-run stabilization policy (whether to try to change C, I, G, or NX) from its consequences (crowding out and crowding in), so let me try to clear that up here. I covered crowding out and crowding in the next post, so the focus here is on whether policy ought to be directed at C or I, or even G (G can be either consumption or investment; also, NX is harder to change, but policies can also be directed at NX, e.g. subsidizing exports).

Andrew recommends focusing on government investment when implementing stabilization policy. I have no problem with spending on infrastructure rather than giving tax rebates so long as such policies can be put into place quickly enough. Andrew's advance planning (see below) is supposed to make the policies easy to implement quickly, but I have some doubts about how well that would work, though I have also made the point that some of these projects are implementable on short-notice (and some, e.g. grants to state and local government, can prevent existing projects from being shut down and can be accomplished very quickly). I am less concerned with whether stabilization policy stimulates private consumption, private investment, or government investment than others seem to be, the important thing is to increase aggregate demand as fast as possible and get the economy moving again, and it doesn't much matter which component of aggregate demand, C, I, G, or NX is behind the stimulus. If you believe theory, which component is changed won't have much long-run impact on investment anyway. Real output growth is independent of demand changes in the long-run in most, but not all macro models. Demand shocks change short-run conditions, but the economy eventually finds its way back to the long-run path (assuming government provides the supporting infrastructure, but that doesn't have to be done with stabilization policy). Stabilization policy simply changes the speed at which you return to the long-run path, but its impact on the path itself is minor or non-existent. So the important thing is to get incentives or money to the people most likely to impact aggregate demand quickly which, fortuitously, is also happens to be the people most in need of help:

A Better Way to Deal With Downturns, by Andrew A. Samwick, Commentary, Washington Post: ...While politically expedient, the stimulus package is unjustified in the short run and harmful in the longer term. ...

The $150 billion agreement calls for tax rebates to low- and middle-income households as well as business incentives. Doubtless, this will boost economic activity. If you pull levers, you get movement. Personal consumption and business investment will increase relative to what they might otherwise have been. But there is no discussion of repaying the money through higher taxes in the near term. Let's drop the euphemism of "stimulus package" and call this agreement by its proper name: "deficit spending."

It is ironic that additional borrowing is prescribed as the remedy for a malady that arose from unwise borrowing. ... If we acknowledge that bad loans fueled the activity, why is it now a widely shared policy objective to maintain that level of activity?

The answer is a combination of three factors. The first is elected officials' fear that they will be punished in November for an economic downturn unless they do "something" to avoid it. Few things precipitate bipartisan agreement so quickly. Using the incomes of future taxpayers to purchase reelection today is irresponsible but common public policy.

The second factor is policymakers' fear that unless "something" is done, a temporary economic downturn could become more protracted. This fear, to the extent that it is justified, is better addressed by the Federal Reserve lowering short-term interest rates, which would stimulate the economy more quickly and comprehensively than would fiscal policy. The Fed did just this on Tuesday. Yet the fiscal-policy lever has been yanked before any data have indicated whether the Fed's stimulus has had its intended effect.

The third factor is the recognition that some households will bear a disproportionate burden of an economic downturn, combined with a belief that "something" should be done to help them. Government has a choice in whom it taxes to finance this relief -- other taxpayers today or all taxpayers in the future. That the agreement holds the former group harmless was also praised by Bush. This "stimulus bill" is really $150 billion worth of some future generation's resources appropriated to finance our own consumption. Why are we entitled to pass on this additional debt? ...

In political arguments, you can't beat something with nothing. But we can learn from this experience to have a better menu of fiscal policy options the next time around. Two changes to our budget policy would go a long way toward that goal.

First, we should rule out deficit spending to finance a consumption binge. As the economy slows, the deficit will widen even without changes in fiscal policy. But an honest budget policy would be calibrated to balance the budget over a complete business cycle. Years of cyclical deficits will be offset by years of cyclical surpluses. As a corollary, we must not waive pay-as-you-go rules that require spending that increases the current deficit to be offset later, when the economy is stronger.

Second, we can plan well in advance. The federal government has a critical role in maintaining and developing public infrastructure, whether in transportation, telecommunications or energy transmission projects. A sensible capital budget would include a prioritized list of projects that need attention. Some would be slated for this year, some for 2009 and so on, over the useful lives of the projects. When economic growth falters, the government would be in a position to move some of the projects from later years into the present year.

This approach to counter-cyclical fiscal policy has several advantages. Perhaps most obvious is that it forces the government to establish priorities for capital projects. It reduces overall expenditures by doing more of the work in times of economic slack, when costs are lower. It also abides by pay-go rules, since projects moved up to 2008 need not be done in 2009. With a little forethought, short-term economic concerns and long-term budget goals need not be in conflict.

Landsburg: Why the Stimulus Shouldn't Stimulate You

Steven Landsburg on the stimulus package. My comments along the way:

Why the Stimulus Shouldn't Stimulate You, by Steven E. Landsburg, Commentary, Washington Post: As a general rule, economic policies command bipartisan support only when they're incoherent. Take, for example, the fiscal stimulus package now bulldozing its way through the legislative process. It's poorly conceived, it's unlikely to work, and it's sure to do a lot of collateral damage.

I agree - it's not the best plan.

The idea, we're told, is to stave off an all-out recession by stimulating both investment (through tax cuts for businesses) and consumption (through tax rebates to individuals). But hold it right there.

Investment and consumption are natural rivals.

Investment means converting resources into machines and factories; consumption means converting those same resources into TV sets and motorboats. In anything but the very short run, more of one means less of the other. ...

The reference here is to "crowding out" [Note: There is a follow-up on this point in the post above this one]. The idea that when the government  spends or cuts taxes and increases the deficit, it competes for financial assets driving interest rates up. The rise in interest rates then chokes of (crowds out) private consumption of durables and business investment so that, treating consumer durables as an investment good, the rise in government deficit causes investment to decline.

But a key part of the crowding out story is that interest rates rise in response to the increase in deficits. However, under globalization, this has not been happening. Foreigners have been very wiling to lend us money and that has kept interest rates down. So crowding out is not much of a worry.

And there is something else to consider. There is also a phenomena called "crowding in". This is, in essence, the increase in investment that comes from having a stronger economy, i.e. from increased output and employment. Because crowding out has been so small, one could plausibly argue that crowding in has dominated in recent years so that deficit spending that bolsters GDP out of a recession actually brings about an increase, not a decrease, in investment.

Fine, but what makes you think that this package will put anyone to work? The idea behind the stimulus deal is to give people tax cuts so they'll feel richer and spend more. But government can't make people richer on average; all it can do is shuffle wealth around. To pay Peter, you must tax Paul (or at least promise to tax Paul in the future, when your debts come due). Peter spends more, but Paul spends less.

Now maybe you can time things so Peter goes on a spending spree today but Paul doesn't tighten his belt until next month. (Then again, maybe you can't: Paul's no fool, and he's likely to start cutting back as soon as he sees higher taxes on the horizon.) But even if you manage to pull this trick off, sooner or later you must tax Paul. So today's fiscal stimulus comes at the expense of tomorrow's fiscal drag.

A couple of things here. He is referring to "Ricardian equivalence." This is the idea that people will understand that any increase in the deficit will mean higher taxes in the future. In fact, in a perfectly functioning market economy (and with other conditions on things such as the "connectedness" of generations) the present value of the future tax burden is equal to the increase in the deficit. If this is the case then, in aggregate, policies such as a tax rebate won't stimulate the economy because the rebate is exactly canceled by the present value of the expected increase in taxes in the future.

There are (at least) two reasons to doubt this works perfectly. First, pure Ricardian equivalence requires perfect capital markets, and there is evidence that this condition is not satisfied. Second, it it possible to give this generation a tax cut, then pass along the burden to future generations. But so long as this generation cares about the next generation, then this will not work - the present value of the taxes the next generation pays matters to us and offsets the rebate as before. However, generations are imperfectly connected so that the pass through is not 100%.

In any case, if you look at the voluminous evidence on this topic, it is somewhat mixed, but overall you will find that people think there is partial, but not full Ricardian equivalence. There is some offset to government spending or tax cuts/rebates because of the expected tax burden policies that increase the deficit bring about, but it is not 100% and fiscal policy is still sufficiently stimulatory.

Finally on this point, the idea that deficit spending now means we will have to raise taxes and lower GDP in the future is exactly right - that's the point of stabilization policy, to shave the peaks and fill the troughs. When the economy is having trouble, we deficit spend to bring up GDP, then when things are so good that the economy is beginning to overheat we run a surplus (raise taxes) to bring GDP down closer to trend. Since deviations from the long-run trend rate of growth are costly whether you are above or below trend, this type of stabilization raises economic welfare.

Continuing:

Moreover, even if you do somehow manage to increase spending, that doesn't mean you'll put Americans to work. More likely, you'll put Asians to work producing goods for the U.S. market.

This current plan is not necessarily the best way to do this, but it's pretty easy to make sure a stimulus plan only increases employment domestically. That's just a matter of targeting (tax cuts to cement companies are unlikely to result in any jobs being offshored, and if government hires people temporarily itself, it's also easy to make sure the jobs are domestic).

President Bush seems to have become confused on this key point because he misunderstands supply-side economics. He has vaguely remembered that tax cuts put people to work, but he's forgotten that only marginal tax cuts put people to work. Non-marginal tax cuts -- such as the ones in the stimulus package -- have exactly the opposite effect, when they have any effect at all.

The reason: When people feel richer, they're less eager to work. An unemployed laborer with a tax rebate in his pocket might well feel less urgency about getting retrained or finding a new job. (Not every unemployed laborer will react this way, but you can be sure that some will.) If Americans demand more but produce less, the difference has to come from abroad.

Here, then, is the great irony: To stimulate spending, tax cuts have to make people feel richer -- but the richer people feel, the slower they'll be to rejoin the workforce. The more effective the tax cuts, the longer they threaten to prolong the expected recession. ...

Yeah, I'm pretty sure giving people a few hundred extra bucks is going to stop them from looking for a job, they can live for months on that. Never mind that most of the people receiving the benefit are already employed. Now if we had extended the length of time for unemployment compensation, we'd have something to talk about - there is evidence on this point, lots and lots of it, but we didn't. Republicans would not allow one of the best means of stimulating the economy (e.g. see the rankings of programs at the CBO) to be part of the bill.

Now let's talk about why we shouldn't want it to [stimulate consumption]. ...

He simply makes the crowding out point again and concludes, wrongly as noted above, that:

If you care about your grandchildren, you should be encouraging everyone else not to consume, but to save.

But much of the stimulus package is designed to achieve exactly the opposite: It encourages consumption, not saving. Not that there's anything wrong with consumption; it's what makes life worth living. But my consumption benefits me, while my saving benefits you.

I've already got plenty of incentive to consume. What you should be worrying about is my incentive to save. To say it again: The more I consume, the poorer your grandchildren will be; the resources I use won't be available to build machines that make your grandchildren more productive. It's all well and good to worry about the people who are struggling today, but let's also remember the people who will be struggling in the future. The worst thing we can do for them is to encourage consumption.

My resources may not be available, but the immense savings in Asia and among oil producing nations are still there waiting to be borrowed at attractive rates.

And while we're thinking about our grandchildren, let's also think about our contemporaries. Over the course of a typical decade, millions of people lose their jobs one at a time. In a severe recession, millions lose their jobs all at once. But it's no more painful to be unemployed for five weeks in the middle of a recession than it is to be unemployed for five weeks at the height of a boom. In fact, it's arguably less painful: Isn't it better to be unemployed at a time when unemployment carries less stigma and when you've got unemployed friends to hang around with? (Ask those striking Hollywood writers.) So it's hard to argue that we should do more for displaced workers during a recession than we do at any other time -- especially when people who lost their jobs a few years ago, and others who will lose them a few years hence, are footing a good chunk of the bill. ...

Suppose that it takes longer to get a job in a recession, a reasonable assumption. Then extending the time period covered by unemployment benefits, increasing the resources available to programs that help to reemploy workers, hiring some of the excess workers into temporary government employment, using tax rebates to stimulate the economy and employment, and so on to compensate for the lowered probability of finding a job during a recession, i.e. implementing policies that make it equally likely that unemployed workers in recessions and unemployed workers during boom times will find a job is not preferential treatment.

Ultimately, the only solution to unemployment is for displaced workers to get retrained and find their way back into the workforce. The new stimulus package only delays that process by propping up dying industries for a while and postponing the day of reckoning. Ultimately, there will be just as much hardship because the stimulus package can't last forever. Why spend all this money trying -- and probably failing -- to delay the inevitable?

Uhm, because it's not inevitable?

Paul Krugman: Stimulus Gone Bad

I'm getting pretty tired of Democrats caving in on important issues rather than standing up and fighting for their core principles:

Stimulus Gone Bad, by Paul Krugman, Commentary, NY Times: House Democrats and the White House have reached an agreement on an economic stimulus plan. Unfortunately, the plan — which essentially consists of nothing but tax cuts and gives most of those tax cuts to people in fairly good financial shape — looks like a lemon.

Specifically, the Democrats appear to have buckled in the face of the Bush administration’s ideological rigidity, dropping demands for provisions that would have helped those most in need. And those happen to be the same provisions that might actually have made the stimulus plan effective.

Those are harsh words, so let me explain... Aside from business tax breaks — which are an unhappy story for another column — the plan ... ensures that the bulk of the money would go to people who are doing O.K. financially — which misses the whole point.

The goal ... should be to support overall spending, so as to avert or limit the depth of a recession. If the money ... doesn’t get spent — if it just gets added to people’s bank accounts or used to pay off debts — the plan will have failed.

And sending checks to people in good financial shape does little or nothing to increase overall spending. ... Give such people a few hundred extra dollars, and they’ll just put it in the bank. In fact, that appears to be what mainly happened to the tax rebates affluent Americans received during the last recession in 2001.

On the other hand, money delivered to people who aren’t in good financial shape ... does double duty: it alleviates hardship and also pumps up consumer spending.

That’s why many of the stimulus proposals we were hearing just a few days ago focused ... on expanding programs that specifically help people who have fallen on hard times, especially unemployment insurance and food stamps. ...

There was also some talk among Democrats about providing temporary aid to state and local governments, whose finances are being pummeled by the weakening economy. Like help for the unemployed, this would have done double duty, averting hardship and heading off spending cuts that could worsen the downturn.

But the Bush administration has apparently succeeded in killing all of these ideas...

Why would the administration want to do this? It has nothing to do with economic efficacy... Instead, what seems to be happening is that the Bush administration refuses to sign on to anything that it can’t call a “tax cut.”

Behind that refusal, in turn, lies the administration’s commitment to slashing tax rates on the affluent while blocking aid for families in trouble — a commitment that requires maintaining the pretense that government spending is always bad. And the result is a plan that not only fails to deliver help where it’s most needed, but is likely to fail as an economic measure...

And the worst of it is that the Democrats, who should have been in a strong position — does this administration have any credibility left on economic policy? — appear to have caved in almost completely. ...[B]asically they allowed themselves to be bullied into doing things the Bush administration’s way.

And that could turn out to be a very bad thing.

We don’t know for sure how deep the coming slump will be... But there’s a real chance not just that it will be a major downturn, but that the usual response to recession — interest rate cuts by the Federal Reserve — won’t be sufficient to turn the economy around...

And if that happens, we’ll deeply regret the fact that the Bush administration insisted on, and Democrats accepted, a so-called stimulus plan that just won’t do the job.

Tim Duy: Adding to the Fiscal Stimulus Discussion

While Tim was in central Oregon this weekend teaching the next generation of Fed Watchers where to go and hide after a bad call, he thought a bit about fiscal policy:

Adding to the Fiscal Stimulus Discussion, by Tim Duy: I rarely comment on fiscal policy. But tonight I feel somewhat adventurous, comfortably ensconced this holiday weekday in the snowy Central Cascades, watching the temperature dip toward zero. I was happy that I brought with me the print edition of the weekend Wall Street Journal, if nothing else for Bruce Bartlett’s op-ed piece and the cover story on fiscal policy. It, as well as Mark’s comments, prompted me to think about potential benefits offered by the proposed stimulus, concluding that there is an important international aspect to the stimulus that is often overlooked.

My initial read of Barlett’s piece was as an argument against temporary tax cuts, not for permanent cuts. And by in large, I agreed with Barlett. To be sure, there will be persons who do in fact spend virtually all of their tax rebate immediately, and those whose liquidity constraints are temporarily relieved. But, when all is said and done, the dollars being talked about are small relative to the size of the economy and temporary. We will see a flurry of press stories detailing the issuance of the checks, the ensuing stories of a spike in consumer spending, complete with the personal accounts of households and retailer. The personal income report will pop, and the GDP report will gain one percentage point over what it would have been otherwise, perhaps staving off a technical recession. Economists will have another data point to beat to death with econometrics, conclusively reaching multiple conclusions.

Reporters could write their stories now, fill in the details later. I have been here before, and will be here again.

This is not meant to imply that I am opposed to a stimulus package – if we can afford to spend $100+ billion in Iraq, we can afford to do it here. And if you want to get cash in the hands of spenders fast, putting checks in the mail is the way to do it. While I am very sympathetic to calls for infrastructure spending, we all know the money will trickle out over time, and thus have a fraction of the impact of $100 billion spent today. I would prefer rebates limited to those households earning less than $85,000, and expansions to a mix of temporary adjustment programs (unemployment insurance, etc.). I am wary of additional support for homeowners, but only because I am appalled that we as a society have created conditions such that households feel compelled to spend upwards of 50% of their income on housing.

Moreover, there is an additional mechanism by which the stimulus could be effective, even if the impacts on domestic consumption are relatively small and temporary – the stimulus may reduce the probability of a disorderly adjustment of the external accounts.

I generally do not view the current situation in a typical closed-economy Keynesian fashion. Keynes focused on situations where domestic consumption fell short of productive capacity due to an unwillingness to spend (excessive saving met with hesitant investment). Government spending – sustained, long term capital investment – could alleviate the imbalance by releasing the unused resources via issuance of debt.

In contrast, the US faces a resource constraint, not an unwillingness to spend. The existence of our sizable trade imbalance is evidence of that constraint. We have no problem spending money – we consume more than we produce in this country. Period. We rely on foreign savings and production (depending on what side of the international accounts you focus on) to support that consumption. Which is why I found this comment to be particularly prescient:

Foreign savers will no longer lend to citizens for consumption (by buying securitized mortgages and such), so the gov will temporarily borrow the money from foreign savers and give it to citizens to spend.

Correct – US consumers lost access to an important source of financing, and market participants are in a “run and hide” mood as they sort out the long term implications. What financial markets remain willing to absorb is US government debt. The fiscal stimulus we enact today can be viewed as an attempt to stabilize markets enough to lure foreign savers, or governments, back into supporting US domestic demand in excess of production capabilities without the US government as an intermediary. Note the desperate attempt of the financial community to recapitalize via foreign savings. And see Brad Setser.

Suppose that the transition away from foreign savings/production is underway – as suggested by the stabilization of the US current account deficit. There is a risk that this becomes disorderly, and the US government can smooth the transition by borrowing funds from abroad to offset a drop in capital inflows to private assets. The temporary stimulus has its impact not by “jump starting” the economy, but instead by preventing a disorderly adjustment as we transition to a new growth path. Then the stimulus was effective, even is “temporary.”

But the other side of the adjustment will not be days of wine and roses. Quite the contrary. Lessening our reliance on external production implies reduced rates of domestic demand growth on the other side of this downturn. It comes as little surprise to me that the Fed’s long term outlook appears looks consistent with potential growth near 2.5%.

Longer term, the potential downsides of stabilization policy emerge if we are not happy with the transition toward lower domestic demand growth rates. Then we will be increasingly using monetary and fiscal policy to foster a growth path that I suspect the rest of the world will be increasingly unwilling to support. As incomes rise across the globe, citizens of other nations will be increasing interested in producing for their own consumption, not ours. At that point, continued reliance on the rest of the world will prove difficult to maintain.