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More thoughts on fiscal policy

January 22, 2013

First, Larry Summers has written an op-ed I spotted in the Financial Times and the Washington Post today. Summers appears to broadly agree with my take that some people are overly focused on shrinking the budget deficit right now. He makes some of the same arguments that plenty of Keynes’ disciples tend to make: fiscal policy should run deficits when the economy is weak, there are important investments we could make as long as output remains below trend and interest rates low, long-term unemployment hurts the country’s economic potential in the future, etc. None of the points Summers makes or policies that he advocates are new, but what is new the way he phrases the debate. Summers points out that we are often obsessing over the fiscal deficit because a deficit is, almost by definition, something bad and should be eliminated. The problem is too much focus on the fiscal deficit could lead us to focus on this one issue at the expense of other important issues. If it helps then, Summers suggests thinking of other problems in terms of deficits as well:

“As important as avoiding the repression of budget deficits is ensuring that the focus on the budget deficit does not come at the expense of other equally real deficits. Interest rates in the United States and much of the industrialized world are remarkably low. In real terms, governments’ cost of borrowing recently has been negative for horizons as long as 20 years. No one who travels abroad from the United States can doubt that this country has an enormous infrastructure deficit. Surely even leaving aside any possible stimulus benefits, current economic conditions make this the ideal time for renewing the nation’s infrastructure. Such investments, borrowed at near-zero interest rates, need not increase debt ratios if their contribution to economic growth raises tax collections.

Infrastructure represents only the most salient of the deficits facing the United States. Nearly six years after the onset of financial crisis, we clearly are living with substantial deficits in jobs and growth. Consider that if an increase of just 0.15 percent in the economy’s growth rate were maintained over the next 10 years, the debt-to-GDP-ratio in 2023 would be reduced by about 2.5 percentage points. That’s an amount equal to the much debated year-end fiscal compromise that raised taxes. Increasing growth also creates jobs and raises incomes.”

I like what he did there: if deficits have such a strong impact on people then try to demonstrate that the gap between the current unemployment rate of 7.8% and what the unemployment rate would be at “full” employment, say, 5.0%?, is also  a deficit of roughly 2.8%.  Does it make sense that we should focus on the fiscal deficit exclusively and ignore this or other deficits, even if they are harder to define?

Next, Tyler Cowen makes some good points when he argues that even if now is not the ideal time to adopt a tight fiscal policy, there are still good reasons to focus on the deficit. It is true that safety net spending is expected to grow at a very high rate in the coming decades as the population ages and the cost of healthcare increases. It would be irresponsible of us not to pay attention to these painfully obvious trends and take some action to avoid future problems. We can enact policies that will curtail future spending in debates that we are having today without tightening fiscal policy right now. This actually could be a positive outcome of the sequester and budget negotiations taking place in Washington right now.

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