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, as Jamie says, scaling down is easier than scaling up, and that asymmetry points to more aggressive action.
Originally published at the Economist’s Viewand reproduced here with the author’s permission.