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The Corner

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Looking Ahead



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Here is the projected deficit for the U.S. government estimated by the Congressional Budget Office(CBO), assuming passage of the president’s budget:

That huge spike this year is the stimulus program, and the ongoing deficits are the result of continuing projected spending after the stimulus is expected to end. The deficit should be about 12% of GDP this year. This chart goes back to 1969; the previous deficit record in any year in this period was about 6% in the early 1980s. If you went back for a century, you would see that the last time we ran deficits bigger than this (and they were much bigger, more like 30% of GDP) was during WWII.

The CBO analysis seems to me to be both thorough and well-presented. If you click through to it, the three most important charts are on the cover. The first is the one in this post. The second decomposes the budget deficit into outlays and revenues. This chart makes the point that while government revenues will decline somewhat this year, as would be expected, the lion’s share of the short-term deificit spike is a massive increase in outlays — from around 20% of GDP to around 28% of GDP.

The third chart shows the estimated difference between total economic output and “potential.” This is essentially an estimate of unutilized capacity or “slack” in the economy. This is very important, as the (non-crazy) theory of deficit spending to end a recession is that when the government borrows money and pays Dave to go pick up a shovel and dig a ditch, if Dave was otherwise sitting around and watching TV, the shovel was leaning against a wall unused, and the field where he was digging the ditch was not being plowed for crops, then the deficit spending really did increase the total measured output of the economy, as opposed to diverting Dave, the shovel, and the field from otherwise-productive activities. In the contrary cartoon where Dave, the shovel and the field were already being used, you would create a lot of problems: (1) you would be diverting Dave, the shovel, and field from presumably higher and better uses, and therefore not necessarily having much positive impact on the total output of the economy, and/or (2) Dave’s current employer, the shovel’s current owner, and the field’s farmer would presumably respond to the government’s offer for each of these by raising the price paid for them as long as they could out-bid the government and still make money, thereby creating inflation, and (3) you would still have the big increase in government debt to paid out of future taxes or inflated away or defaulted upon. Historically, the consistent pattern has been that counter-recessionary deficit spending tends to really kick in after the recovery is already underway, thus creating these inflationary problems during the recovery.

The CBO (along with everybody else) estimates that we have a large output gap right now. They believe that the expectation of a continued output gap means that we don’t have to worry much about inflation, saying directly:

With a large and sustained output gap, inflation is expected to be very low during the next several years.

The problems are that potential output of an economy has always been easier to measure in theory than practice (and measurement is almost certainly more difficult now than in the mature phase of the industrial economy), and as we’ve seen, the political process tends to overshoot. Notice in the CBO output-gap chart that the late 1970s were characterized by an economy that was mostly under-utilized, yet was still a period of very problematic inflation.

I decided to go back through the now-public Fed minutes from the 1970s methodically to try to see the decision process they went through with the information available to them at the time that they had to make decisions. It didn’t take long to hit pay dirt. In the August 1970 Fed meeting discussion notes, you see this statement that is eerily similar to the CBO’s current report:

Moreover, the upturn would be starting from a point where there is substantial underutilization of resources, as evidenced by a 5 percent unemployment rate and an operating rate in manufacturing at well under 80 per cent of capacity. In these circumstances, there is virtually no risk that economic recovery over the year ahead would add to the inflationary problem through the stimulation of excessive or even robust demand in product or labor markets.

Inflation turned out to be a huge problem, of course, but hindsight is 20/20. People weren’t stupid in 1970. We don’t have some “new science” of economics available to us now that they didn’t then; presumably those who were pretty arrogant about how we can’t repeat the mistakes of earlier policy-makers because we’re so much smarter now are a little more humble after the past 12 months.

The CBO estimates that the public debt of the United States will balloon from about 40% of GDP to about 65% of GDP just within the next couple of years, and then rise to about 80% of GDP over the next decade. And there is no reason to imagine that the world will end in 2019. By these forecasts we will be running at a structural, and worsening, annual deficit of about 6% of GDP. That is, a normal year would have the same amount of deficit spending as the worst deficit year of the modern era. This is unsustainable, even on its own terms.

But we will even be able to accomplish this? Will we really massively reduce spending and/or increase tax collections immediately after the current spending binge (which is what’s called for even under the president’s budget)? Nobody can say this for sure. As you live through a long-term economic crisis, you don’t know how or when it will end. You keep seeing signs of recovery that turn out to be false dawns. In the mid-1930s, many people thought we were emerging from the Great Depression, but then came 1937. In fact, many economists argue that we were emerging by 1935 or so, and had we not made policy mistakes, we would have continued to do so. But that’s not how it actually worked out.

Our gigantic stimulus could very plausibly create a mild recovery later this year, even if the fundamental economy remains very, very sick (kind of like a huge spike in credit-card debt can maintain your personal spending — for a while). But suppose we relapse into another recession in 2011/2012, and unemployment is at 12% and rising in 2012 — would we really manage to summon the political will to cut the deficit (as is assumed in this forecast)? Many of the same very smart economists who argue for deficit spending now will argue that this would be counter-productive in this case.

Further, in addition to the government budget deficit, we have the massive “off balance sheet” activities of the Fed. The Fed announced last week that it will create $1.2 trillion of new money, which is apparently much less interesting to everyone than the offensive bonuses paid by AIG. Ceteris paribus, that sure sounds inflationary to me. Do you think we’re done with this?

You know what the Fed didn’t spend a huge amount of time worrying about in August of 1970? OPEC quadrupling oil prices three years later. The U.S economy is enormous and resilient, but it is not limitless. We managed to have a national debt that exceeded 100% of GDP at the end of WWII, and still did pretty well thereafter. But of course, the entire globe was either bombed to rubble, in a primitive economic state, or under the boot of communism, which we now know stifled real economic competition for us. Does that sound like the world we live in today? Nobody knows what curveballs history will throw at us over the next decade, and we are making ourselves a lot more vulnerable to whatever these turn out to be. I’ve always been skeptical of people who claim that they can draw straight lines between politicians’ backgrounds and behavior, but it seems to me that Obama’s lack of practical experience is showing here: He is insufficiently aware of the need for a huge margin of error in any plan to account for inevitable contingencies.

The obvious counter-argument is that the risks of inaction are also huge. This is correct. It is very likely that some amount of deficit spending today is both inevitable and intelligent. Further, though nobody really likes to put it this way, some amount of sticking our kids with the bill for cleaning up the financial mess, via both Fed and Treasury actions (which are increasingly intertwined) is probably wise, given the mess we have made for ourselves with our profligacy. Based on analogies with other countries that have gone through similar crises, this is likely to be a huge amount of money.

But when we move from the cartoons of “bold action” versus “stand pat,” degree matters a lot. Here are the basic opportunities for improving the current approach as I see them:

• The CBO estimated output gap in the 1981-82 recession was quite similar to what it is today (even prior to the stimulus bill), but we managed to run a deficit of 6% of GDP rather than 12% of GDP, and emerged from that into 20 years of great economic performance. There is a lot of rhetoric about how the stimulus needs to be at least this big, and even some theoretical “models” for why this is so, but very little compelling evidence.

• The stimulus bill included a lot of spending that has very little to do with stimulus, and was really disguised appropriations — the objection here isn’t that “Obama won the election, but shouldn’t get to choose spending priorities,” but rather that a lot of the nature of the programs selected as part of this package will create inherent pressure for longer-term deficits, even before consideration of potential macroeconomic deterioration in 2011, 2012 and beyond.

• The president’s budget adds fuel to the fire by locking in yet further structural spending increases. Even before any yet-further increases from the potential unanticipated continuation of stimulus spending (whether driven by the nature of these programs and/or macro deterioration), this is an unsustainable fiscal plan. If this is a reverse “starve the beast” strategy for ensuring large tax increases down the road, it is, like the original “starve the beast” strategy, too clever by half.

• The huge commitments made by the Fed and Treasury to unwind our financial mess are far too opaque. I supported the original TARP program in the face of the emergency last September, and continue to support that decision. Even by the time of the authorization debate for the second tranche of the TARP program in December, however, it was apparent that further clarity was needed before committing the next $350 billion to it (which in those quaint days seemed like a lot of money). We still don’t have anything like the information required to make an informed decision as a democracy about what to do. I have the suspicion that the very smart people don’t either.

At the root of the decisions around the financial fix (e.g., Do we loan GM money or let it go bankrupt?, Should the government buy equity in Citi or nationalize it?, etc.) is one huge strategic question: Do we have a liquidity problem or a solvency problem? There is no obvious answer to this question, and it will surely vary for different entities. Ezra Klein has a great interview in which an unnamed Treasury official (with an incredible ring of truth to me) describes Treasury’s attempt to feel its way through some of this. This, not some let’s-settle-this-once-and-for-all debate is how it is likely to go. Therefore, we need a process of much clearer accountability for managing our way through this, which is going to take years.



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