John Cochrane on the Power of the Bond Market

by Reihan Salam

John Cochrane has written a lucid, informative Wall Street Journal op-ed on why we should care about our long-run spending trajectory. Basically, our government borrows money for short periods of time, because short-term debt seems cheap. Yet it also carries greater risk:

 

Short-term debt is the fuel of financial crises. It’s safe to lend for a year, even to an insolvent government, if you think everybody else will roll over your loan next year. But if you get a hint that others won’t lend the government new money next year to pay back your loan, run now. This is basically what happened to Greece, Portugal and Lehman Brothers. They didn’t need money for immediate deficits or even to pay interest; they needed money to roll over maturing short-term debt. The market ran away because it didn’t trust a long-run solution. We are vulnerable to the same sort of run.

Like any run, we get few warning signs. People think it could never happen, just as they thought house prices could never fall nationwide, euro-zone sovereign debt could never get in trouble, or a major investment bank could never fail. We can go a long time, even with long-run fiscal policy that is labeled “unsustainable” by the administration proposing it and the Congressional Budget Office scoring it, so long as markets believe that sooner or later it will be fixed. And then, suddenly, markets no longer believe it.

And taxing our way to solvency will, in Cochrane’s view, prove difficult if not impossible:

 

If you raise tax rates, income declines: People work less hard and start fewer businesses, and people and businesses move abroad. The government may get additional revenue for the higher rates for a few years. But Laffer’s famous curve is much more dramatic for long-term problems, as lower growth compounds.

For example, suppose national income is expected to grow 3% but higher tax rates reduce that to 2%. National income is only 1% lower in the first year. But after 30 years, when a newly issued bond is retired, national income at the lower rate would be 34% larger.

The path to higher economic growth and higher tax revenue is to lower tax rates, broaden the tax base by eliminating deductions and breaks, simplify the obscenely complex tax code, and remove growth-suffocating regulation. [Emphasis added]

Yuval Levin has argued that the debate between right and left can be understood as the difference between long-termism and short-termism. I have to assume that people on the left see things very differently, e.g., that the right want tax cuts today while shortchanging public investments that will pay off in the long term. I do think that Cochrane is right about taxes over the long run, which is why it’s frustrating to see short-run analyses of the elasticity of taxable income trotted out as justification for steep tax increases.