As he watches policy makers cry “fire fire” in Noah’s flood, Paul Krugman becomes almost shrill. He has a simple (rigorous) model which suggests more stimulus would be ideal and that, when in a liquidity trap, government spending should be set to give unemployment equal to the non accelerating rate of unemployment. In this model, he assumes Ricardian equivalence. That’s the problem.
In the model, there is no problem with running up a large public debt. The timing of taxes doesn’t matter at all. In the real world, we are concerned about the public debt. In normal times, Krugman is very concerned because, he believes, people mistake bonds for net wealth and this distorts consumption/saving decisions. In a liquidity trap there would be an additional advantage of public spending (giving a multiplier greater than 1). However, the debt will still be with us when we exit the liquidity trap.
This does not have to be true. It is possible to pay for the stimulus by cutting public spending when the economy exits the liquidity trap. This does not reduce the stimulating effect (if consumers are rational and forward looking it increases the effect as lower government spending in the future implies more private consumption now). It is also possible to pay for it by raising taxes in the future. However, both cutting spending and raising taxes is difficult. Below, I will just pretend that I find this argument that further stimulus is only OK if it doesn’t add to the deficit convincing, even though I don’t.
So the problem is how to cause increased aggregate demand without increasing the budget deficit.
I think the solution is a temporary increase in the progressivity of the tax code. A temporary tax cut for the poor will cause a large increase in their spending as many of the poor are liquidity constrained. A temporary tax increase for the rich will cause a small decrease in their spending as few of the rich are liquidity constrained.
Explicitly temporary tax cuts do not all become permanent. There is no movement to extend the temporary tax cuts in the stimulus bill, even though Obama promised permanent tax cuts which were to be identical except five fourths as big. It might be hard to let a temporary tax increase for the rich expire. So my approach might reduce the deficit in the long run.
I think it is likely that none of the people who claim they oppose further stimulus because it will add to the debt* will support my proposal. I do mean my subjective mode for the number is exactly zero. Few people will hear of my proposal. Few of them oppose further stimulus. Most people who oppose further stimulus and call themselves deficit hawks are hypocrites. Sincere deficit hawks might find my argument unconvincing.
Maybe there is one sincere deficit hawk who will read this and be convinced, but I doubt it.
* typo corrected.