There’s an interesting argument in play right now as to whether current deficit spending is welcomed or problematic, and what its impact might be. The motivation for the argument is the deficit financing of the tax cut and the new budget deal (which adds at least 0-0 billion to the debt over the next decade), particularly at a time when the economy is closing in on full employment. As I recently pointed out, deficits of around 4-6% of GDP, which is what we’re probably looking at over the next few years, are highly unusual at such low unemployment. On average, going back many decades, the deficit/GDP at such low unemployment has hovered around zero. The figure below makes the point: Source: Alec Phillips, GS Research The figure is a little tricky, because the unemployment rate is
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There’s an interesting argument in play right now as to whether current deficit spending is welcomed or problematic, and what its impact might be. The motivation for the argument is the deficit financing of the tax cut and the new budget deal (which adds at least $300-$400 billion to the debt over the next decade), particularly at a time when the economy is closing in on full employment. As I recently pointed out, deficits of around 4-6% of GDP, which is what we’re probably looking at over the next few years, are highly unusual at such low unemployment. On average, going back many decades, the deficit/GDP at such low unemployment has hovered around zero.
The figure below makes the point:
The figure is a little tricky, because the unemployment rate is inverted, meaning when the line goes up, unemployment’s going down. The reason to do it that way is to show how closely linked the jobless rate usually is with the def/GDP.
“These are both highly cyclical variables. When unemployment goes up a lot, the deficit tends to go up as well, as various “countercyclical” spending programs kick in, while tax revenue take a hit. So, outside of wars, when deficit spending goes up for noneconomic reasons, the two lines hug each other pretty tightly.
Until recently. The timing of the tax cuts [and now the budget deal] is such that they’re throwing a lot of fiscal stimulus—hundreds of billions in new, deficit spending—at an economy that’s already, on its own, closing in on full employment. Based on the already strong, negative trend in the unemployment rate, and the added stimulus, the unemployment rate could be in the mid-3s by the end of this year (it’s currently 4.1 percent). That’s a jobless rate we haven’t seen since the late 1960s.”
That’s the backdrop for the argument. The participants fall into these camps (there are other camps, I’m sure, but these are the ones of interest to me today):
–Political deficit-chicken-hawks. These are politicians who whine about deficit spending but that’s largely for show. Since I’m trying to get into the substance of the argument, this post isn’t about them. There are good questions about whether their hypocrisy costs them anything, politically, but that’s for a later day.
–Actual deficit hawks. Folks like my friends at the CRFB who are genuinely concerned about the impact of all this debt on government functionality and future generations.
–Keynesian types who think we’re not yet at full employment. Let’s call them NYFE’s (Not Yet Full Emp).
–Keynesian types who think we are at full employment. Let’s call them FEs.
Though our views intersect here and there, I tend not to share the concerns of the actual hawks, and I worry their arguments feed a damaging austerity agenda. It’s possible to be so focused on the future that you shortchange the present. That said, where we come together is a) deficits should generally come down, not rise, as you close in on full employment, and b) as I wrote in another piece this morning, it’s very hard to lastingly sustain and defend programs that are deficit, versus revenue, financed.
A related argument to that of the true hawks, one with which I couldn’t agree more strongly, is that not all deficit spending is created equal, and the revenue losses in the tax plan and some (not all) of the spending in the new budget deal are wasteful and terribly targeted. I’ve argued this in many other places.
But it’s the FEs and the NYFEs that interest me most. The NYFEs, among which I count myself, believe that there’s still some amount of slack in the current economy, and that those 4-6% deficits/GDPs over the next couple of years could create a high-pressure economy with more benefits than costs, especially to the least advantaged who are, in the age of inequality, the last to participate in the expansion. In fact, they’re LIFO–last in, first out–the benefits of growth take the longest to reach them but they’re the first to get smacked by the downturn.
Evidence? The NYFEs best evidence by far is inflation, which remains low and stable, despite much angst in recent days. Some measures of inflation expectations are showing an uptick, especially market-based measures, like TIPs breakeven rates and especially the 5-yr/5-yr forward inflation expectation rate. But survey measures haven’t yet turned up as much as the market measures, and the market measures are not pure expectation metrics; research finds they also mix in inflation premiums demanded by lenders and other short-term, volatile price pressures, like the ups-and-downs in oil prices.
Also, there’s no question in my mind that we cannot identify, within policy relevant confidence intervals, either the “natural rate” of unemployment–the lowest rate consistent with stable prices–or the level of potential GDP to shoot for (the level of GDP consistent with full resource utilization). On this latter point, I was moved by this smart, new paper by Coibion et al recently published by our Full Employment Project, showing estimates of potential that are well north of the conventional wisdom. See also the note by economist Olivier Blanchard, who’s sympathetic to the findings and particularly, the inflation point.
On the “we-can’t-identify-the-full-employment-unemployment-rate” point, see the figure below from a forthcoming paper I wrote, soon to be published by the Brookings’ Hamilton Project, on ways to get to and stay at full employment. (I’m excited about this paper, if one can say that about their own work, but I think it’s OK in this case because I got a lot of great input from others; this figure is from an ERP from a few years ago. so I’m not scooping anything.) It shows the confidence interval around estimates of the “natural rate” literally exploding (well, not literally…).
In sum, while we NYFEs hate the targeting of the tax cut–corporate tax cuts, tax goodies to rich heirs and high-end pass-throughs are terrible forms of stimulus with a weak bang-for-the-buck–we think there’s still slack in the job market (I didn’t get into prime-age employment rates and wage trends, but they also arguably provide support to the NYFE’s case). I’ve suggested that if the Fed accommodates, the jobless rate could hit the mid-3’s by the end of this year. At that point, I believe the benefits of full employment would be much more widely felt than they are now.
The position of the FE’s is easiest to explain with an arcane diagram, borrowed from no less than Paul Krugman, who has used it make accurate predictions since the downturn, so it’s got some street cred. It’s the old ISLM workhorse, a bare-bones representation of how interest rates and output interact in the macroeconomy, drawn here with a key wrinkle. The flat part of the curve, in this context, just means that under certain conditions, extra fiscal impulse should be expected to boost growth, not interest rates or prices.
But this sort of dynamic exists only in weak economies, when the desire and need to save outpaces that of investment or spending. Conversely, in strong economies, at full employment on the graph, interest rates and inflation become a lot more responsive to more spending. That’s the FE’s case, in a nutshell. They think we’ve moved from the flat part to the up-slope.
[An interesting aside: the trade deficit is looking like it be an increasing drag on growth in coming quarters, slowing the rightward progress of that IS curve. If so, the extra government spending could offset the drag from trade, as it has often done in recent decades
At some point, I’d guess over the next 6-12 months, we should get a sense of who’s right. And “we” includes the Fed, who will likely move from brake-tap to brake-slam if inflation takes off. If, on the other hand, we see 1960s levels of unemployment pulling side-liners into the job market, faster wage growth throughout the pay scale, and some, but not too much, faster price growth (remember, given the Fed’s years of downside misses on their 2% inflation target, there’s ample room for some upside quarters; patience, Powell and Co.!), then team NYFE will look good.
There’s the political economy of all this, which I just don’t have the stomach to get into right now. I’ve been pushing for a version of this sort of fiscal policy–one with much better targeting, of course–for a long time, and while I certainly never envisioned it at 4% unemployment, here it is. I owe readers thoughts about the politics of all that and will eventually deliver. But for now, let’s stew on the econ.