Nonsense on the Deficit Question
In a recent piece I reported the shocking ignorance in a Huffington Post article on the alleged harmlessness of the federal deficit. Several readers wrote to tell me that as bad as the HuffPo article was, James Galbraith's interview with Ezra Klein was even worse.
They were right. In today's piece I'll walk through some of Galbraith's biggest whoppers.
What's the Danger of Deficits?
Right out of the chute, Galbraith pulls no punches:
[Ezra Klein]: You think the danger posed by the long-term deficit is overstated by most economists and economic commentators.
[James Galbraith]: No, I think the danger is zero. It's not overstated. It's completely misstated.
JG: What is the nature of the danger? The only possible answer is that this larger deficit would cause a rise in the interest rate. Well, if the markets thought that was a serious risk, the rate on 20-year treasury bonds wouldn't be 4 percent and change now. If the markets thought that the interest rate would be forced up by funding difficulties 10 year[s] from now, it would show up in the 20-year rate. That rate has actually been coming down in the wake of the European crisis.
So there are two possibilities here. One is the theory is wrong. The other is that the market isn't rational. And if the market isn't rational, there's no point in designing policy to accommodate the markets because you can't accommodate an irrational entity.
Wow! Now I'm not too familiar with James Galbraith (son of John Kenneth Galbraith), so I don't know if he is always this flippant. For all I know, he had had a few cocktails before talking with Ezra Klein. I will assume for the sake of argument that he sincerely holds the views expressed in this interview, and will answer them accordingly.
If nothing else, Galbraith's glib response shows the problem with free-market analyses that don't get to the core issues. It is certainly true that students in an introductory economics course will learn that the downside of government deficits is "crowding out," which occurs when government borrowing pushes up interest rates and leads private-sector businesses to reduce their spending on investment. In a related vein, it is also true that many "right-wing" financial pundits write of the "fiscal discipline" imposed by the bond markets on profligate governments.
There is nothing wrong with these sentiments, but there is a danger in making them the case against government deficits. For in times like these, when the government runs trillion-dollar-plus deficits amidst record-low interest rates, the opponents of big government have no leg to stand on. They are reduced to warning of an impending jump in interest rates any day now, a view with which Paul Krugman has been having a field day.
Contrary to Galbraith's claim, huge government deficits are dangerous regardless of the level of interest rates. In the first place, taxpayers are still on the hook for the federal debt, with or without massive finance charges. And yet Galbraith acts as if adding trillions of dollars to the federal debt carries no strings at all.
Consider a simple analogy: Suppose a parent opens the American Express bill to discover that her teenager has used the card to buy thousands of dollars of merchandise online. Further suppose that the son, when confronted, offers the following explanation: "Whoa whoa calm down! Before I bought that stuff, I called up AmEx, pretending to be dad. I got you guys a special 1% promotional APR that's good through next year. So my actions can't possibly hurt you guys." Now is this defense likely to calm, or further enrage, the parent?
Beyond the finances, the basic economic fact is that all government spending diverts real, physical resources out of the private sector and into politically-determined sectors. If the government borrows money to build a highway, the labor hours, concrete, and other materials used in the project are not available to private entrepreneurs. (Even in cases of high unemployment, it still doesn't follow that deficit spending increases total output, as I explain in this article.) Since it is government spending that is the problem, the real complaint against deficits is that they allow the politicians to get away with siphoning more resources out of the private sector than if their budget were limited to what they dared take from the public in explicit taxes.
The last portion of Galbraith's answer is simply incredible. The whole world just lived through a massive asset bubble in which "the market" clearly did not see the brewing storm. Although there are some critics of big government who subscribe to the so-called efficient-markets hypothesis, the same does not hold for most Austrians. After Obama first came into office, the stock market regained much of the ground it had previously lost. At the time many analysts attributed this to a "vote of confidence" in the new administration's economic and financial policies. Austrian economists, on the contrary, had no hesitation in saying the recovery was a sham and that any investor who thought otherwise was a fool.
The same holds true today. The reason for cutting government spending isn't to "appease the bond markets," it's to return resources to the private sector to aid recovery. It is simply incredible that Galbraith (a) uses the current yields on long-term Treasurys to suggest there is no danger, and then (b) shrugs off the possibility that the market could be wrong by saying the only point of good economic policy is to reassure markets.
What is particularly vexing about Galbraith's stance is that he doesn't care what the markets think, when it comes to implementing good policy. For example, when it comes to something like regulation of the "shadow banking system," I don't know what Galbraith's specific views are. But what I am sure about is that his recommendations wouldn't rely on Wall Street investors being "rational." If the markets tanked after a new regulation limiting leverage were imposed, Galbraith surely wouldn't say, "Oh, I guess this new regulation was a bad idea after all. Let's get rid of it to make shareholders happy."
Inflate Your Worries Away
Ezra Klein wants a balanced interview and plays devil's advocate with Galbraith. Are all the deficit-phobes just idiots?
EK: Then why are the bulk of your colleagues so worried about this?
JG: Let's push a bit deeper on the CBO forecasts. They publish a baseline set of projections. One of those projections holds the economy will return to a normal high-employment level with low inflation over the next 10 years. If true, that would be wonderful news. Go down a few lines and they also have the short-term interest rate going up to 5 percent. It's that short-term interest rate combined with that low inflation rate that allows them to generate, quite mechanically, these enormous future deficit forecasts. And those forecasts are driven partially by the assumption that health-care costs will rise forever at a faster rate than everything else and by interest payments on the debt will hit 20 or 25 percent of GDP.
At this point, the whole thing is completely incoherent. You cannot write checks [for] 20 percent [of GDP to bondholders] without that money entering the economy and increasing employment and inflation. And if it does that, then debt-to-GDP has to be lower, because inflation figures into how much debt we have. These numbers need to come together in a coherent story, and the CBO's forecast does not give us a coherent story. So everything that is said that is based on the CBO's baseline is, strictly speaking, nonsense.
EK: But couldn't there be a space between the CBO being totally correct and the debt not being a problem? It seems certain, for instance, that health-care costs will continue to rise faster than other sectors of the economy.
JG: No, it's not reasonable. Share of health-care cost would rise as part of total GDP and the inflation would rise to be nearer to what the rate of health-care inflation is. And if healthcare does get that expensive, and we're paying 30 percent of GDP while everyone else is paying 12 percent, we could buy Paris and all the doctors and just move our elderly there.
There are two things to notice in the above, after you get over the shock of the Paris quip. First of all, Galbraith is saying that the CBO story is incoherent because surely we will have either higher unemployment or higher price inflation than CBO is forecasting. In other words, Galbraith is saying that it is nonsense to think that the economy will soon return to "full employment" and that price inflation will remain tame. On the contrary, Galbraith argues that either the economy will stay in a rut (and hence keep the pressure off the price level); or the extra demand needed to create jobs will cause price inflation. (And remember, this is supposed to reassure us.)
On this point I would just add that the Keynesians always fail to mention the third possibility, that there could be high unemployment and price inflation, i.e. stagflation. The US experienced this in the late 1970s, and Zimbabwe recently suffered through hyperstagflation. So it is certainly a real possibility, even though Galbraith and others still cling to the belief that you can't get rising prices when there's "excess capacity" in the economy.
Before moving on, let's make sure we see the precise rhetorical sleight-of-hand that Galbraith used to defuse the problem of healthcare expenditures. Rather than explain how the trend will be reversed, and why we should be as optimistic as he is about federal spending, look at what Galbraith does instead: he points out that if the alarming projections turn out to be true, then it would be cheaper for the US to "buy Paris and all the doctors and just move our elderly there."
Now does anybody think it makes economic sense, or could possibly be affordable, to do such a thing? Of course not. If it ever came to the point where the US had to do something that drastic, the country would obviously be in financial ruin. But notice that Galbraith technically didn't offer any explanation as to why these alarming predictions are wrong; he simply pointed out that in such a scenario, it would be cheaper to "buy Paris" than to pay for domestic healthcare.
Are Deficits Necessary For Saving?
As it turns out, not only is the deficit harmless, but Galbraith argues that it's actually crucial for economic growth:
The government needs to run a deficit, it's the only way to inject financial resources into the economy. If you're not running a deficit, it's draining the pockets of the private sector. I was at a meeting in Cambridge last month where the managing director of the IMF said he was against deficits but in favor of saving, but they're exactly the same thing! A government deficit means more money in private pockets.
As much as I dislike the Keynesian prescriptions of Paul Krugman and Brad DeLong, at least they don't go this far; they claim that pump-priming government spending only provides stimulus under certain conditions (such as those we face today). As far as I know, they have never made such a sweeping endorsement of deficits as Galbraith does above.
Of course, the statement, "If you're not running a deficit, it's draining the pockets of the private sector" is nonsense. In terms of cash flows, it's a wash: the government borrows money from the private sector, and then spends it right back. What the private bondholders gain in savings, the private taxpayers lose in the higher federal debt. And in terms of real, physical resources, government spending in general siphons them away from the private sector.
It's really amazing that Galbraith can throw out statements like that without some sort of warning light going off in the back of his mind. Does he really think that, say, a $30 trillion deficit this year, would translate into $30 trillion in additional US savings? My hunch is that he would, but that at some point — maybe a $4 trillion deficit — the government would have put everybody back to work, and then any deficit spending beyond that would push up prices.
Even if we take this view at face value, I would still be curious to know: does Galbraith really think that there is nothing to be said for frugal lifestyles? For example, suppose we have two identical countries, but in Country A the people save half their incomes, while in Country B they save nothing. Does Galbraith think the people in Country B can live at twice the standard of living, and save as much as the people in Country A, if only the government in Country B would run massive deficits?
James Galbraith wins the award for the most over-the-top and nonsensical defenses of government deficits.
If his remarks came from a letter to the editor of a local newspaper, they would be amusing. Yet Galbraith is apparently "an economist and the Lloyd M. Bentsen Jr. chair in government and business relations at the University of Texas at Austin."
In the face of such opponents, all the Austrians can do is repeat the truism: it doesn't make the country richer when politicians spend money they don't have.