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Upping the Dosage Would Kill the Patient

e21 | 02/04/2013

As former Council of Economics Advisers (CEA) Chair Greg Mankiw has analogized, the Obama Administration’s policy response to the Great Recession is like medicine offered to a sick patient. The ineffectiveness of the treatment is obvious given the economy’s continued illness, as most recently evidenced by the fourth quarter GDP report, which found that the U.S. economy actually contracted by 0.1%. The question is whether the ineffectiveness of the treatment is the result of an insufficient dose of the right medicine, or whether the problem is the wrong treatment altogether.

John Makin of the American Enterprise Institute (AEI) made waves recently when he suggested that Congress heed the lessons of Japan and not “obsess” about budget deficits. Makin made the rather simple point that if spending cuts cause aggregate demand, and hence GDP, to contract, the net impact could leave the debt and debt-to-income ratios higher than would have otherwise been the case. It is inarguable that the interest rate-growth differential determines the sustainability of existing debt burdens. But Makin embraces the Keynesian conclusion that future primary deficits (the budget deficit excluding interest payments) can be positive, on net, because the incremental new debt increases the rate of GDP growth. The negative impact of increasing indebtedness is entirely offset by a wider interest rate-growth differential, which results in a lower debt-to-income ratio.

Makin makes clear with this analysis that he is in the “insufficient dosage” camp when it comes to the failure of the Obama Administration’s economic remedies. To be clear, this is not a wholesale embrace of the Obama Administration’s policies: Makin clearly supports tax and entitlement reform, two issues where the Obama Administration has either missed opportunities (refusing to generate revenue by closing loopholes rather than raising marginal rates, for instance) or been the main impediment to policy change. Still, Makin clearly agrees that increases in government expenditure play a supporting role in the determination of national income and that reducing these expenditures would lead to predictable declines in GDP. Indeed, Makin argues that the Obama Administration’s spending policies have boosted U.S. GDP by 3%, on average, over the past four years and that recent deficit reduction will subtract 1.5% from GDP in 2013. Since growth averaged less than 2% between 2009 and 2012, Makin apparently believes that the stimulus and inflated appropriations bills kept the economy from experiencing a persistent, six year-long contraction (the original recession plus the four additional years of contraction). With this passage, Makin also (implicitly) agrees with Paul Krugman that the economy would have recovered significantly faster had the stimulus been two-to-three times larger.

It is interesting to note that despite the supposed fiscal drag, both the OECD and IMF anticipate that growth in the U.S. economy will average about 2% in 2013, somewhat faster than the 1.8% average annual growth experienced over the past four years. Would growth have expected to magically accelerate to 3.5% in the absence of fiscal tightening? This seems to be a highly unlikely counterfactual, especially because growth in countries that chose not to pursue elective fiscal expansions, like Germany and Sweden, grew at a slightly faster cumulative rates from 2010 to 2012. If the U.S. economy again grows at 2% in 2013, it’s reasonable to conclude that the net effect of expansionary fiscal policy over the past few years was extremely small.

Makin also relies on Krugman’s favorite straw man when admonishing those “obsessed” with deficits. To both men, the only argument against larger deficits is the potential for rising interest rates, which undermines the government’s access to finance and potentially crowds out private investment. So either you’re for fiscal stimulus, or you’re an alarmist who makes predictions about coming spikes in interest rates and inflation that fail to materialize. This framework completely ignores the possibility that low interest rates and depressed economic activity are themselves the result of unsustainable debt accumulation. As explained previously by e21:

This Keynesian framework is especially troubling not because it’s necessarily wrong in an absolute sense, but because it cannot be invalidated without a crisis. The government (again, it is argued) should spend more and run larger deficits in all cases where interest rates are low and an output gap persists (i.e. unemployment exceeds 5% for a long period). But what if the subpar economic performance and low interest rates are themselves caused, in part, by the unsustainable fiscal policy? In this case, the expansionary fiscal policy would continue to depress economic activity until it led, eventually, to a public debt or currency crisis.

Unsustainable fiscal policy must be reversed at some point. Until it is, households and businesses are left to speculate about whose ox is to be gored, which increases the risk associated with new irreversible investment, increases savings rates, and leads to more conservative portfolios. The result is slower growth and lower interest rates on putatively risk-free securities, as households and businesses save more and allocate more of that savings to cash and cash equivalents. In this framework, large cuts to government spending are stimulative because they reduce the future taxes necessary to stabilize and reduce future debt ratios. Had Japan heeded this lesson, the economy might not find itself in its current state. Those “obsessed” with deficits were hardly in control of Japanese fiscal policy over the past 15 years given the increase in gross public debt to 220% of GDP.

At current rates, U.S. net debt levels (total debt excluding Social Security and other trust funds) are scheduled to exceed 100% of GDP by the end of the next decade. The current treatment is not working; dialing back on the dosage will have little effect in the short-run and result in much improved long-run prognosis for the patient.