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Deficit Lessons for the Pandemic From the 2008 Crisis

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This is part of our economists roundtable on the corona crisis.

Economics is sometimes defined as the science of scarcity. If resources are scarce, it would seem, a country can’t print money, give it to someone, without consequences: There will be inflation, and those receiving the money will get resources at the expense of others. But Keynes put the lie to this reasoning, pointing out that often the economy is not using all available resources, and giving more purchasing power to some individuals may result not in inflation, but in higher levels of production and prosperity. Keynes was right, but left a number of questions unsettled: how do we know when all resources are fully utilized? Is there a clear demarcation? Will inflation set in while there may still be some underutilized resources?

In the subsequent decades we thought we had learned the answers: As resources get “tight,” inflation increases—and will even accelerate, as people come to expect more inflation. Sufficient expansion of the monetary base and large deficits will lead us eventually into such inflation.

But the new millennium has not been kind to this consensus view of orthodox macroeconomics. There appears no stable relationship between the slack in resource utilization (measured say, by unemployment) and inflation. And the massive expansion of the base money supply and the accompanying low interest rates after 2008 did not lead to inflation. In some parts of the world, the fear was, instead, deflation.

But some have learned the wrong lesson from these experiences. At least part of the reason that there was no inflation was that the banks that had access to these funds didn’t lend them out: With no demand from consumers and firms, of course, there was no inflation. Monetary policy was both ineffective and non-inflationary. But that outcome was because of the way that we distributed the money. If we had had “helicopter money,” raining dollar bills on poor Americans, I feel confident we would have a quicker recovery; and if we had a large enough helicopter downpour, we would have had inflation.

How inflationary any expansion of money or increase in the deficit is thus depends on how the money is spent. If it goes to finance investments, aggregate supply will eventually increase. But the increase in demand and in supply may not move in tandem: If before the increased public investment, resources were fully used, there could be a period of inflation, followed by a period in which inflation is lower than it otherwise be.

The notion that expanding deficits necessarily lowers private investment is just wrong. As is the notion that we can ascertain the effects of monetary policy on inflation by just looking at the interest rate (real or nominal). If policy expands aggregate demand, it will enhance businesses’ willingness to invest. And if monetary policy expands the availability of credit, say to small and medium sized enterprises, it will enhance their ability to invest. But obviously, if we give the banks free reign—to create a housing bubble, to finance speculative investments, and to engage in others forms of mischief—looser monetary policy may not result in more investment. There may be more effective ways of stimulating investment than just relying on monetary policy—such as investment tax credits. And even if there were some crowding out—so an increase in the deficit to finance an increase in public investment resulted in less private investment—the increase in long-starved public investment may be far more productive, with far higher returns, so national income may still go up.

This crisis presents a particular challenge. The underlying problem is not an insufficiency of aggregate demand; that’s why referring to the bill that Congress passed as a stimulus bill is a misnomer. The problem is that the virus has led to social distancing—undermining both demand and supply. In addition to trying to protect our health, the spending was directed (at the insistence of the Democrats) to protecting the most vulnerable. We were on target for a deficit of 5 percent of GDP; now it looks like three times that or more—a new record.

To me, there is little doubt that in the absence of this deficit spending, not only would there be enormous suffering today, but our economy’s revival would be imperiled. There is a chance we would have been in a financial gridlock—or worse. Households and firms couldn’t pay their creditors and landlords, leading to a bottom-up bankruptcy cascade—the opposite of the top-down trauma our economy went through in 2008, and far harder to deal with. The recovery may still be difficult: Firm and household balance sheets will have worsened; despite the help, some firms will go bankrupt—and won’t be un-bankrupted once the pandemic passes. Provision of liquidity will help, but there will be many facing solvency problems, and aggregate demand may still be tempered. But if we have succeeded in getting large amounts of money into the pockets of ordinary Americans, eventually, this money will be spent. And the coronavirus has, at the same time, resulted in a marked reduction in supply, at least for the duration of the pandemic. One can’t help but think that eventually the imbalance of demand and supply might have consequences.

But I’m not particularly worried (or I wouldn’t be if I had confidence in our economic leadership.) First, before the crisis, it was clear that there was at least some slack in the economy. Secondly, recent evidence is that when inflation increases, it does so only slowly, and that gives us time to respond. We could reverse the tax cuts for corporations and billionaires of 2017. We could move towards a fairer tax system, by taxing the returns to capital, including capital gains, at least the same rate that we tax workers. We could tax pollution and other negative externalities. In short, if and when there is evidence of excess demand, we can take countervailing measures.

After the pandemic is conquered, we’ll still face two other crises: our inequality crisis and our climate crisis. Addressing each of these will require significant increases in government spending. We need to retrofit our economy, for instance, through “green infrastructure.” If we had to have a larger deficit to save the planet, the choice should be a no-brainer. But moving towards a greener economy, even financed by deficits, will lead us to a more robust and more innovative economy—and as we’ve learned time and time again, that could even lead to lower deficit.

One might have hoped that the silver lining of this pandemic is that we have gotten over our debt obsession. But I’m worried that it may return. Paul Krugman talks about “zombie ideas”—ideas that have long been discredited, but nonetheless continue to have sway among the living. I’ve discussed two of these zombie ideas: that deficits are necessarily inflationary and crowd out private investment. A third zombie idea, related to these two, is that deficits beyond a certain level (say 80 percent of GDP) are bad for economic growth.

That was an idea popularized by Harvard Professors Ken Rogoff and Carmen Reinhardt, based on a paper that was thoroughly discredited by a graduate student from UMass Amherst. While he called attention to the “spreadsheet error,” others before and after had talked about some of the deeper econometric and theoretical fallacies. There had been no test of the statistical significance of the difference in growth rates associated with higher levels of debt. There was no test of causality—was it that countries that were having deep structural problems which led them to grow more slowly wound up having more debt? Low growth led to high debt, not the other way around. There was no examination of how the debt was created, what the money was spent on, who got it, which our analysis above suggested was crucial. And it was totally ahistorical: At the end of World War II, both the U.S. and the U.K. had very high levels of debt, yet the period after the war was the fastest period of growth. And with that fast growth, the debt-to-GDP ratio rapidly came down.

Of course, if one uses a high debt-to-GDP ratio as an excuse for austerity, and, as is typically the case, austerity leads to slow growth, then there will be an association between debt and low growth. But that association is a result of the misguided policy advice coming from these deficit hawks. Their false narrative has had consequences—it has led to low growth. It wasn’t the laws of economics that led to these adverse outcomes; it was bad economic analysis, and bad policy.

This lesson is of particular importance as we emerge from the pandemic. There will be those who look at the large increase in the debt-to-GDP ratio and saw we need another dose of austerity. It will be used as an argument to cut vital public investments and social protection programs—including expenditures that would make us better prepared to meet the next health, economic, or societal crisis. We should steel ourselves for the coming battles: Deficits for tax cuts for billionaires and corporations—and for massive corporate welfare—are one thing; social expenditures and public investments are another. Of course, these deficit hawks have gotten it exactly wrong. And that’s where the political battle will lie. 

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