For many economists, the chicken and egg question is, which came first, consumption or production? What drives growth? Let’s continue with our series on debt, in which I have been contrasting my views with those of Paul Krugman.
Our differences aside, what Paul and I readily agree on is that the solution to our current economic dilemma is more and higher-quality growth. There is nothing like 5–7% nominal growth to tackle a problem of too much debt. And if the real growth is 3–4%, then so much better, as employment and wages will rise as well. But what drives growth? That’s actually a complex question with multiple answers. There is simply no one magic policy that you can pursue that is sufficient in and of itself to create growth. I would think Krugman and I also would agree that the stimulation of growth requires a whole bunch of smart policies, and we would likely agree on what some of those policies should be. Our policy disagreement stems from our differing views on fundamental economic questions as opposed to any simplistic analysis of today’s numbers.
Last week we looked at some of the differences between Paul’s presuppositions and mine, presuppositions that most people might think of as being more philosophical than analytical in nature. That letter generated more response than any other letter I’ve written in a very long time. Most of the comments were really very thoughtful, and I appreciate them. We’re going to look at one reply in particular, because the writer offers legitimate criticisms and asks a number of questions that I believe deserve answers – and these are questions I get everywhere I go. Let’s look at the comment from Thomas Willisch:
Hi John: There is a saying: let those who live in glass houses not throw the first stone. Does either Paul Krugman or you live in a glass house? First, it is important to understand why Paul, and others of his economic point of view, believe that taking on additional debt in the form of fiscal stimulus is desirable when the private sector is in severe economic contraction. Then we will be in position to determine whether the argument in favor of such is compelling or weak. You look to answer this question but I don't believe really so. Pointing to Paul’s supposed presuppositional preference for government or contentions about the significance of owing money to ourselves does not really answer the question.
Among others, Paul’s arguments – semi mock him as “Homo neo-keynesianis” if you wish, but please interact with the substance of his central arguments – are that the accumulation of additional debt in fiscal stimulus is an effective temporary tool to stave off a much deeper economic collapse when widespread private consumption and investment have fallen off a cliff and unemployment is skyrocketing. In times of recovery, when stimulus should be reigned in (and Paul does believe stimulus should be reigned in in these circumstances), the burden of the debt stabilizes and eventually shrinks relative to the resulting higher GDP, potentially more so than would have been the case with less aggregate debt absent the stimulus but debt measured against collapsed tax receipts and collapsed GDP. Paul lays out his arguments in chapter and verse, in books and in peer reviewed economic papers, with much greater depth and expertise than I can pretend to do in a paragraph quickly written here. In important respects your and Paul’s views overlap, for example in your mention of the value of government infrastructure spending and scientific research, both of which Paul strongly supports, yet which your Republican party constantly undermines.
On the other side of the coin, my second point is that, in order to fairly weigh whether you live in more or less of a glass house than Paul, we first must know what your policy response would have been as opposed to Paul’s in response to the collapse of the Great Recession. While criticizing Paul, you continue to not clearly articulate his own policy recommendation, here or in prior newsletters. Saying that “too much” debt is undesirable and countries tend to eventually default when debt becomes too high, while true with the caveat of properly nuanced context, is hardly explicatory enough. Nor does it weigh against the alternatives from which some course of action had to be selected. Do you believe there should have been no fiscal stimulus? What should have taken its place? For how long? Do you believe in “expansionary austerity”? Should the economy have been allowed to completely implode and unemployment skyrocket much higher than it actually did, in the name of letting the private sector have its just dessert?
Paul’s argument is that there is a time when government intervention is necessary in order to stave off an economic collapse brought on by the private sector, because such collapse would be enormously deeper and impoverish many more people in its wake without the government intervention the nature of which he has detailed. John, what was your prescription, so that it can be set beside Paul’s? Once your own solution to how the 2008 downturn should have been met is cogently presented, readers should study Paul for themselves, not just encounter him through the eyes of an opponent (never a good approach in any intellectual debate), and also study Richard Koo’s books on balance sheet recessions for one, then decide whose house is made of what.
Thomas, thanks for your comments, and I appreciate you outlining Krugman’s basic views so succinctly. Let me answer your second point first, as I think doing so will lead naturally into a response to your first point. (Readers please note that this is a short answer laying out principles that I would adhere to, rather than a full treatise.)
I’ve been quite clear over the years that I believe the primary purpose of a central bank, other than its mundane purpose as a clearing house, is to provide liquidity in times of a liquidity crisis. Central banks should follow Bagehot’s rule, which can be summarized as: “Lend without limit, to solvent firms, against good collateral, at ‘high rates’.”
A little history lesson is in order, from Kurt Schuler, writing at Alt-M:
Walter Bagehot (1826-1877) was the most famous editor of The Economist. (His last name, by the way, is pronounced “BADGE-it.”) For his wisdom on financial matters, he was dubbed “the spare chancellor,” a reference to the Chancellor of the Exchequer, the British minister of finance. His book Lombard Street (1873), named after the English equivalent of Wall Street, criticized the Bank of England for not using its powers to alleviate financial crises. Bagehot argued that the Bank’s monopoly position gave it both the responsibility and the ability to do so, and that the Bank should not conduct itself as if it were an ordinary commercial bank. For its explanation of how the Bank of England should act, Lombard Street became the foundation document of modern central banking. (Schuler)
The causes of the Great Recession were many, and there were numerous culprits. Many, but by no means all, of the problems can be laid at the feet of government. However, that does not answer your question as to what we should do when we find ourselves in a crisis. I believe it was entirely appropriate for the Federal Reserve to step in and provide liquidity. As odious as it was, the Fed had to bail out the banks; or, as you say, the system would have collapsed. I would have wiped out shareholders of the major insolvent banks along with investors in junior debt, rather than bail them out. Because of the peculiar situation of senior debt in US banking, it would probably have cost as much or more to wipe out those who held it as it would to simply guarantee it, and failure to cover it would have potentially posed even greater systemic risk. Still, I would have had to hold my nose while covering it. The four or five banks that would have been taken over took on 30:1 leverage with the permission of the government. Clearly that was unwise, and to bail out management and investors, let alone reward them for imprudent decisions, is not proper.
That said, a complete guarantee of bank deposits had to be made. Otherwise we would have fallen into the abyss. The insolvent banks should have been recapitalized and sold by the FDIC, just as every insolvent bank has been for the last 50 years. It is likely that the FDIC would have been forced to break up the banks into smaller pieces in order for them to be absorbed and sold. If we had done that, we would probably not now have five even larger banks posing systemic risk.
On a side note, I had a lengthy conversation a few years ago with current Speaker of the House John Boehner. It was his forcefully argued view that his big mistake was to bail out the banks and their shareholders. When asked what he would do next time, he very graphically (in his colorful style) stated that shareholders and bank management operated at their own risk.
As to whether I would favor stimulus, that is a more nuanced question. Of course we maintain a safety net for individuals and families who fall on hard times, and that commitment certainly increases the deficit significantly. Much of the other stimulus that we did provide was generally a waste. It financed current consumption but provided no longer-term value.
As you noted, I would be in favor, if it were necessary, of providing stimulus for the funding of infrastructure projects during a recession. A couple of thoughts on that process. Even though we are some two to three trillion dollars behind in maintaining our nation’s core infrastructure, there were distressingly few “shovel-ready” projects available at the time of the Great Recession. Let me think outside my conservative box for a moment and offer the following possibilities.
There is always another recession in our future; we just don’t know when it will hit. When it does, it will in fact reduce GDP and increase unemployment. Further, we know that we need to spend several trillion dollars on infrastructure upgrades in the coming decades. The reigning economic paradigm suggests that we need to “lean against” a recession by spending money. If that is the case, then let’s at least spend the money to get something that will be useful to our kids, since, when they grow up to be taxpayers, they will be paying part of that money back.
I would suggest that Congress today allocate $250 million (or whatever makes sense) of matching funds for infrastructure planning projects. Cities, counties, and states could access these funds for the planning required to refurbish their infrastructure: water systems, power grids, bridges, roads, etc. Then, when we do in fact hit the next recession, there will be an adequate number of shovel-ready projects. Congress can decide how much to allocate to implement those projects and determine what projects should take priority. Congress can even authorize the Federal Reserve to use quantitative easing if it so desires to help fund the projects.
Any such projects could be financed at low rates for 40 years and would require the borrowing entities to pay off the bonds during those 40 years. Congressional approval for such bonds should require a 60% supermajority. (For the record, Thomas, I’m in favor of a balanced-budget amendment that would require 60% supermajority approval to run a deficit. I would also like to see an amendment that would require a 60% supermajority to raise taxes.)
And that brings us to what I call the “Keynesian Conundrum,” which is at the heart of your first question. John Keynes suggested running deficits in times of recession but also advocated paying down that debt after a recession is over. I could get my head around that if I could ever get someone on the Keynesian side to say when exactly it is time to pay the debt back. Mr. Krugman, while giving lip service to paying the debt back, never actually articulates what that process would look like. To pay the debt back, you have to run surpluses or, at a very minimum, run deficits that are less than nominal GDP, so that the debt relative to the size of GDP is reduced.
I want to express a large quibble. People are constantly writing me and talking about “your Republicans” doing this or that as if somehow or another I approve of all things done by Republican officeholders. Let me state once again that I believe that what the second Bush administration did was categorically, unequivocally, emphatically wrong. We wasted the budget compromise of the Clinton/Gingrich years, which was actually paying down the debt. If we had continued to hold the line on spending, we would have gone into the Great Recession with very little debt, and a stimulus of a few trillion dollars here or there would not have done much damage. We have now run up a truly massive debt; and if we were to run into another recession, the felt need would be to run up even more debt, well past the 100% of GDP range.
We are not now in recession, yet Krugman argues that to hold the line on spending is somehow a resumption of what he calls austerity. I call it living with a budget. Running a surplus certainly did not hurt the economy during the late ’90s. We had a recession in the 2000s because of a stock market bubble collapsing. That collapse was compounded by 9/11. That recession had nothing to do with budget surpluses or “austerity.” If the United States were now to freeze spending for a few years, we would once again be back in balance. There is nothing austere about the size of our federal government.
Yes, the deficits have been coming down, and that is a good thing. But that misses the point. We could have easily afforded the deficit spending we incurred during the Great Recession if we had gone into the recession with little or no debt. There has to be some type of disciplined process to keep a country from accumulating too much debt. Generally, the process is the market itself, which begins to ask for higher interest rates for perceived risk. Of course the United States could run more debt than any other country, because we are not perceived as being a risk. But just because we can run up a large debt doesn’t mean we should.
As the McKinsey report I cited last week demonstrates and a large body of other research confirms, outsized debt at some point becomes a drag on growth. Just because we aren’t there yet doesn’t mean it’s okay to pile up debt until we stop growing.
At a certain size relative to the ability to pay, debt is like a black hole. If it gets too big, it sucks in everything around it.
“High debt levels, whether in the public or private sector, have historically placed a drag on growth and raised the risk of financial crises that spark deep economic recessions.”
– The McKinsey Institute, “Debt and (not much) deleveraging”
In very simplistic terms, Keynesians today assume that consumption is the driver of the economy. For them, it is all about empowering the consumer, even if consumption is driven by debt, whether the debt is absorbed by individuals or created (more preferably in their view) by the government.
Thus, they perceive that the remedy to a recession is to run deficits in order to increase consumption, which will stimulate production, which will create jobs.
On the other side of the economic fence, “Austrian” economist Friedrich Hayek asserted that it is actually production that stimulates the economy and drives consumption. An entrepreneur sees a need and figures out a way to fulfill that need. It may even be a need that no one realizes they have until they see the product that addresses it. For Hayek it is production that sets the wheels of the economy spinning, and increased production comes about because of innovation and free capital markets. Economic cause and effect become far more complicated than that very quickly as you drill down into actual history and real data. Schumpeter took our understanding further with his research on creative destruction and the process of competition.
The next graph shows the rise of global economic growth in recent centuries, and the following one depicts per capita GDP in certain Asian countries compared to the US. I don’t think there’s any dispute that it was not an increase in government spending or consumption but rather it was innovation and enhanced production that drove the remarkable growth of GDP that we’ve seen in the last 250 years.
Niall Ferguson ascribes that growth to what he calls the “six killer apps of prosperity”: