Deficits Debt and Capital Formation

Robert Waldmann

Matthew Yglesias is completely mystified by opposition to deficit spending by the public and by Michele Boldrin. I basically agree with him, but I think that he is missing something.

In response to public opposition to deficit spending he expresses the Keynesian argument perfectly

Thinking about it rationally, the reason to worry about large deficits is that they can impede economic growth. That makes it generally worthwhile to try to run balanced budgets over the course of the business cycle. But under circumstances when running a larger deficit doesn’t hurt growth, there’s no real reason to try to avoid deficits. It’s not like the Gods of budgetary balance have some other way to punish countries for large deficits other than reduced growth.

In responce to Michele

If the quantity of the borrowing becomes so large that it’s driving up interest rates, then the situation really is different. But I think all stimulus advocates acknowledge that. And if interest rates aren’t moving, then nothing magical happens when the rainy day fund [-1 times public debt] goes from $5 to $-5 and nothing about the lack of fiscal prudence of the Bush administration changes the fact that it would be perverse for the federal government to respond to a recession with pro-cyclical fiscal policies.

In each case Yglesias considers current interest rates and the deficit not the stock of debt.

Put roughly, when the public debt goes from $-5 to $5 the effect on welfare is much less than $10, but when it goes from $10,000,000,000,000 to
$ 10,000,000,000,010 then the social cost is much migher (maybe even $1).

Yglesias’ argument is made less elegantly by Krugman being ultra wonkish. In Krugman’s model, the stock of debt at the time we fall into the recession and liquidity trap doesn’t matter at all.
I’d alwmost tend to suspect that Yglesias read that post and found the model a convincingly useful approximation to reality.

However, Krugman’s model was designed to be immune to fresh water criticisms and not to be realistic. In the model there is Ricardian equivalence. This means that higher public debt does drive up consumption (government bonds are not perceived to be net wealth) and crowd out investment.

In the real world, public debt crowds out investment. This means that when deciding fiscal policy now, we have to forecast its effect on public debt in the future. Even if interest rates now are at the zero barrier (liquidity trap) they won’t be in the future. If deficit spending now implies more debt in the future, then it will cause higher interest rates and less investment in the future.

Deficit spending now will imply more debt in the future. Another aspect of Krugman’s model is that Krugman assumes that he is in control (he discusses optimal policy). In the real world, it is almost impossible to raise taxes. It makes no sense to assume that Obama, say, can run a deficit now and a surplus later. This would be the optimal policy but it is politically impossible. If one assumes that there is a political limit on future tax increases and spending cuts so all future deficts can’t be reduced to make up for the stimulus, then one should assume that future debt will go up (1+r)^n for one with current deficit spending.

In that case the level of the debt matters. It is still true to quote Krugman that “Zero isn’t an espectially important number” but the social cost of a distortion are convex in that distortion. We will be consuming much more and investing much less than we would if we were not mislead by the illusion of wealth created by public debt. This means an increase in future debt will have a first order welfare cost. If we had a huge public endowement (rainy day fund) then it would create an illusion of poverty and increased deficits would have benefits even if we weren’t in a recession. However, we have a huge public debt, aren’t willing to pay it back and aren’t Ricardian, so, other things equal, adding to the debt is bad for us.

That doesn’t mean we should have no stimulus. It doesn’t even mean we shouldn’t have a larger stimulus. It does mean that the stimulus suggested by Krugman’s simple model is too large and it means that the current level of debt affects the optimal size of the stimulus.