I cannot believe that Lawrence Kudlow let Thomas Nugent put this out:
A few years back, traditionalists said that paying for the Iraq war would result in bigger budget deficits and rising interest rates, which would crowd out private investment. Yet, here we are – four years later – with low interest rates, rising investment, a booming economy, and a shrinking deficit. Then Hurricane Katrina hit, after which President Bush announced a plan to spend $200 billion to rebuild the ravaged Gulf Coast. The opposition responded that the resulting larger budget deficit would penalize future generations and drive interest rates higher. Some politicians even wanted to cut spending, postpone tax cuts, and raise taxes to pay for the hurricane damage. Yet here we are – one-and-a-half years later – with lower interest rates, a growing economy, rising incomes, and mounting wealth via record highs in the stock market.
Before we get to the really stupid parts of this, let me backtrack and say that I can believe that Kudlow would allow stupid writing to be placed at the National Review given all the stupid things Kudlow has written himself. What I can’t believe is that the National Review has let an advocate of more government spending loose.
Bernanke recently spoke extensively about the risks of a growing budget deficit, and of how it could precipitate federal insolvency and slow economic growth as investment is crowded out. Fortunately, Bernanke’s forecasting of Armageddon is based on the same traditional approach to fiscal policy practiced by many of today’s deficit hawks; it’s an approach that is easily refuted, as problem-solvers viewing the situation through an outsider’s lens might attest. Essentially, there is no relationship between budget deficits and insolvency. In fact, as former Fed chairman Alan Greenspan pointed out, with a floating exchange rate, there is no such thing as federal insolvency. Rather, the problem is the risk of future inflation caused by excessive federal-government demands on the private sector. But somehow Bernanke, our top inflation fighter, overlooks this fact, focusing instead on nonexistent insolvency risks. This insolvency issue is not unlike the accusation that, unless something is done, the Social Security system will go bankrupt. Again, one must understand how the U.S. government functions in a floating-exchange-rate environment. In effect, fiscal policies – i.e., spending and taxation – are not constrained by some fixed asset, such as the gold in Fort Knox. This had been the case prior to 1971, when the U.S. was constrained by the gold standard. But today the federal government can write as many checks as it desires, with the only limitation being the inflation risk created by excessive demands on the private sector. As an example, the federal government writes checks to construction companies for aircraft carriers, just as it writes checks to Social Security recipients in retirement. These entities then deposit their checks at local banks. When each check clears, the Federal Reserve credits the local bank’s reserve account at the Fed, after which the local bank credits the corporate or individual account with what is known as “good” funds. Operationally, virtually all of the federal government’s “spending” consists of the Fed crediting an account — that’s it. So essentially, there is no distinction between printing money and not printing money. Similarly, there is no federal “box of money” which receives tax collections and the proceeds from new Treasury securities, with these proceeds then available for use by the government through spending or lending.
I suspect that Nugent never read Ben Bernanke’s testimony or the similar testimony from his predecessor. Both Federal Reserve chairmen were warning of the dangers of continuing to run large deficits for decades – not some one-off spending to address a single natural disaster. Heck, even the Iraq War does not constitute very long-term fiscal stimulus. And if Nugent thinks the Federal debt to GDP ratio can rise forever, he’s wrong. At some point, people will lose faith in even Federal bonds if we decide to permanently run the kind of fiscal irresponsibility that has infected us for the past six years.
Nugent’s time horizon seems to be limited to the last four years (dating back to before we invaded Iraq). It turns out that we entered 2003 with an employment to population ratio of only 62.5% and saw this drop to 62.0% by September 2003. So a little short-term fiscal stimulus from more government spending might have been prudent fiscal policy if it were combined with a commitment to move back to fiscal restraint in the long-run.
But could someone tell me what Nugent means by “yet here we are – one-and-a-half years later – with lower interest rates, a growing economy, rising incomes, and mounting wealth via record highs in the stock market.” The interest rate on ten-year Federal bonds, which was 4% as of mid-2005 ended 2006 above 4.5%. If Nugent thinks fiscal stimulus lowers interest rates, he really should listen more carefully to Ben Bernanke.
Update: While we’re on the topic of really dumb things, perhaps I should relay something emailed to me by our friend Mark Thoma – the latest from John Tammy and his sidekick Wayne Jett:
Laffer Curve adherents should not be surprised that inflation is spurred by rate hikes. Just as a rising income tax rate drives the marginal producer to the sidelines, increased interest costs drain capital accounts and discourage productive investment by reducing profits. Dollar demand decreases and inflationary pressures increase when central bank actions cool economic growth. The dollar weakens as the economy weakens.
Tight monetary policy leads to more inflation and dollar devaluation? Thank goodness we have Ben Bernanke heading the FED and not clowns like these two. Just imagine it – more tax cuts, higher government spending, and monetary expansion all at the same time! Worry about inflation? Heavens no – not as long as one is wearing the makeup, the big shoes, and the rest of that clown suit!