The Federal Budget Deficit is Not a Problem Right Now

In 1936 John Maynard Keynes, the most important economist in the history of economics after Adam Smith and Karl Marx, published a book called The General Theory of Employment, Interest, and Money. The book is highly technical and difficult to follow for a non-specialist. I have read it, but had a very difficult time getting through it. Luckily for those of us who are not economists, there are many very bright people who devote their lives to this stuff and many of them have done a very good job of explaining it to the rest of us. The key insight of the book, despite the book's difficulty, is relatively easy to understand. In it Keynes argues convincingly and at length for the thesis that full employment, meaning the economic state where everyone who wants to work can find work, is not a function of the price of labor, but of the aggregate demand in the economy. Even as I rephrase that I can't help but notice how it's rife with jargon, shibboleths and mathematical concepts that are beyond the high school mathematical education of most American adults.

So think of it this way: suppose the economy consisted of just four people. One of those people is a consumer, one is a capitalist, and two of them are workers. The consumer pays the capitalist for the things the consumer wants and the capitalist sells them to him. The capitalist pays his workers to make the things that he wants to sell to the consumer. The workers do what the capitalist tells them to do. The consumer is independently wealthy. The capitalist makes money from profits that are the difference between what he has to pay the workers and what the consumer pays him for his goods. Got all that? Ok good.

Now suppose that the consumer doesn't have infinite money, but has to bargain for what he gets from the capitalist because he needs to keep some of that in reserve. This places an upper limit on what the consumer can pay to the capitalist no matter what the capitalist's costs are. The workers also have a fixed lower limit to what they will take in pay. They are only willing to work if the capitalist pays them enough money to live on. What this means is that profits for the capitalist only exist in that space between the upper limit of the consumer demands, and the lower limit of the workers' needs. Make sure you understand that and we'll move on.

Ok, so now let's throw another wooden shoe into the machinery. Suppose that if the capitalist pushed one of the workers really hard, he could meet almost all of the consumer's demand. Not all of it, but enough of it that the consumer will be satisfied with what he gets. This means that the capitalist can fire the other worker, reduce the lower limit on his profits, and make more money while producing and selling fewer goods. It just makes sense for the capitalist to do that, doesn't it? And the capitalist is no idiot so of course he's going to do it. And there with the stroke of a pen on a pink slip, as if by magic, the economy creates unemployment because half of the workers who want to work are no longer able to find it. Production is at the maximum capacity needed to produce the maximum profit.

To fix this problem there has to be a change made to this economic system. You can add another capitalist, but that only forces the two capitalists to compete with each other for the consumer's money, bringing down both of their profits. You can add more workers, but that just creates more competition for jobs and higher unemployment, longer hours, and lower wages. So the only real solution to the problem is to either add another consumer to the economy and thereby increase demand, or remove a worker from the system entirely so he is no longer a person in the system seeking work and unable to find it. Since there is a serious moral issue with terminating an individual, the possibilities for removing a worker from the economy are limited. It only happens when people die or they are able to save enough money to retire either briefly or permanently from the workforce (and become a pure consumer). And both of those events are unpredictable and take a lot of time. Therefore, the only practicable solution to an immediate problem of a lack of full employment is to add consumers.

Well, great, but how do you do that? Luckily in the real world, unlike our model, there is a fourth category of actor in the system who is neither a consumer, a capitalist, nor a worker. Even better, that actor has the ability to spend however much money it needs to in order to increase the total demand in the economy high enough that capitalists need to hire all the workers available in order to meet the demand. That actor is the state.

Now ideally, the state won't have to do anything to increase the total demand. In the real world, workers themselves are also consumers, as are capitalists. Between all of them put together, if the economy is equitable, they will create enough demand that the capitalists will have to employ all the workers to meet it. When you're in that sort of a situation for other reasons inflation becomes a potential problem, and there are other things that the government can do (like manipulate interest rates on debt and the amount of money in the economy) to keep inflation low. But when unemployment is very high, as it is right now in the United States, there's really no reason to worry about inflation. So the situation that you have is this, consumer demand falls which causes capitalists to spend less money and reduce their workforce. As a result of this, the total demand is less. People are less willing to spend money, so less needs to be produced. This reduces the capitalists profits, and since they can't directly stimulate demand, the only way to raise their profits is to again reduce their workforce. All of a sudden all of those workers who were just let go have less money to spend, total demand goes down again, profits go down, and the vicious cycle continues.

The only way to counteract this is for the state to act to increase demand. However, the state only has so much income, and that income is determined by the taxes paid by the workers, consumers, and capitalists. But if consumers are spending less money, capitalists are making less profit, and workers are taking home less in wages, all of which are the case during a period of high unemployment, the state's income is also reduced. So the only way that the state can do what it needs to do in order to create more aggregate demand is if it spends more money than it takes in. That spending is a budget deficit, and therefore budget deficits are not only necessary, they are a very good thing during a period of high unemployment. They are a very good thing because they prove that the state is doing what it needs to do to eventually return to full employment.

Current unemployment in the United States is something around 10% of the workforce. Full employment in the real world means that that number needs to be somewhere around 3% (it would be zero, but some amount of "structural unemployment" which is where there are enough jobs for every worker seeking work, but where the skills of the jobless don't meet the needs of employers, is inevitable in a post-industrial economy). This means that what we would expect to see is that right now the federal government and the individual states would be borrowing heavily against future revenues to increase the aggregate demand in the economy. And at least at the federal level, and for those states that are responsible enough to issue bonds right now, that's exactly what is happening. It is right and it is necessary.

That may come as a bit of a surprise to you if you've been watching and listening to all the talking heads in the world who look at the budget deficit as though it means the sky is falling. After all, these are for the most part intelligent, educated people who should know all about this stuff. So does that mean that they maybe know something we don't? It's true, after all, that deficits create long term national debt, and that that debt will eventually need to be paid off from future revenues. Could that commitment of future revenues to debt reduction really be such a huge problem that even in a situation with high unemployment it is wiser for the government to reduce its deficits in order to fend off that long term problem? Well, maybe. That's certainly a reasonable hypothesis and we ought to think about it. But consider for a moment a couple of other special powers that the government has when it runs deficits. First it has ultimate control over how much interest it will pay on those debts. Well, that's certainly useful. Since the long term prospects of the American economy are very good, a very small interest rate will still be appealing to large investors because it's such a sure thing.

The other thing the government can do in the future when there isn't an unemployment problem is raise taxes in order to increase its revenue. It's true that tax increases have an overall detrimental effect on the economy because particularly if those tax dollars are just going to pay off debt, it's taking some demand out of the economy. But if you're already at full employment and more importantly if the economy is growing at a healthy rate, you can take a little extra out without having too deleterious an effect on the employment situation. Just like unemployment is a vicious downward cycle, full employment is robust and able to sustain itself pretty well, with the only real danger being inflation (which raising taxes and taking money out of the economy will help to control).

What this means in the end is that a responsible economic policy adopts deficits during bad times and raises taxes and spends less during good times. Make sense? Good.

So then why do the talking heads who know all of this stuff still harp on about the deficit? The simple answer is that they're just stupid. And probably there is a bit of that. I have no doubt that there are many people in government and in the punditocracy who simply haven't thought this stuff through, and who really do believe that the government is just like a consumer or a worker in the economy, and that just as consumers and workers rationally must reduce their spending and not take on debt when their means are reduced, so too must the government. In good faith, I have to believe that that is the case, because not to do so ascribes some supremely evil motives to them all.

What I mean by that, is that there is another reason why someone might make a big deal about the deficit during a time of economic fragility, and that is for long term personal gain. You see, current deficits more or less require that at some point taxes will go up. It's a cliché that taxes are one of the only two certainties in life, and this is part of what makes them so certain. And it's also true that for the vast bulk of the nation, say the bottom 99% of income earners, really only so much taxation can be bourn. You hit a limit to taxation with those people beyond which the amount of income that's left over is simply unjust. In a republic such as ours, any policy maker who pushes that limit is almost certain to be out of work himself before too long. Therefore if you are a policy maker and you need more revenue to pay off debt and you can't increase taxes on 99% of the population, then the only option is to raise taxes on that top 1% of incomes who can bear the additional tax burden and still have a lot of money left over.

So now imagine you're a part of that top 1% and you really want to keep as much money to yourself as you can. What then do you think of deficit spending, knowing full well that you are the guy who is going to have to pay that off one day? If you're that guy, you might not think much of deficit spending. You might then think that you should try to put your thumb on the scale to try to keep that debt as small as possible. And more importantly, you might want to curtail spending on government programs that don't directly benefit you or that you plain don't like so that when the day comes to pay the debt, there will be fewer competing interests for existing revenues and therefore a smaller gap to fill between that existing tax income and the additional amount the government needs to take from you in order to pay its debt. If that's the case, then even though deficits are a necessary and righteous thing that benefit everyone during an economic downturn, you might use some of your ample resources to gin up public antipathy against deficits and elect politicians who agree that you deserve to keep all of that money you've got. And that sort of action, because it comes on the backs of the poor, the elderly, the unemployed, and least well-educated, and because its genesis is out of purely selfish greed, that sort of action is evil.

So no, the federal budget deficit is not a problem right now. It's the exact opposite of a problem, it's a solution. And the people who want to tell you otherwise are either stupid or evil. Take your pick.

Comments

That was... really quite

That was... really quite good.

glad you think so

glad you think so

Nice

It was interesting how the debate shifted from tax cuts v. fiscal stimulus in winter 2008 to "deficits are always bad" by fall 2010.

I also had this overview link saved from the early days: http://www.economist.com/blogs/freeexchange/2008/12/tax_or_spend

It's still difficult, though, to say that government spending leads to more aggregate demand in the next time period. C+I+G+nX is not the mechanism, its the status quo. Maybe the deficit hawks are secretly assuming that the government spending multiplier is less than 1.0 and we should be spending the money on something more productive or leaving it with consumers. Or maybe not . . .

If you do the kind of

If you do the kind of spending that I'm implicitly talking about—an immediate increase in direct government hiring, increases in infrastructure improvement, and additional grant money for worker retraining programs and extended unemployment benefits,—it's hard (for me) to see how it can fail to result in increased aggregate demand in the next time period. But then, I'm only an armchair economist. I'll grant you that I don't see a lot of benefit to the US economy if we suddently started sinking a lot more money into Afghanistan or something. But I take your point.

Short-run/Long-run

I agree. Anyone talking about the deficit being "bad" is not thinking deeply enough about the issue. While some people who are involved in the debate might come to the conclusion that fiscal spending is inefficient and crowds out private investment, they probably wouldn't say the deficit is bad, they would say fiscal stimulus is bad. And they would probably be in the minority. I think it is pretty clear that some government spending, e.g. unemployment insurance, is probably very good and brings great returns.

The Keynesian accounting function can be broken down into functions for consumption, investment and government spending that explain changes between time periods. (wikipedia has a really poorly notated section on it here: http://en.wikipedia.org/wiki/Fiscal_multiplier#United_States_of_America ). Whether these equations are correct and what values might be acceptable are two big points for debate.

This article is good, defending the necessary level of inefficiency for Keynesian government spending to be irrelevant: http://www.marginalrevolution.com/marginalrevolution/2010/08/me-defending-fiscal-policy-or-confusions-about-the-multiplier.html

Though this was a good perspective on how much plumping up checkbooks with government spending can really do when no one wants to spend: http://www.pimco.com/Pages/Global%20Perspectives%20March%202009%20Clarida%20A%20Lot%20of%20Bucks%20How%20Much%20Bang.aspx

I think intelligent conservatives argue that fiscal spending now will have a small effect and will not improve the economy much more than we would expect with no intervention. They then argue that future tax increases to make up for current short-run fiscal stimulus will cause greater reductions in the future (consumer's disposable income, or investment), more than offsetting gains in the present.

We have had two big fiscal stimulus bumps (Bush and then Obama) - I don't know if we can say that the fiscal stimulus has been particularly effective, although it does seem like there have been few downsides as well (little to no crowding out of private investment, debt is still not that high, even if deficits are). Things have turned around, but are they that much better than the baseline scenario?

Good links, thanks. I do

Good links, thanks. I do question the notion that future reductions are that much of a problem though considering the historical lows that current top marginal income tax rates are and the high levels of unnecessary subsidies of various industries currently built into the corporate tax laws. It seems to me that boosting income taxes to their Reagan era peaks and closing off some of that inefficient corporate welfare couldn't have that negative an effect on investment and disposable incomes (at least disposable incomes that will be spent and not saved). Also, it seems to me that Paul Krugman was right about the Obama stimulus being too small and too concentrated on less stimulative tax breaks. Which is to say that even the smart conservative argument has a couple of big obstacles at the moment, and while they might be pertinent once unemployment gets down to 6-7%, right now there's no bigger problem than these crazy european style long term unemployment numbers and its premature to be worrying about deficits.

Also

I really only turn to Keynes because I recognize that my postmarxist impulses about the ethical implications of huge capital gains while workers suffer don't have much rhetorical force with econ realists and their weird calvinism cum social darwinist view that free markets=meritocracy. In truth, I think it's simply morally wrong for the government to be tightening it's belt when it can be doing more to help individuals who are struggling. But that's evil kenyan socialist secret muslim empathy or something and it has no place in Serious Policy Discussion.

is this more your

is this more your speed:

Incentives, Inequality, and Community
G . A . COHEN
THE TANNER LECTURES ON HUMAN VALUES
http://www.tannerlectures.utah.edu/lectures/documents/cohen92.pdf

Great points. All except for

Great points. All except for . . . .the fact that it doesn't work. And not just the the failure of the $878 billion stimulus to create jobs. There's also the examples of Greece, Spain, Ireland, and now it looks like Italy is headed the same direction.

The assumption is that short-term deficits will stimulate enough overall growth to return to full employment and robust revenues. And that assumption may be correct until the deficit and/or debt reach a critical mass in the overall picture of the economy. When real unemployment is floating above 15% and the debt is a substantial portion of total GDP then the model breaks down completely. Again, Greece, Spain, etc . . .

It's a lovely idea, that somebody else gets to dictate the "morality" of the economy--unfortunately, the reality of that is a lot more pain for a lot more people.

Generally speaking, we don't

Generally speaking, we don't tolerate this kind of comment because it's very close to trolling. You're free to disagree and you're free to make you case for a different idea, but you are not free to make bald assertions of fact and specious comparisons in defense of the otherwise unsupported statement that "it doesn't work."

You have one more chance. Further comments in this mode will be deleted if all you're going to do is spout GOP talking points.

It appears

That your prognostication was incorrect. It seems that raising the debt limit did little to stop the economy from faltering. Instead it appears that most credit rating agencies were looking for a realistic slash in spending more than they were a debt increase.

Who's to blame? Since I am Libertarian you already know my answer. But I am curious how you will frame the last two days (August 4th and 5th) with this theme you have going.

raising the debt limit has

raising the debt limit has nothing to do with anything. it was something that needed to be done to pay for things congress had already appropriated spending on but that revenues weren't adequate to meet. the problem of inadequate demand remains and will remain until either the meager levels of growth get us to a point where there is greater employment. the deficit has nothing at all to do with the health of the economy at its present sign.

as for the ratings agencies, i'm a socialist and i'm sure you know what I think of them/