Stephanie Kelton: The Fiscal Paddle Isn’t Broken, But The Policy Narrative Is

We're trained in school to take whatever comes out of Brookings seriously, very seriously. That doesn't mean they always get it right though. Henry Aaron's piece Thursday, Tax and Spending Legislation Disarms Us Against Next Recession is... oldthink. When we watched the embarrassing display of ignorance by elderly senators questioning Zuckerberg about the tubes and technology this week, we have to shudder to realize they're just as ignorant and clueless about the economy. Let's hope they have good staffers.

When Congress enacted tax legislation in December 2017, commentators debated whether the tax bill was fair or good for economic growth. When Congress struck a budget deal in February 2018, members of Congress congratulated themselves on avoiding a government shutdown. Some commentators warned that added stimulus from reduced taxes and added spending could cause an economy already near full employment to overheat.

But what went unremarked was that these two actions effectively spiked any weapons to fight the next recession. Were another financial crisis to emerge, an economic shock from somewhere in this terrifyingly unstable world, there is very little Congress, the Federal Reserve, or anyone else would be able to do to shield the U.S. workers and businesses from it.

To be sure, the economy is currently strong. But economic expansions don’t last forever. The current one is nearly nine years old and is the second longest on record. Sooner or later, another recession will come. Customarily, two tools are used to combat recessions-- monetary policy or fiscal policy-- if they are available. Right now, neither is. And that means that the next recession will be longer and deeper than it has to be.

Monetary policy is now largely sidelined. In 2008 and 2009 the Federal Reserve (FED) aggressively drove the interest rate it controls to zero and kept it there. That action and others helped prevent a major recession from metastasizing into a catastrophic depression. Continued low interest rates have helped sustain economic recovery.

Stephanie Kelton was the Democrats' Chief Economist on the Senate Budget Committee in 2015 and then Bernie's top economic advisor during his 2016 campaign. She teaches economics and public policy at Stony Brook now and is a founding member of the Sanders Foundation. Her take on this is very different-- and more up-to-date-- than Brookings'. She wrote about it a month ago for Bloomberg: Use Fiscal Policy, Not the Fed, to Fight the Next Slump. Her point is that "Trump's tax cuts and expanding deficits don't tie lawmakers' hands: They just need the will to act."

This economic recovery is looking long in the tooth. It’s already the third longest U.S. expansion on record, and many observers are worried about what will happen when this phase of the cycle is over and the country falls into recession. That’s unavoidable, of course, so it makes sense to think ahead about what policy-makers should do to fight the next downturn. Don’t think a fiscal response is off the table.

Normally in a recession, everyone expects the Federal Reserve to handle the situation. That’s because, in 1977, Congress effectively shifted the burden of maintaining a good economy-- defined as one that delivers “maximum sustainable growth” with modest inflation-- onto the central bank. When the economy goes sour, the dual mandate requires the Fed to fix it.

Prior to the Great Recession, the Fed had a straightforward way of fighting recessions: It dropped its short-term interest rate until things improved. That might mean a few substantial cuts or a series of smaller reductions that cumulatively total 4 percentage points or more. Eventually, the theory goes, credit gets cheap enough that businesses and consumers can be enticed to borrow and spend enough to counteract whatever had dragged the economy down.

There’s just one problem (actually, there are two, but I’ll save discussion of the other for another day). The Fed’s target rate is now 1.25 percent to 1.5 percent. Even if the Fed tightens three or four times by the end of the year, as many expect, it would put rates between 2 percent and 2.5 percent. That doesn’t leave much conventional ammunition in the event of a meltdown.

Matthew C. Klein, at the Financial Times, neatly captures this concern.

It’s not difficult to imagine the US economy tipping into recession by the early 2020s, if not before. Monetary tightening has already squashed the difference between short-term and long-term interest rates to its narrowest level since the start of the financial crisis. Federal Reserve officials forecast slower growth and higher joblessness over the next few years from further interest rate increases. The danger is that the tools used to fight the last downturn may be insufficient next time around. Investors should prepare for some radical innovations.

So let’s suppose he’s right, and the next recession hits before the Fed has raised rates high enough to be able to cut them enough to fight the slowdown in the usual way. What then?

In 2016, then Fed Chair Janet Yellen talked about this at the Fed’s annual convening in Jackson Hole, Wyoming. She basically argued that the Fed could deal with any future recession, even without the space to cut interest rates by 4 percentage points or more. In a pinch, she insisted, the Fed could always return to unconventional policy. In other words, we got this.

She spoke, not of “radical innovations” but of becoming creative in ways “that have been employed by other central banks.” Instead of restricting themselves to buying mortgage-backed securities and U.S. Treasuries, “future policy-makers may wish to explore the possibility of purchasing a broader range of assets,” she said. That might mean following the lead of the European Central Bank or the Bank of Japan, which have purchased corporate bonds, stocks, real estate investment trusts and securitized small-business loans as part of their expanded quantitative easing programs. Who knows, maybe the Fed would even consider emulating other banks’ negative interest rate policies or targeting nominal gross domestic product as part of the new toolkit.

I, for one, hope we can avoid relying on the Fed to get creative when the next crisis hits. As former Fed Chairman Ben Bernanke explained, “unconventional monetary policies come with possible risks and costs,” and monetary policy “is not a panacea.” But what else is there?

Fiscal policy, of course!

The problem is, there’s a growing perception that we’re going to find ourselves up recession creek without a fiscal paddle. It’s an argument that former Treasury Secretary Jack Lew made last week during an interview on CNBC:

If we had a crisis right now whether a financial crisis or a business cycle recession, we don’t have the fiscal policy to respond or the monetary policy. It’s quite scary… We now don’t have a fiscal arsenal because we spent it on the tax cut and on the spending agreement. We’ve kind of spent the fiscal resources.

He’s not alone. One of his predecessors, Larry Summers, has also complained that the tax cuts have seized valuable fiscal real estate. But Summers’ assessment is even more alarmist than Lew’s:

Our country will be living on a shoestring for decades because of the increases in the deficits that will result. This is a serious threat to our national security because of what it will mean over time for our ability to fund national defense.

This kind of rhetoric worries me for at least a couple of reasons. First, the tax cuts didn’t weld the fiscal door shut. There’s nothing to prevent lawmakers (in this Congress or any other) from voting for legislation that will further expand budget deficits. It’s purely a political choice, as Summers surely knows. What he must mean, then, is that Americans are so turned off by deficits that future lawmakers won’t have the courage to vote to protect our economy or our nation. (In that case, be thankful for the automatic stabilizers.)

Second, what happens if the “blue wave” continues, and Democrats end up controlling one or both houses of Congress, along with the White House in 2020? Are they supposed to govern as if reducing the budget deficit is the great legislative challenge of our time? Or should they learn a little something from the Republican Party, namely that voters really don’t seem to care all that much about deficits, so it’s better to stay focused on delivering your agenda?

And while we're looking at concern of the consequences of the government's large and growing debt, over which the CBO claims concern, Scott Fullwiler goes after their phony baloney projections of "sustainability" of the national debt and entitlement programs. The noted economist asserts, correctly, that the CBO’s analysis is "out of paradigm" in that it is inapplicable to a sovereign, currency-currency issuing government.

Here's the CBO's 4 incorrect consequences of growing debt:

• Less National Saving and Future Income–Large federal budget deficits over the long term would reduce investment, resulting in lower national income and higher interest rates than would otherwise occur. Increased government borrowing would cause a larger share of the savings potentially available for investment to be used for purchasing government securities, such as Treasury bonds. Those purchases would crowd out investment in capital goods-- factories and computers, for example-- which makes workers more productive.

This would be laughable if it weren’t for the fact that most economists believe it and the dangers of following policy based on such a belief. The analysis is based on the loanable funds market-- which DOES NOT EXIST in the real world. In reality, the funds that banks lend are created out of thin air, not constrained by saving, the flow of deposits, or fractional reserve requirements. Even a 100% requirement changes nothing as long as the central bank is targeting the interbank rate that sets the banks’ cost of funds. More reserves are always forthcoming via open market operations if the interbank rate starts to move above the central bank’s target, so there is no rise in interest rates of the sort that the loanable funds model supposes.

So there is no threat to funding available for private investment in capital goods, and no threat to the growth rate of future national income.  CBO’s analysis is simply inconsistent with how the modern financial system actually works.  (My post here from 2012 described the process of bank lending.

• Pressure for Larger Tax Increases or Spending Cuts in the Future— When the federal debt is large, the government ordinarily must make substantial interest payments to its lenders, and growth in the debt causes those interest payments to increase. (Net interest payments are currently fairly small relative to the size of the economy because interest rates are exceptionally low, but CBO anticipates that those payments will increase considerably as interest rates return to more typical levels.) 

In other words, when interest rates rise, they will take up a larger percentage of the government’s outlays, increasing the likelihood of future large deficits unless spending is cut or taxes are raised. Similarly, a desire to raise spending or cut taxes in the future will be thwarted by projections of even larger deficits and require still greater cuts or taxes elsewhere. CBO wants us to believe that it is just trying to protect us from the difficult political decisions this would bring. In some ways this is a legitimate point, but I would say it differently. Any increase in the government’s deficit can result in greater aggregate spending on existing productive capacity, so if the government is sending more interest to bond holders, ceteris paribus, this is creating the potential for inflation. However, the issue here isn’t the larger deficits as much as it is the larger deficits relative to the inflation threat. But CBO presents us with no analysis of the future inflation threat of rising debt service-- in fact, its long-term analysis assumes both an economy at full employment beginning a few years from now and very modest inflation throughout even with the larger deficit and debt service projections. In other words, the real danger of rising debt service or rising government deficits in general (aside from the obvious potential misallocation of the government’s spending) is assumed away by CBO from the start.

...In any case, an economy reaching the point at which a central bank running a Taylor Rule type of interest rate targeting strategy will raise rates should also be precisely when the government is experiencing fairly rapidly declining primary deficits (the deficit aside from debt service)-- which is the case in the US’s history-- and probably shouldn’t be entertaining thoughts of increasing deficits at that point if low and stable inflation is a serious policy goal.  In most other cases, the central bank shouldn’t be raising rates and the government should be increasing its deficit. CBO’s assumption of continuous full employment and low inflation mistakenly abstracts from the fact that the real world economy is always in the midst of some stage of a business cycle.

• Reduced Ability to Respond to Domestic and International Problems–When the amount of outstanding debt is relatively small, a government can borrow money to address significant unexpected events-- recessions, financial crises, or wars, for example. In contrast, when outstanding debt is large, a government has less flexibility to address financial and economic crises-- a very costly circumstance for many countries. A large amount of debt also can compromise a country’s national security by constraining military spending in times of international crisis or by limiting the country’s ability to prepare for such a crisis.

This one’s pretty amazing-- seriously, how can someone actually believe this stuff?  First off, as we know, government’s that issue their own currencies don’t need to borrow back their own money. Second, even if you do think so, as above, the interest rate on this increase in the national debt is a monetary policy variable, not one that is set by markets. There is no danger of a currency issuing government not being able to finance its deficits in a time of crisis. And we know that times of war and financial crisis are in particular the times at which safe, default-risk free government debt is at its lowest rate of interest relative to the debt of non-currency issuers. Third, such crises are also the points at which the central bank typically has its policy rate-- and by extension interest rates on the national debt—set at its lowest. In fact, it is the private sector that experiences such problems in these times, not the currency-issuing governments-- just look back to how private credit markets responded to the global financial crisis of 2008-2009 for the most recent example. The second part of CBO’s rationale here is even more ridiculous-- did they not notice that times of war and financial crisis have been the times of most of the largest increases in the US national debt?  Indeed, the real danger is that in a time of such crisis policy makers will actually believe analysis like CBO’s here. Thankfully, during WWII they didn’t. They didn’t listen after September 11, 2001. And they didn’t listen in 2008 (TARP) or 2009 (Obama stimulus-- though the CBO-types did in fact keep the Obama stimulus insufficiently small, not that I was necessarily in favor of many of the spending priorities in the bill). And in every case of policy makers not listening, interest rates remained low while the government ran the deficits it wanted to run.

• Greater Chance of a Fiscal Crisis-- A large and continuously growing federal debt would have another significant negative consequence: It would increase the likelihood of a fiscal crisis in the United States. Specifically, there would be a greater risk that investors would become unwilling to finance the government’s borrowing needs unless they were compensated with very high interest rates and, as a result, interest rates on federal debt would rise suddenly and sharply relative to rates of return on other assets. That increase in interest rates would reduce the market value of outstanding government bonds, causing losses for investors and perhaps precipitating a broader financial crisis by creating losses for mutual funds, pension funds, insurance companies, banks, and other holders of government debt—losses that might be large enough to cause some financial institutions to fail. Unfortunately, there is no way to predict with any confidence whether or when such a fiscal crisis might occur in the United States. In particular, there is no identifiable tipping point in the debt-to-GDP ratio to indicate that a crisis is likely or imminent. All else being equal, however, the larger a government’s debt, the greater the risk of a fiscal crisis.

Here we see the “US could become Greece” argument, with “we can’t say when it could become Greece, but we don’t want to find out!” added on. In fact, the CBO in the footnotes links to its 2010 report, “Federal Debt and the Risk of a Fiscal Crisis” (in which it makes the same four points as here, by the way, regarding the consequences of large and rising debt), which analyzes recent fiscal crises in Argentina, Ireland, and Greece and then considers how their difficulties dealing with rising interest rates on the national debt, diminished access to financial markets, etc., could harm the US economy.

Again, though, a currency-issuing government under flexible exchange rates can’t have such crises because it doesn’t need to borrow its money; interest rates on its debt are a monetary policy variable. The doomsayers have been at this for decades now, but have not explained why the US, UK, and Japan ran continually large deficits starting in 2008 at low interest rates while Greece, Spain, Italy, etc., could not. Their only response is, “Just wait!  This time is NOT different!”  At least CBO doesn’t fall into the typical trap of citing the Reinhart/Rogoff paper on “tipping points,” which has been discredited. CBO simply notes here that as of yet “there is no identifiable tipping point”-- this is true of course, since there isn’t a tipping point at all if it’s your own currency and you have the ability to set the interest rate on it. At some point one would think the “US could become Greece” argument would be widely recognized as fraudulent, but if you’re in the wrong paradigm it’s difficult to accept even a simple explanation of why the paradigm is wrong. In the end, what we see from these four points made by CBO is that the real danger to policymakers isn’t large deficits and debt.  The real danger is that they will pay attention to analysis done of large deficits and debt by CBO and others like it—such as most economists-- and unfortunately they are all paying attention and echoing this same sort of analysis. And here we all sit in a six year trough relative to potential GDP, continued high unemployment (particularly if you include underemployment, etc.) and low participation rates, and with even fairly decent job creation that however is focused on the low-wage end compared to previous recoveries. And this isn’t even to mention the Eurozone nations that are still in depression states.