@jimpethokoukis: Reminder: Consensus economics view is that lowering corporate income taxes would increase the wages of workers. That isn’t Laffer-ism.
@de1ong: Lowering corporate income taxes and replacing the lost revenue with lump-sum taxes would raise average wages. not what you said…
If you require that the government’s budget constraint be met in your model, consensus economics says “it depends”. Given that raising worker standards of living is not a terribly high priority goal in the Repub House caucus, the way to bet is that when you add in whatever policies they would enact to meet the government budget constraint, the Republican House bill, if enacted, would not raise wages at all.
Saying that replacing a distortionary with a distortionary-free revenue source will (probably) raise some category of income is not “Lafferism”. But it is something not good. What name would you suggest for an analysis that is badly flawed by its inclusion of magic asterisks and its neglect of the government budget constraint?
I would suggest “Stockmanism”, after Reagan’s budget director, known most famously for saying “none of us understand what is going on with these numbers”.
Kansas is—in some strong sense—unbelievably loony.
No sooner does Sam Brownback manage to plant his behind in the Governor’s chair in Topeka, KS than does Kansas’s share of American nonfarm jobs and people start to drop like a stone. It is not so much absolute net flight—there were 1.397 million nonfarm jobs in Kansas at the last business cycle peak in April 2008; there are 1.400 million nonfarm jobs in Kansas today. But Kansas has seen none of the country’s net employment growth over the past decade: the jobs it lost in the 2007-2009 recession it has barely recovered, while the country has recovered what was lost and has added on almost as many more in addition.
There is no sense in which the share of U.S. nonfarm employment in Kansas was in any sort of long-run decline: the employment share was strongly up at the start of the 1990s, flat in the mid-1990s, up and down into the 2000s, down in the mid-2000s, up again in the late 2000s. But since Brownback took the chair over from Kathleen Sibelius and Mark Parkinson, it has been down, down, down, down. A fall of 6%-points in the relative share of employment in little more than six short years is astonishing in its rapidity.
Nothing like this was seen before. Yes, Kansas’s share of U.S. nonfarm employment shrank from 1995-2003 under Republican Governor Graves, but there ups as well as downs—and the net shift was strong. Yes, Kansas’s share of nonfarm employment grew under both Graves’s Democratic predecessor Finney and his successors Sibelius and Parkinson—but there were downs as well as ups. It is only under Brownback that it has been down, down, down, down. You can argue how much of it is hostility to immigrants and strangers. How much of it is the profoundly un-Christian cast of a “Christian” government, and how much of it is the collapse of public services. But it has been effective.
My friend Dan Davies says that the best proof that there is a skill and art of management comes from the fact that nobody doubts that there is such a thing as gross mismanagement. Similarly, the best proof that there is such a thing as good technocratic government leading to shared prosperity and equitable growth is… Brownback, and his acolytes and supporters, in Kansas:
You can’t blame this on farm or oil or natural gas booms or busts. You can’t blame this on “globalization” or whatever. It is what it is.
…Brownback leaves a financial train wreck in his wake. From the state’s drained highway fund to its beleaguered pension system for state workers, Kansas taxpayers now have a lot of fiscal ground to make up. In fact, the total reaches into the billions. Our advice to taxpayers: Grab a shovel and start digging. Escaping from this fiscal mess is going to take a lot of work—and possibly still more tax increases, as we’ve pointed out. “For a small Midwestern state, it’s a massive hole,” said Senate Minority Leader Anthony Hensley, a Topeka Democrat. “And it’s going to take years to recover.” At this point, there’s no excuse for anybody to be surprised….
On the day in 2012 when Brownback signed the tax-cut bill, critics were already forecasting fiscal doomsday. The measure slashed state income taxes by roughly $3.7 billion over five years. State financial analysts were predicting budget deficits totaling $2.5 billion in 2018. Undaunted, Brownback insisted that the improved business climate would benefit all. “We’re going to move this forward and make it work and take care of our fundamental services,” Brownback said that day….
Since Brownback’s first year in office, the state has raided various funds or delayed payments to the tune of $3.1 billion… $2.5 billion in payments to the state highway fund… diverted… delayed payments totaling more than $407 million from the employee retirement system…. Economic development programs were raided to the tune of $125 million. About $47 million intended for children’s programs was diverted… borrowed $1 billion and deposited it into the retirement account for needed stability. That money will have to be repaid, and so will the $407 million to make pension payments. Likewise, we’ll never know what was lost in terms of progress for kids via those early childhood programs. Years from now, taxpayers will still be footing the Brownback bill…
…[it] led to sluggish growth, lower than expected revenues, and brutal cuts to government programs…. One of the cleanest experiments for measuring the effects of tax cuts on economic growth in the U.S., were eventually reversed by a Republican-controlled legislature as a failure…. [Do] not… expect tax cuts to boost the economy much, if at all…. The tax reform discussion should include what it is that citizens are getting from the taxes they pay…
…hey, that’s what Brownback himself called it, although he refused to accept the crystal-clear results of that experiment—mark a turning point in U.S. politics?… I have my doubts…. There was an idea, a theory, behind the Kansas tax cuts: the claim that cutting taxes on the wealthy would produce explosive economic growth. It was a foolish theory…. But still, it was a theory, and eventually the theory’s failure was too much even for Republican legislators. Now consider the AHCA, aka Trumpcare…. What’s the theory behind their proposed replacement?… Wat we’re seeing now is so bad, so cynical, that it makes the Kansas experiment looks like a model of idealism and honesty by comparison. I don’t think we’re in Kansas anymore. We’re now in someplace much, much worse…
…then they could expand the Earned Income Tax Credit… for low-income families, particularly workers without dependent children…. A substantial academic literature finds that the EITC boosts labor supply, creating jobs…. Even an unprecedentedly large expansion of the EITC could be accomplished for a fraction of the cost of President Trump’s high-income and business tax cuts…
…His critics on Wednesday quickly pointed out the governor’s tremendous failures, while his supporters gave some outright loony reasons for saying he’d done great things. Brownback’s reckless income tax cuts starting in 2013 almost bankrupted the state, damaged funding for roads and education, and made Kansas into a laughingstock across the nation. For good reasons, Kansans made Brownback one of the most unpopular governors in America in a few polls…. It will take years to rebuild the institutions that Sam Brownback badly damaged as governor. Good riddance to him…
David Atkins: Austerity Fever Breaks in Kansas, Rebuking the Conservative Cult: “When Oklahomans cut taxes so deeply that they can’t afford to run their own schools more than four days a week…
…that’s not an act of prejudice, or a wistful vote to bring back the factories, or an angry yawp to punish rich coastal elites. That’s an act of political blood sacrifice…. So it’s heartening in a way to see that Kansas, which has long been ground zero for the most extreme version of tax-cut orthodoxy in America and has suffered mightily for it, is finally coming to its senses somewhat…. Not that there isn’t resistance from the true believers:
Dan Cox… said that Brownback’s defeat did not augur more victories for Republicans pursuing more moderate economic policies. He said Republican policymakers and their advisers around the country are likely to view the example of Kansas as a failure of implementation, rather than one of principle, and they will argue that Kansas’s experiment would have succeeded had the legislature reduced spending even more. Moreover, Cox said, the business lobby remains more influential in the party than those who support centrist or populist points of view…
…Income tax receipts have fallen short of the state projections from last summer, turning a $380 million budget reserve into a two-year $700 million hole. Liberals claim the shortfall is proof that tax reform is a sham, but Mr. Brownback never claimed his plan would be instant Miracle Gro for public coffers…. The Governor’s major blunder was assuming that reduced revenues would induce lawmakers to scale back entitlements…. As Steve Moore describes nearby, Republican governors across the country are still making tax cuts a priority, despite the claims by some of our liberal friends that Mr. Brownback’s travails have shut them down. The difference is that some of them are moving more cautiously than they might if the economy were growing faster and revenues were rising. The real moral of Mr. Brownback’s unfortunate story is that lower tax rates are hard to sustain without either faster economic growth or restraints on government…
…Mr. Brownback has made pro-growth tax reform his highest priority…. Mr. Brownback says the income tax cut will put Kansas “on a road to faster growth.”… Low tax rates aren’t the only policy needed for growth, and Kansas would be better off had Senate Republicans agreed to reduce loopholes while cutting rates. But the tax cut will force state politicians to restrain spending, and above all it sends a signal to businesses and taxpayers that Kansas wants more of both…
…Tax reform probably should have gone first, but now is the time to move it forward with urgency…. Cut the federal corporate and small-business highest tax rate to 15 percent from 35 percent…. Allow businesses to immediately deduct the full cost of their capital purchases…. Impose a low tax on the repatriation of foreign profits brought back to the United States…. President Trump and Paul Ryan, the speaker of the House, should stop insisting on “revenue neutrality.” In the short term, the bill will add to the deficit…
…In 2010, the tea-party wave put Sam Brownback into the Sunflower State’s governor’s mansion and Republican majorities in both houses of its legislature. Together, they implemented the conservative movement’s blueprint for Utopia: They passed massive tax breaks for the wealthy and repealed all income taxes on more than 100,000 businesses. They tightened welfare requirements, privatized the delivery of Medicaid, cut $200 million from the education budget, eliminated four state agencies and 2,000 government employees. In 2012, Brownback helped replace the few remaining moderate Republicans in the legislature with conservative true believers. The following January, after signing the largest tax cut in Kansas history, Brownback told the Wall Street Journal, “My focus is to create a red-state model that allows the Republican ticket to say, ‘See, we’ve got a different way, and it works.’” As you’ve probably guessed, that model collapsed…
…Republicans in the state legislature on Tuesday voted to reverse Governor Sam Brownback’s signature tax cuts, dealing a blow to the kind of fiscal policy the Trump administration wants to enact nationally…. For Brownback, a former senator and one-time presidential hopeful, the vote was nothing less than a humiliation. He had hailed his tax cuts as “a real live experiment” in conservative governance and offered them up as a model for other states and the Trump administration. Instead, they left him as the most unpopular governor in the country, who was reportedly casting about for a federal posting that would allow him to escape Topeka before the legislature could eviscerate his legacy. “The Brownback experiment didn’t work. We saw that loud and clear,” said Heidi Holliday, executive director of the Kansas Center for Economic Growth…
…The Kansas state legislature on Tuesday voted to override Gov. Sam Brownback’s veto and roll back $1.2 billion of tax cuts over two years. The vote marked a bipartisan repudiation of what Brownback had described as an “experiment” in a particular brand of anti-tax fiscal conservatism. The failure of that experiment has implications beyond Kansas because Brownback’s approach was meant to be a model for conservatives elsewhere, including in Washington. (It was drafted with the help of prominent conservative thinkers, including former Ronald Reagan adviser Arthur Laffer and Heritage Foundation economist Stephen Moore.) Brownback’s version was particularly radical: He aimed to push personal income taxes to zero and exempted certain kinds of businesses, known as “pass-through” entities, from taxes entirely…. Brownback and his supporters predicted that cutting taxes would create jobs and spur entrepreneurship while boosting government revenue. That isn’t what happened…
Tracy M. Turner and Brandon Blagg: The Short-term Effects of the Kansas Income Tax Cuts on Employment Growth: “The state of Kansas made dramatic changes to the structure of its personal income tax… http://journals.sagepub.com/doi/pdf/10.1177/1091142117699274
…by eliminating taxation of business income and lowering marginal tax rates on other personal income sources. Proponents of the legislation maintain that the tax reductions will stimulate employment growth. Using a difference-in-differences approach, we estimate the impact of the tax changes on private-sector employment in the state of Kansas, relative to its border states, using data on the number of establishment employees and proprietors. We apply multistate county fixed effect model and county-border matching approaches to identify tax effects. Our findings indicate that two years post enactment, the tax law changes have not yielded a net increase in private-sector employment…
And I think: Gee, if I rise to this, like a moth to the flame, then Chris Shea of http://vox.com–to whom I owe 3000 overdue words on trade, manufacturing, politics, NAFTA, China’s accession to the WTO, and TPP–will be really annoyed that I am letting Matt Yglesias be a higher priority assignment editor than him.
I need to lie down until the desire to respond to Matt goes away, and then get up on things that have, you know, deadlines in the past…
Didn’t work…
We have a pretty good theory of how we ought to make decisions under uncertainty. It is, in fact, the same as our pretty good theory of how we ought to make decisions for society as a whole…
Let’s take the individual-uncertainty version first:
We exist behind a veil of ignorance: We do not know what the future will bring. We can, say, slice the future into 10,000 different 0.01% probability chunks, in each of which we would be different. Maybe only one of those 10,000 will actually happen, and the rest are unreal shadows produced only by our ignorance. Maybe (this is version I prefer) all 10,000 of them “exist” and will “occur”, as they are different branches of the quantum wave function of the multiverse, with each having wave-function amplitude that is the appropriate complex square root of 0.0001. (But the answer to the question of which appears to be unknowable. And which is “true” makes no difference.)
In deciding to take action X today, we are, given the uncertainties, doing something to benefit some of our 10,000 future selves and penalize others. We have some sort of obligation to our future selves, either because it makes us happy to sacrifice some of our present comfort for the sake of our future selves or because we wish to be people who are not total a–holes. (Again, it makes no difference.)
Do we take action X?
The economists’ theory tells us that if the effects on our 10,000 future selves generated by action X are unsystematic–if the variance of the effects over our 10,000 future selves is of the kind that can be diversified away–we should just care about the average effect. Thus we should take action X if the average effect is such that we would judge it worthwhile if we knew that the average effect would occur with certainty.
The economists’ theory further tells us that if the variability of the effects on our 10,000 future selves is systematic–that it tends to make those of our future selves who are relatively poor even poorer, and those who are relatively rich even richer–then we should aggregate the effects on our 10,000 future selves with an egalitarian bias: It makes little difference to our aggregation calculation if action X takes an extra dollar away from a future self with a lifetime income 90% and gives one to one with 110% of the future-self average. But by the time the consequences of our actions are taking wealth away from future selves with 30% and giving them to future selves with 170% of the average–then we need to incorporate a risk premium into our calculations.
And here comes punchline one: The effects of government interventions in infrastructure are about as systematic as are corporate business investments. The two, after all, are very strong complements. If the value of private sector goods produced is lower, the value of the infrastructure that enables the efficient production of those private sector goods is lower as well. If the value of infrastructure is high, that can only be because it is greatly assisting in the production and distribution of high-value goods. Tyler is right in asserting that the hurdle rate for government infrastructure and private sector investments should be roughly the same.
But–and here comes punchline two–Tyler goes wrong in asserting that the price charged by savers to fund private sector corporate investments is the right price from society’s point of view, and the price charged the government for borrowing is the wrong price to use to calculate the common hurdle rate for public infrastructure and private investments
Think of it: Neither government investments in infrastructure nor private sector investments in physical capital are that systematic as far as their risk his concert. And, at least on the scale at which we are currently investing, we are much closer to the 90% – 110% case than to the 30%-170% case. The average return required should therefore be governed by:
pure time preference,
the speed with which are wealth is increasing, and
the degree to which increasing wealth satiates us.
I see few signs that we are at the stage where increasing wealth satiates us to any strong degree. The speed with which our wealth is increasing is a per capita rate of about 1.5% per year. And as for pure time preference–well, from a social choice point of view, such a thing can only be irrational myopia. Your future self has the same philosophical and moral standing that your present self does: there is no compelling reason to prefer the interests of the one over the interests of the other. There is force majeur–your present self is here and now and has its mits on the stuff and controls what happens–but that is not a principal of moral but rather of immoral philosophy. In fact, there is an evolutionary-morality point working in the other direction, if you believe in any form of evolutionary morality. (You don’t have to.) Just because your present self happens to come first and time does not produce a moral principle that the interests of later-comers should be sacrificed to its selfish hedonistic pleasures.
Thus I, at least, find there to be a very strong and not yet refuted by anyone case that the presumption should be for a very low hurdle rate, from a social choice point of view at least. That low hurdle rate should apply to both government infrastructure and to private corporate investments. Claims that a higher hurdle rate is in some sense optimal or appropriate seem to me implausible, and to require very hard argumentative work for plausibility that has not yet been done.
What is this hurdle rate? I think you have to start from the rate of growth of per capita income, and make adjustments up and down from there: 1.5% per year in real terms. That is punchline two.
Why, then, does the financial system of a modern capitalist market economy grind out not a 1.5% per year real interest rate for risky private corporate investments? Why does it grind out a 5% per year rate for β=1 investments? Good question!
In my view, the answer is threefold. The market grinds out a wrong 5%/year rather than the right 1.5%/year because:
Modern capitalist financial markets do a horrible job at mobilizing the potential systematic risk-bearing capacity of society as a whole.
Modern capitalist financial markets singularly fail to solve the enormous moral-hazard and adverse-selection asymmetric-information problems involved in trusting your money to Steve Ballmer or Jamie Dimon–let alone Dick Fuld. (Cf.: Noah Smith.)
We have brains design by evolution to do three things: calculate (a) whether the fruit is ripe; (b) whether it is safe to leap to the next branch, and (c) whether we should and how best to amuse men (women) so that they might mate with us. We do not have ranged can reliably make complicated and appropriate moral-philosophical calculations under conditions of great uncertainty and ignorance.
But that modern private capitalist financial markets are ridden by market failures of human psychological myopia, institutional map-design, and asymmetric information–and thus use the wrong hurdle rate–provides no reason at all for using the wrong hurdle rate when solving the public-sector part of the societal-welfare optimization problem.
Moreover, I have a punchline three: The argument as I have made it so far is a very general argument. It creates, in my mind at least a very strong and so far unrebutted (but possibly, with sufficient very hard intellectual work, rebuttable) presumption that the appropriate real hurdle rate is an expected return of less than 2% per year.
But ever since 2005 or so we have been in a very unusual time. For a large number of poorly understood reasons, the world has been awash in savings and yet short of investment. The appropriate hurdle rate has thus been less than the one established by the general argument. We are still in an unusual time. The U.S. labor market no longer has large obvious amounts of slack, but as the Paul Krugman with his Krell-like brainpoints out, considerations of asymmetric policy risks and global rather than local macroeconomic balance strongly suggest that the right policy is to still act as though the U.S. still has large obvious amounts of slack, and so needs to penalize saving and encourage investment at the margin by more than it is currently doing.
Take the mechanics of demand stabilization and management off the table. Move, in our imagination at least, into a world in which short-term safe nominal interest rates rarely if ever hit the zero nominal bound. In that world, as a result, the full employment and price stability stabilization-policy mission could be left to central banks and monetary policy. Furthermore, confine our thinking to the North Atlantic, possibly plus Japan.
It seems to me then that there are four big remaining questions:
Can, in a political-economy sense, central banks be trusted with this mission? Are they not captured, to too great an extent, by the commercial-banking sector that, myopically, favors higher nominal interest rates to directly improve bank cash flows and indirectly dampen inflation and so redistribute wealth to nominal creditors–like banks?
What is the proper size of the twenty-first century public sector?
What is the proper size of the public debt for (a) countries that do possess exorbitant privilege because they do issue reserve currencies, and (b) countries that do not?
What are the real risks associated with the public debt in the context of historically-low present and anticipated future interest rates?
I gave my preliminary answers to (2), (3), and (4) here. But what about (1)? And what about others’ takes on my answers to (2), (3), and (4)?
I think that these are among the most important questions for macroeconomists to be grappling with right now, and yet I am disappointed to see relatively little serious work on them. Am I missing active literatures because I am not looking in the right places?
…Insolvency… [is] when liabilities are greater than assets. That’s very basic accounting. One of the U.S. government’s assets is its ability to tax…. The national debt–which includes debt held by the public and money owed to other branches of the government–is only equal to about six years’ worth of tax revenue. If the U.S. devoted a fifth of tax revenue to paying down the entire national debt, it would take 30 years to do it. That’s not insolvency….
The federal debt held by the public is now growing at about a 3 percent rate, while the economy is growing at about a 3.4 percent rate (these are both in nominal terms)…. the U.S. deficit is now perfectly sustainable. This represents a remarkable–possibly even excessive–display of fiscal responsibility by the U.S. government…. So the U.S. debt isn’t frighteningly large, nor is it growing in relation to the economy. In the future, it might do so, if health care prices accelerate again, or if the population ages more. But the U.S. can take steps to address those contingencies when they happen. For now, the U.S. is living in the greatest period of fiscal responsibility since the second Clinton administration.
Resist the urge to engage in debt hysterics, please.
Must-Read: I think the extremely-sharp Olivier Blanchard misses an important part of my argument here. If g the rate of growth of a government’s taxing capacity > r its cost of funds via borrowing and if the government is risk-neutral then obviously the government should issue more debt: the economy is then dynamically inefficient with respect to the investments taxpayers have made in their “ownership” of the government and its assets. Any argument that such a government should not be frantically running up its debt must hinge on aversion to interest-rate risk caused by fear of the consequences in the event of an interest-rate spike. But in the case of a reserve currency-issuing sovereign, what are those consequences? The consequences are merely that one must then balance the government’s budget constraint, via some combination of higher taxes, inflation, and financial repression. And there is no reason to think that, for reserve currency-issuing sovereigns, the costs of such a balancing are unduly large.
Other policies to get rid of the distortions that produce g > r for government debt may well be better than running up the debt. But in the absence of those other policies, running up the debt is certainly better than the status quo unless the government is near the edge of its financial repression and taxing capacities and the costs of inflation are very large. And for reserve currency-issuing sovereigns those are none of them the case.
…was offered by Brad DeLong: If the rate at which the government can borrow (r) is less than the growth rate (g), then, he argued, governments should increase, not decrease, current debt levels. If people value safety so much (and thus the safe rate is so low), then it makes sense for the state to issue safe debt, and possibly use it for productive investment. And if the interest rate is less than the growth rate, debt is safe: the debt- to-GDP ratio will decrease, even if the government never repays the debt.
One senses that the argument has strong limits, from the likelihood that r remains less than g (the two letters appear to have become part of the general vocabulary), to the issue of what determines the demand for safe assets, to whether r less than g is an indication of dynamic inefficiency or some distortion, to whether, even if this world, high levels of debt increase the probability of multiple equilibria, rollover crises and sudden stops.
Jack Morton Auditorium, George Washington University :: April 15-16, 2015
It has now been seven years since the onset of the global financial crisis. A central question is how the crisis has changed our view on macroeconomic policy. The IMF originally tackled this issue at a 2011 conference and again at a 2013 conference. Both conferences proved very successful, spawning books titled In the Wake of the Crisis and What Have We Learned? published by the MIT Press.
The time seemed right for another assessment. Research has continued, policies have been tried, and the debate has been intense. How much progress has been made? Are we closer to a new framework? To address these questions the IMF organized a follow up conference on “Rethinking Macro Policy III: Progress or Confusion?”, which took place at the Jack Morton Auditorium in George Washington University, Washington DC, on April 15–16, 2015.
The conference was co-organized by IMF Economic Counselor Olivier Blanchard, RBI Governor Raghu Rajan, and Harvard Professors Ken Rogoff and Larry Summers. It brought together leading academics and policymakers from around the globe, as well as representatives from civil society, the private sector, and the media. Attendance was by invitation only.
Wrap Up Video:
J. Bradford DeLong
On the Proper Size of the Public Sector, and the Proper Level of Public Debt, in the Twenty-First Century
Introduction
Olivier Blanchard, when he parachuted me into the panel, asked me to “be provocative.”
So let me provoke:
My assigned focus on “fiscal policy in the medium term” has implications. It requires me to assume that things are or will be true that are not now or may not be true in the future, at least not for the rest of this decade and into the next. It makes sense to distinguish the medium from the short term only if the North Atlantic economies will relatively soon enter a regime in which the economy is not at the zero lower bound on safe nominal interest rates. The medium term is at a horizon at which monetary policy can adequately handle all of the demand-stabilization role.
The focus on a medium run thus assumes that answers have been found and policies implemented for three of the most important macroeconomic questions facing us right now, here in the short run, today. Those three are:
What role does fiscal policy have to play as a cyclical stabilization policy?
What is the proper level of the inflation target so that open-market operation-driven normal monetary policy has sufficient purchase?
Should truly extraordinary measures that could be classified as “social credit” policies—mixed monetary and fiscal expansion via direct assignment of seigniorage to households, money-financed government purchases, central bank–undertaken large-scale public lending programs, and other such—be on the table?
Those three are still the most urgent questions facing us today. But I will drop them, and leave them to others. I will presume that satisfactory answers have been found to them, and that they have thus been answered.
As I see it, there are three major medium-run questions that then remain, even further confining my scope to the North Atlantic alone, and to the major sovereigns of the North Atlantic. (Extending the focus to emerging markets, to the links between the North Atlantic and the rest of the world, and to Japan would raise additional important questions, which I would also drop on the floor.) These three remaining medium-run questions are:
What is the proper size of the twenty-first-century public sector?
What is the proper level of the twenty-first-century public debt for growth and prosperity?
What are the systemic risks caused by government debt, and what adjustment to the proper level of twenty-first-century public debt is advisable because of systemic risk considerations?
To me, at least, the answer to the first question—what is the proper size of the twenty-first-century public sector?—appears very clear:
The optimal size of the twenty-first-century public sector will be significantly larger than the optimal size of the twentieth-century public sector. Changes in technology and social organization are moving us away from a “Smithian” economy, one in which the presumption is that the free market or the Pigovian-adjusted market does well, to one that requires more economic activity to be regulated by differently tuned social and economic arrangements (see DeLong and Froomkin 2000). One such is the government. Thus, there should be more public sector and less private sector in the twenty-first century than there was in the twentieth.
Similarly, the answer to the second question appears clear, to me at least:
Thus, at the margin, additional government debt has not required a greater primary surplus but rather has allowed a greater primary deficit—a consideration that strongly militates for higher debt levels unless interest rates in the twenty-first century reverse the pattern we have seen in the twentieth century, and mount to levels greater than economic growth rates.
The answer to the third question—what are the systemic risks caused by government debt?—is much more murky:
To be clear: the point is not that additional government debt imposes an undue burden in the form of distortionary taxation and inequitable income distribution on the future. When current and projected interest rates are low, they do not do so. The point is not that additional government debt crowds out productive investment and slows growth. When interest rates are unresponsive or minimally responsive to deficits, they do not do so. Were either of those to fail to hold, we would have exited the current regime of ultra-low interest rates, and the answer to the second question immediately above would become different.
The question, instead, is this: in a world of low current and projected future interest rates—and thus also one in which interest rates are not responsive to deficits—without much expected crowding out or expected burdens on the future, what happens in the lower tail, and how should that lower tail move policies away from those optimal on certainty equivalence? And that question has four subquestions: How much more likely does higher debt make it that interest rates will spike in the absence of fundamental reasons? How much would they spike? What would government policy be in response to such a spike? And what would be the effect on the economy?
The answer thus hinges on:
the risk of a large sudden upward shift in the willingness to hold government debt, even absent substantial fundamental news, and
the ability of governments to deal with such a risk that threatens to push economies far enough up the Laffer curve to turn a sustainable into an unsustainable debt.
I believe the risk in such a panicked flight from an otherwise sustainable debt is small. I hold, along with Reinhart and Rogoff (2013), that the government’s legal tools to finance its debt through financial repression are very powerful. Thus I think this consideration has little weight. I believe that little adjustment to one’s view of the proper level of twenty-first-century public debt of reserve-currency-issuing sovereigns with exorbitant privilege is called for because of systemic risk considerations.
But my belief here is fragile. And my comprehension of the issues is inadequate.
Let me expand on these three answers:
The Proper Size of Twenty-First-Century Government
Suppose commodities produced and distributed are properly rival and excludible:
Access to them needs to be cheaply and easily controlled.
They need to be scarce.
*They need to be produced under roughly constant-returns-to-scale conditions.
Suppose, further, that information about what is being bought and sold is equally present on both sides of the marketplace—that is, limited adverse selection and moral hazard.
Suppose, last, that the distribution of wealth is such as to accord fairly with utility and desert.
If all these hold, then the competitive Smithian market has its standard powerful advantages. And so the role of the public sector should then be confined to:
antitrust policy, to reduce market power and microeconomic price and contract stickinesses,
demand-stabilization policy, to offset the macroeconomic damage caused by macroeconomic price and contract stickinesses,
financial regulation, to try to neutralize the effect on asset prices of the correlation of current wealth with biases toward optimism or pessimism, along with
largely fruitless public-sector attempts to deal with other behavioral economics-psychological market failures—envy, spite, myopia, salience, etc.
The problem, however, is that as we move into the twenty-first century, the commodities we will be producing are becoming:
less rival,
less excludible,
more subject to adverse selection and moral hazard, and
more subject to myopia and other behavioral-psychological market failures.
The twenty-first century sees more knowledge to be learned, and thus a greater role for education. If there is a single sector in which behavioral economics and adverse selection have major roles to play, it is education. Deciding to fund education through very long-term loan financing, and thus to leave the cost-benefit investment calculations to be undertaken by adolescents, shows every sign of having been a disaster when it has been tried (see Goldin and Katz 2009).
The twenty-first century will see longer life expectancy, and thus a greater role for pensions. Yet here in the United States the privatization of pensions via 401(k)s has been, in my assessment, an equally great disaster (Munnell 2015).
The twenty-first century will see health care spending as a share of total income cross 25 percent if not 33 percent, or even higher. The skewed distribution across potential patients of health care expenditures, the vulnerability of health insurance markets to adverse selection and moral hazard, and simple arithmetic mandate either that social insurance will have to cover a greater share of health care costs or that enormous utilitarian benefits from health care will be left on the sidewalk.
Moreover, the twenty-first century will see information goods a much larger part of the total pie than in the twentieth. And if we know one thing, it is that it is not efficient to try to provide information goods by means of a competitive market for they are neither rival nor excludible. It makes no microeconomic sense at all for services like those provided by Google to be funded and incentivized by how much money can be raised not fromthe value of the services but fromthe fumes rising from Google’s ability to sell the eyeballs of the users to advertisers as an intermediate good.
And then there are the standard public goods, like infrastructure and basic research.
Enough said.
The only major category of potential government spending that both should not—and to an important degree cannot—be provided by a competitive price-taking market, and that might be a smaller share of total income in the twenty-first century than it was in the twentieth? Defense.
We thus face a pronounced secular shift away from commodities that have the characteristics—rivalry, excludability, and enough repetition in purchasing and value of reputation to limit myopia—needed for the Smithian market to function well as a societal coordinating mechanism. This raises enormous problems: We know that as bad as market failures can be, government failures can often be little if any less immense.
We will badly need to develop new effective institutional forms for the twenty-first century.
But, meanwhile, it is clear that the increasing salience of these market failures has powerful implications for the relative sizes of the private market and the public administrative spheres in the twenty-first century. The decreasing salience of “Smithian” commodities in the twenty-first century means that rational governance would expect the private-market sphere to shrink relative to the public. This is very elementary micro- and behavioral economics. And we need to think hard about what its implications for public finance are.
The Proper Size of the Twenty-First-Century Public Debt
Back in the Clinton administration—back when the US government’s debt really did look like it was on an unsustainable course—we noted that the correlation between shocks to US interest rates and the value of the dollar appeared to be shifting from positive to zero, and we were scared that the United States was alarmingly close to its debt capacity and needed major, radical policy changes to reduce the deficit (see Blinder and Yellen 2000).
Whether we were starting at shadows then, or whether we were right then and the world has changed since, or whether the current world is in an unstable configuration and we will return to normal within a decade is unclear to me.
But right now, financial markets are telling us very strange things about the debt capacity of reserve-currency-issuing sovereigns.
Since 2005, the interest rate on US ten-year Treasury bonds has fallen from roughly the growth rate of nominal GDP—5 percent/year—to 250 basis points below the growth rate of nominal GDP. Because the duration of the debt is short, the average interest rate on Treasury securities has gone from 100 basis points below the economy’s trend growth rate to nearly 350 basis points below. Maybe you can convince yourself that the market expects the ten-year rate over the next generation to average 50 basis points higher than it is now. Maybe.
Taking a longer run view, Richard Kogan and co-workers (2015) of the Center on Budget and Policy Priorities have been cleaning the data from the Office of Management and Budget. Over the past two hundred years, for the United States, the government’s borrowing rate has averaged 100 basis points lower than the economy’s growth rate. Over the past one hundred years, 170 basis points lower. Over the past fifty years, 30 basis points lower. Over the past twenty years, the Treasury’s borrowing rate has been on average greater than g by 20 basis points. And over the past ten years, it has been 70 basis points lower.
When we examine the public finance history of major North Atlantic industrial powers, we find that the last time that the average over any decade of government debt service as a percentage of outstanding principal was higher than the average growth rate of its economy was during the Great Depression. And before that, in 1890.
Since then, over any extended time period for the major North Atlantic reserve-currency-issuing economies, g > r, for government debt.
Only those who see a very large and I believe exaggerated chance of global thermonuclear war or environmental collapse see the North Atlantic economies as dynamically inefficient from the standpoint of our past investments in private physical, knowledge, and organizational capital: r > g by a very comfortable margin for investments made in private capital. Investments in wealth in the form of private capital are, comfortably, a cash flow source for savers.
But the fact that g > r with respect to the investments we have made in our governments raises deep and troubling questions.
Since 1890, a North Atlantic government that borrows more at the margin benefits its current citizens, increases economic growth, and increases the well-being of its bondholders (for they do buy the paper voluntarily): it is win-win-win. That fact strongly suggests that North Atlantic economies throughout the entire twentieth century suffered from excessive accumulation of societal wealth in the form of net government capital—in other words, government debt has been too low.
The North Atlantic economies of major sovereigns throughout the entire twentieth century have thus suffered from a peculiar and particular form of dynamic inefficiency. Over the past one hundred years, in the United States, at the margin, each extra stock 10 percent of annual GDP’s worth of debt has provided a flow of 0.1 percent of GDP of services to taxpayers, either in increased primary expenditures, reduced taxes, or both.
What is the elementary macroeconomics of dynamic inefficiency? If a class of investment—in this case, investment by taxpayers in the form of wealth held by the government through amortizing the debt—is dynamically inefficient, do less of it. Do less of it until you get to the Golden Rule, and do even less if you are impatient. How do taxpayers move away from dynamic inefficiency toward the Golden Rule? By not amortizing the debt, but rather by borrowing more.
Now we resist this logic. I resist this logic.
Debt secured by government-held social wealth ought to be a close substitute in investors’ portfolios with debt secured by private capital formation. So it is difficult to understand how economies can be dynamically efficient with respect to private capital and yet “dynamically inefficient” with respect to government-held societal wealth. But it appears to be the case that it is so. But there is this outsized risk premium, outsized equity and low-quality debt premium, outsized wedge. And that means that while investments in wealth in the form of private capital are a dynamically efficient cash flow source for savers, investments by taxpayers in the form of paying down debt are a cash flow sink.
I tend to say that we have a huge underlying market failure here that we see in the form of the equity return premium—a failure of financial markets to mobilize society’s risk-bearing capacity—and that pushes down the value of risky investments and pushes up the value of assets perceived as safe, in this case the debt of sovereigns possessing exorbitant privilege. But how do we fix this risk-bearing capacity mobilization market failure? And isn’t the point of the market economy to make things that are valuable? And isn’t the debt of reserve-currency-issuing sovereigns an extraordinarily valuable thing that is very cheap to make? So shouldn’t we be making more of it? Looking out the yield curve, such government debt looks to be incredibly valuable for the next half century, at least.
These considerations militate strongly for higher public debts in the twenty-first century then we saw in the twentieth century. Investors want to hold more government debt: the extraordinary prices at which it has sold since 1890 tell us that. Market economies are supposed to be in the business of producing things that households want whenever that can be done cheaply. Government debt fits the bill, especially now. And looking out the yield curve, government debt looks to fit the bill for the next half century at least.
Systemic Risks and Public Debt Accumulation
One very important question remains very live: Would levels of government debt issue large enough to drive r > g for government bonds create significant systemic risks? Yes, the prices of the government debt of major North Atlantic industrial economies are very high now. But what if there is a sudden downward shock to the willingness of investors to hold this debt? What if the next generation born and coming to the market is much more impatient? Governments might then have to roll over their debt on terms that require high debt-amortization taxes, and if the debt is high enough, those taxes could push economies far enough up a debt Laffer curve. That might render the debt unsustainable in the aftermath of such a preference shift.
Two considerations make me think that this is a relatively small danger:
When I look back in history, I cannot see any such strong fundamental news-free negative preference shock to the willingness to hold the government debt of the North Atlantic’s major industrial powers since the advent of parliamentary government. The fiscal crises we see—of the Weimar Republic, Louis XIV Bourbon, Charles II Stuart, Felipe IV Habsburg, and so forth—were all driven by fundamental news.
As [Reinhart and Rogoff (2013)(http://www.imf.org/external/pubs/ft/wp/2013/wp13266.pdf) have pointed out at substantial length, twentieth- and nineteenth-century North Atlantic governments proved able to tax their financial sectors through financial repression with great ease. The amount of real wealth for debt amortization raised by financial repression scales roughly with the value of outstanding government debt. And such taxes are painful for those taxed. But only when even semi-major industrial countries have allowed large-scale borrowing in potentially harder currencies than their own—and thus have written unhedged puts on their currencies in large volume—is there any substantial likelihood of major additional difficulty or disruption.
Now, Kenneth Rogoff (2015) disagrees with drawing this lesson from Reinhart and Rogoff (2013). And one always disagrees analytically with Kenneth Rogoff at one’s great intellectual peril. He sees the profoundly depressed level of interest rates on the debt of major North Atlantic sovereigns as a temporary and disequilibrium phenomenon that will soon be rectified. He believes that excessive debt issue and overleverage are at the roots of our problems—call it secular stagnation, the global savings glut, the safe asset shortage, the balance sheet recession, whatever.
Unlike secular stagnation, a debt supercycle is not forever.… Modern macroeconomics has been slow to get to grips with the analytics of how to incorporate debt supercycles.… There has been far too much focus on orthodox policy responses and not enough on heterodox responses.… In a world where regulation has sharply curtailed access for many smaller and riskier borrowers, low sovereign bond yields do not necessarily capture the broader “credit surface” the global economy faces.… The elevated credit surface is partly due to inherent riskiness and slow growth in the post-Crisis economy, but policy has also played a large role.
The key here is Rogoff’s assertion that the low borrowing rate faced by major North Atlantic sovereigns “do[es] not necessarily capture the broader ‘credit surface’”—that the proper shadow price of government debt issue is far in excess of the sovereign borrowing rate. Why? Apparently because future states of the world in which private bondholders would default are also those in which it would be very costly in social utility terms for the government to raise money through taxes.
I do not see this. A major North Atlantic sovereign’s potential tax base is immensely wide and deep. The instruments at its disposal to raise revenue are varied and powerful. The correlation between the government’s taxing capacity and the operating cash flow of private borrowers is not that high. A shock like that of 2008–2009 temporarily destroyed the American corporate sector’s ability to generate operating cash flows to repay debt at the same time that it greatly raised the cost of rolling over debt. But the US government’s financial opportunities became much more favorable during that episode.
Moreover, Rogoff also says:
When it comes to government spending that productively and efficiently enhances future growth, the differences are not first order. With low real interest rates, and large numbers of unemployed (or underemployed) construction workers, good infrastructure projects should offer a much higher rate of return than usual.
and thus, with sensible financing and recapture of the economic benefits of government spending, have little or no impact on debt-to-income ratios.
Conclusion
Looking forward, I draw the following conclusions:
North Atlantic public sectors for major sovereigns ought, technocratically, to be larger than they have been in the past century.
North Atlantic relative public debt levels for major sovereigns ought, technocratically, to be higher than they have been in the past century.
With prudent regulation—that is, the effective limitation of the banking sector’s ability to write unhedged puts on the currency—the power major sovereigns possess to tax the financial sector through financial repression provides sufficient insurance against an adverse preference shock to the desire for government debt.
The first two of these conclusions appear to me to be close to rock-solid. The third is, I think, considerably less secure.
Nevertheless, in my view, if the argument against a larger public sector and more public debt in the twenty-first century than in the twentieth for major North Atlantic sovereigns is going to be made successfully, it seems to me that it needs to be made on a political-economy government-failure basis.
The argument needs to be not that larger government spending and a higher government debt issued by a functional government would diminish utility but rather that government itself will be highly dysfunctional. Government needs to be viewed not as one of several instrumentalities we possess and can deploy to manage and coordinate our societal division of labor, but rather as the equivalent of a loss-making industry under really existing socialism. Government spending must be viewed as worse than useless. Therefore relaxing any constraints that limit the size of the government needs to be viewed as an evil.
Now the public choice school has gone there. As Lawrence Summers (2011) said, they have taken the insights on government failure and “driven it relentlessly towards nihilism in a way that isn’t actually helpful for those charged with designing regulatory institutions,” or, indeed, making public policy in general. In my opinion, if this argument is to be made, it needs a helpful public choice foundation before it can be properly built.
Figure 20.1: Ten-year Constant Maturity U.S. Treasury Nominal Rate:
Source: Federal Reserve Economic Data, Federal Reserve Bank of St. Louis.
Figure 20.2: Economic Growth and Interest Rates Have Become More Closely Aligned:
Nominal Interest Rate & Smoothed Forward Nominal GDP Growth Rate:
Source: Richard Kogan and colleagues of the Center on Budget and Policy Priorities http://CBPP.org
References
Blinder, Alan, and Janet Yellen. 2000. The Fabulous Decade: Macroeconomic Lessons from the 1990s. New York: Century Foundation.
DeLong, J. Bradford. 2014. “Notes on Fiscal Policy in a Depressed Interest-Rate Environment.” Faculty blog, Department of Economics, University of California, Berkeley, March 16. http://delong.typepad.com/delonglongform/2014/03/talk-preliminary-notes-on-fiscal-policy-in-a-depressed-interest-rate-environment-the-honest-broker-for-the-week-of-february.html.
DeLong, J. Bradford, and A. Michael Froomkin. 2000. “Speculative Microeconomics for Tomorrow’s Economy.” First Monday 5 (2), February 7. http://firstmonday.org/ojs/index.php/fm/article/view/726.
Goldin, Claudia, and Lawrence Katz. 2009. The Race between Education and Technology. Cambridge, MA: Harvard University Press.
Kogan, Richard, Chad Stone, Bryann Dasilva, and Jan Rezeski. 2015. “Difference between Economic Growth Rates and Treasury Interest Rates Significantly Affects Long-Term Budget Outlook.” Washington, DC: Center on Budget and Policy Priorities, February 27. http://www.cbpp.org/research/federal-budget/difference-between-economic-growth-rates-and-treasury-interest-rates.
Munnell, Alicia. 2015. “Falling Short: The Coming Retirement Crisis and What to Do About It.” Brief 15-7. Center for Retirement and Research, Boston College,April. http://crr.bc.edu/briefs/falling-short-the-coming-retirement-crisis-and-what-to-do-about-it-2.
Reinhart, Carmen M., and Kenneth S. Rogoff. 2013. “Financial and Sovereign Debt Crises: Some Lessons Learned and Those Forgotten.” Working Paper 266. Washington, DC: IMF, December 24. https://www.imf.org/external/pubs/cat/longres.aspx?sk=41173.0.
Rogoff, Kenneth. 2015. “Debt Supercycle, Not Secular Stagnation.” VoxEU. Centre for Economic Policy and Research, April 22. http://www.voxeu.org/article/debt-supercycle-not-secular-stagnation.
Summers, Lawrence. 2011. “A Conversation on New Economic Thinking.” LarrySummers.com, April 8. http://larrysummers.com/commentary/speeches/brenton-woods-speech.
Summers, Lawrence. 2014. “U.S. Economic Prospects: Secular Stagnation, Hysteresis, and the Zero Lower Bound.” Business Economics 49 (2): 65–73.
