I think it's important to recognize that in many ways the short-term vs. long-term distinction is a fairly arbitrary construct. Economists like to use different theoretical models to articulate the forces that are relatively more important in each time frame (be it aggregate demand in the short-run or technological growth in the long-run). This is a useful classroom device--dividing the world into long-run and short-run--but in the real world short-run outcomes do influence long-term growth.

Consider a few examples. The closure of otherwise viable start-up companies in a recession would mean a delay or abandonment of promising new product R&D. Increased unemployment and under-employment can lead to an erosion or underutilization of worker skills and a decline in “human capital”. Deteriorating family finances could mean a foregone college education. A home foreclosure can ruin the credit of a promising entrepreneur and thus threaten their ability to raise start-up capital for many years. Thus, the consequences of a short-run downturn can thus impact long-run economic potential.

So, I agree with Krugman and see no tradeoff between short-term stimulus and long-term growth. The best thing for long-term growth would be to get things moving ASAP, and this means increased deficit spending today. Over the longer-term, we should certainly strive for sustainable debt levels, but I simply don’t see a long-term economic cost of an immediate stimulus.

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It isn’t often that I agree with Paul Krugman, but I find myself in general agreement with his recent article on stimulus and the deficit. In these unusual times, a significant stimulus package is necessary to get the economy moving quickly and, as such, will swell the deficit in the short run. I am not overly concerned about negative effects stemming from a temporary increase in the deficit, especially in such an unusual time period. There are a couple of reasons for my response: first, much of the expected short run increase in the deficit is from asset acquisitions in the stabilization legislation that should result in cash inflows when the assets are sold; and, second, more rapid longer-run economic growth  will generate more tax revenue.

While we don’t disagree about negative effects of short-run deficits, I expect that we might have some disagreement about the composition of a stimulus package. I would like to see more pro-growth tax cuts and less government transfer payments (i.e. refundable tax credits for those who don’t pay taxes). We would likely disagree on the type of government spending to be included in a stimulus package, but we both agree on the need for, and the benefit of, more spending on necessary infrastructure.

No.  The question is grossly  misconceived.  Right now and for the immediate future, the budget deficit is the only source of demand that can fuel a recovery.  Our present problem is not that it is too big, but that
it is too small.   Far too small.

In principle, economic growth can come from household consumption, business
investment, government spending, or exports.   This is a tautology,
indisputable and known to everyone who has ever opened a textbook.

Household consumption depends on incomes and on credit.  The collapse of credit, rooted in the decline of housing values, is at the root of the crisis.  In parts of California home values have fallen 50 percent already, which would place them far below the debt owed on the homes in most cases. 
Quite apart from the fact that the banking sector is in deep trouble, borrowing power has collapsed. For this reason, rescuing the banks, though necessary, has not and will not produce recovery.

Business investment depends on the expectation of profit. But with consumption falling, there can be no expectation of profitability for the time being.  So business investment will follow consumption down.

Thanks to a low dollar, exports were the one bright spot in the growth picture for most of 2008.  But the flight to quality that rescued the dollar will clobber the competitiveness of American exports.

For these reasons, the entire private sector, across the entire country and
indeed the world,  is pulling the economy downward at the present time.  
This is an unprecedented event in my professional lifetime.  Previous deep recessions, for example in 1974 and 1981, were caused by external shocks or policy shocks.  This one is driven by an internal collapse of the credit system, the first in almost eighty years.

In normal times, after a passage of time, as cars and appliances age and people are born, married, move around and die, pent-up demand grows in the household sector.  Once that has happened, a sharp fall in interest rates is normally sufficient to kick-start the resumption of sales of durable goods, home construction and then a general credit expansion.  There should be no expectation of this for the foreseeable future, because of the
condition of the banks and the vast excess inventory of housing.   These
are not normal times and the normal mechanics of a credit recovery cannot be counted on.

Meanwhile, as consumption, investment and exports decline, so will tax revenues.  The government budget deficit is destined to rise, by a lot, on this account alone.  This is helpful: a falling tax burden in a progressive tax structure keeps money in private pockets.  But it is a weak device to promote expansion, since tax savings will be used first to try to pay down debt, a slow process.  A major tax cut, focused on working Americans such as by remitting the payroll tax, would help sustain after-tax incomes and provide funds to pay mortgages and buy cars.  But even these effects are uncertain in a debt deflation.

In these conditions, only government spending can pull the economy out of the ditch.  Government must spend.  It must do so by as much as necessary in order to maintain a high level of employment.  Aid to states and localities, an infrastructure fund, increased social security benefits, foreclosure relief,  loans or grants to industry, a green jobs program -- all can be useful in coping with the crisis.  All will, of course, add to the public budget deficit.

There is no harm in seeking out wasteful or unnecessary programs to cut as
the President-elect proposes.   The war in Iraq is a huge waste of money
with minor benefits to employment. Missile defense is a vast waste of construction, engineering and scientific resources with no benefit to
security.   Bridges to nowhere and roads to the wilderness add nothing to
the value of the national capital stock.  But the point of cutting waste and boondoggles is not to reduce the deficit, but to release real resources for better uses.  The obligation to use those resources, and to deploy the public funds necessary to ensure that they are used, remains.

Will the projected future deficit "crowd out" future private investment as so many claim?  This is absolutely improbable. To the contrary, a successful program of public expenditure will create profit opportunities that will encourage private businesses, many of which will otherwise close, to stay open and eventually to expand.  A general improvement of economic conditions can only lower, not raise, the presently prohibitive risk
premiums on interest rates being charged private borrowers!   There is no
way that present or future public spending, even in very large volumes, would under these conditions raise long term interest rates generally  by enough to offset the positive effects of an increase in activity and a
reduction of risk.  Quite the contrary!   Public spending will crowd in,
not crowd out, private investment.

Whether they know it or not, those who argue a "crowding out" model are working from a mental construct under which the economy is always operating at or near full employment, and under which there is a fixed supply of credit resources, a pool which government and the private sector must
share.  This is not the case!   We are far below full use of available
resources now and will certainly fall very much farther in the months ahead, whatever the new administration does.  And there is no fixed pool of
credit!   The entire purpose of the capitalist banking system under the
Federal Reserve Act, ever since 1913,  has been to create an "elastic currency" not subject to fixed limits to the supply of finance. With due respect to those who continue to have reservations about "crowding out", please stop.  This is a moment when an unfamiliarity with the most basic economic and financial facts can be very dangerous to national well-being.

Finally, there are those who have argued, in times past, that projected future deficits might have a psychological or other effect, detectable in statistical data, on long term interest rates and therefore on private
business investment.   But whatever the merits of the statistical case,
there is no risk under present conditions that something so remote and ethereal as a psychological fear of deficits in the distant future is going to drive up the long-term interest on public debt.  We are in a full- fledged flight to safety!  That is a flight to cash and to Treasury bonds and bills, not merely here but worldwide, as witnessed by the rising dollar.  Right now and for the foreseeable future Uncle Sam can borrow, for whatever term, on whatever scale, for practically nothing.  In fact, he has suddenly become a creditor to much of the world -- notably the European Central Bank -- because of a worldwide shortage of dollar assets!

Finally, there is the question of whether it is possible to go too far. 
The answer is yes. Maybe my diagnosis is wrong.  Maybe private credit will recover faster than I think likely.  But even allowing for this possibility, action now should be on a grand scale.  It is far easier to trim back tax relief in an expansion, than it will be to repeat the political effort of passing a large expansion package if the first one is too small.  For this reason, the conditions call for error on the side of action, not of caution.  "Wait-and-see," in an emergency,  is the worst possible advice.

Official Washington and many economists have for many years "known" that Americans save too little, spend too much, and that governments should work toward balanced budgets. It is hard to unlearn these convictions when conditions change. But we now see the consequences of a forced-draft attempt by beleaguered households to reduce spending and pay down debt: it is a decline in economic activity bordering on collapse.

In these circumstance, large budget deficits are essential, and preoccupation with budget balance is counterproductive. In very simple terms, it means reducing incomes in the private sector, just when it is most  necessary that those incomes be supported, through public spending and tax relief.  Those who hang on to simple views of economic virtue in present times need to rethink: time is short and action is needed.
 

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In case you missed it elsewhere, here is the chapter from Adam Posen's book on the trouble Japan had stimulating in the 1990s.

In my view, framing fiscal policy as a policy of deficits is misleading. Of course, deficits rise automatically in a recession, and more stimulus is needed not just for macro-economic reasons but because the needs of the population rise more than proportionately with the drop in income.

Good stimulus policy has always meant being balanced at some sustainable level over the long term. One can favor larger deficits during some periods and smaller deficits during others. Just because we earn less and pay more bills in our households when we get sick doesn't mean that we still don't have to worry about how to earn enough to pay our bills in the long run. As Walter Heller once said, "I blow on my hands to warm them up. That doesn't keep me from blowing on my soup to cool it down."

A budget that moves toward balance when the economy is back on track is one that is better able to handle this recession, should it get deeper, or the next recession when it comes along. There’s a lot that we still don't know: how deep this recession might be, whether we could have back-to-back recessions as in 1979 and 1981, whether the world-wide aging of the developed world could play out in ways not yet predicted, or how well our financial house can be brought back into a adequate state of repair. The more prudent our long-term budget policy, the more firepower we will have to meet current and future downturns and other emergencies.

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Paul Krugman is surely correct that 2009 and 2010 should not be years when policymakers devote most of their efforts to spending restraint and short-term deficit reduction. Almost all observers agree the U.S. is in a recession. Output and consumption are likely to weaken further before they recover. When there are abundant unemployed resources and the government faces very low borrowing costs, it makes sense for the government to increase its borrowing in order to put some of the idle resources to productive use.

Next year and the year after are likely to be years when increasing the public debt will improve rather than hurt the prospects of future taxpayers. This is especially true if a large portion of the economic recovery package is devoted to investment, for example, in public infrastructure and human capital. New federal programs to boost investments in public highways, schools, and laboratories or to increase enrollments in community colleges and universities will add to the federal debt, but they will also add to the nation’s future productive capacity. If the added public spending is prudent and well targeted, future taxpayers will benefit.

I was surprised by one remark in Krugman’s column. He noted parenthetically that the public debt is “basically money we owe to ourselves.” This has not been true for a number of years. At the end of September 2008 about 54 percent of publicly held U.S. Treasury debt was owned by foreign entities, including foreign governments. As recently as 1997 only about a third of the net federal debt was held by foreigners. It’s likely that half or more of the additional public debt issued over the next couple of years will be purchased by overseas lenders. The interest we pay on that debt will be paid to foreign rather than domestic lenders. To a first approximation, we will owe the half the money to foreigners, not to ourselves.

Of course, the government will be financing new and rolled-over debt at a very low interest rate. The burden of the public debt is the interest payments we must make in order to support it. Even though the federal government will be issuing much more than a trillion dollars in new debt over the next two years, lower interest rates will probably cause the burden of the public debt to fall. At the beginning of this decade, massive federal deficits caused the public debt to soar. However, lower interest rates meant that the government’s net interest payments fell more than a quarter when measured as a percentage of national income.

Running a bigger deficit is a sensible response to a recession. Worrying about future deficits is a sensible activity whenever there is a serious imbalance between the government’s long-term obligations and its expected revenues. The U.S. faces a serious recession and a long-term imbalance between obligations and revenues. It should deal with both problems, though on different schedules. The government must eventually reduce its spending obligations or increase its revenues to eliminate a substantial part of the long-run deficit. To quote St. Augustine, however, “Grant me chastity and purity, oh Lord, but not yet.” A deepening recession is not the right moment to embark on a major round spending cuts or tax increases.

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This year’s base budget deficit – even before adding any new stimulus package – is estimated at $1 trillion. At 8% of GDP, that is the highest budget deficit since World War II. If that is not enough Keynesian-deficit-spending stimulus, what is? 10% of GDP? 15%? 20%? The Keynesian gas paddle has already been pushed enough (with little to show for it), its time for a new approach.

Furthermore, the problem with these spending stimulus proposals is that Congress does not have a vault of money waiting to be distributed. Thus, every dollar that Congress “injects” into the economy must first be taxed or borrowed out of the economy. No new spending power is created. It is merely transferred from one group of people to another.

If Congress funds new spending with taxes, it is redistributing existing income. If Congress borrows the money from domestic investors, investment will fall correspondingly. If its borrowed from foreigners, net exports will fall correspondingly (in order for the balance of payments to balance). No matter what happens, Congress cannot create new purchasing power out of thin air.

Even redistributing from “savers” to “spenders ignores the fact that people already either bank their savings (where it is lent to others) or invest it. People aren’t storing their savings in their mattresses anymore, the money is already circulating through the economy.

But if Congress insists on passing a “stimulus” package, they should acknowledge that the only real way to increase per-capita GDP is by increasing productivity. Reducing marginal tax rates will increase incentives to work, save, and invest, and thus help American workers create new wealth and aid the economy.

Then, Congress and President-Elect Obama should focus on the $53 trillion tsunami of unfunded liabilities in Social Security and Medicare. Otherwise taxpayers will not be able to afford even today’s federal programs, much less the new spending the President-elect and Congress have planned.

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Krugman is correct that a large fiscal “stimulus” program should not be expected to increase interest rates. He is not correct in assuming that such a program would increase near-term demand; the cost of such a program would be borne by our children and grandchildren. The only fiscal measures that are likely to increase economic growth are those that increase the incentive to work, save, invest or increase productivity, not those that attempt to increase demand. .

I am not aware of any respectable economist who is arguing that deficit spending to get the economy out of a recession is a bad idea because it increases the deficit. The argument that Krugman attacks seems like a straw man. Like Krugman, I think a big stimulus is needed since, as he argues, we are in a liquidity trap of sorts. There is no source of stimulus right now other than the government.

Where I would take exception is with his inference that we are only borrowing the money from ourselves. Since 1994 we have borrowed about three-quarters of the additional funds we've needed to finance our borrowing from abroad and we are going to have to accept a lower standard of living in the future when it comes time to paying them back.

I also think that we should rein in long-term spending at the same time that we enact short-term stimulus. Absent such efforts to signal that we have a plan to control burgeoning deficits over the next several decades, the global appetite for U.S. assets could wane and create an even more serious problem than we face at present.

Paul Krugman is right that the economy needs fiscal stimulus now -- a combination of spending (particularly on projects that can both start up in the short term and be useful for the long-term) and tax cuts (particulalry for the lower 95% of workers, as the President-Elect says). He is right that we don't have to worry about crowding out of private investment via higher interest rates at the moment. Getting the economy moving is the priority. But a few years down the road we will have to worry a lot about the legacy of huge deficits left from the current decade. This will happen when the recovery is in place, interest rates are rising substantially, the debt/GDP ratio is high, and we are staring in the face even larger future deficits from social security and (especially) Medicare. I don't agree that the proper approach is to wait until that time arrives to start thinking again about long-run fiscal responsibility. We saw in the Bush Administration what can happen when legislation shifts the economy firmly onto a long-term high-deficit path. (The legislation I am referring to was the 2001 and 2003 tax cuts, together with the decision to allow the spending caps and PAYGO provisions enacted by the preceding two presidents to expire). Even if the part of the stimulus that falls in the early recession years happens to be well-timed to moderate a recession (2001 and 2008, respectively), the adverse effects in the long term can be substantial, unnecessary, and difficult to reverse.

What is wanted is a combination of stimulus in the short-term, combined with built-in restraint in the longer term.
In the case of taxes, the short-term stimulus could include abolishing income taxes and payroll taxes on the lowest income workers (which would also have long-term efficiency payoffs arising from simplication and incentives). The long-term restraint would include a commitment to allowing the Bush tax cuts for the rich to expire, and carefully instituting future energy taxes (to address environmental and national security concerns, in addition to the fiscal motivation). In the case of spending, the short-term stimulus could include public infrastructure especially at the state level (modernization and repair of schools, roads, and those famous bridges), and well-chosen environmental investment. The long-term spending restraint should include the reinstitution of PAYGO and caps, and fundamental reform of social security, medicare, and defense procurement.

The argument for including the provisions for long-term fiscal restraint from the very beginning is not just to avoid saddling our grandchildren with even more debt. It is also so that when the economic recovery does get underway in a year or two, it is not automatically braked by well-founded fears of high interest rates, low securities prices, and perhaps even a looming debt crisis.

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Let us first agree that large current reductions in federal spending would make little sense, given the decline in the broader economy that is emanating from our financial crisis. Whatever the form an enacted economic stimulus takes, we should not undercut it with contractionary policy.

Then why devote effort to combing through the budget looking for programs to cut? Let us think back to the recent presidential campaign, and ask why John McCain harped continually on the $18 billion in earmarks that he aimed to reduce. To some, this was a puzzling strategy, given that reducing earmarks would have had an inconsequential impact on our enormous fiscal imbalance – how could it, when the federal budget exceeds $3 trillion and the annual deficit is on its way to $1 trillion? Rather, talking about budget cuts is a mechanism for trying to signal fiscal responsibility. In McCain’s case, the intended message was that the responsibility wouldn’t end with earmark-cutting.

President-elect Obama faces a very difficult task in his design of fiscal policy, thanks in no small part to the fiscal profligacy of his predecessor. He shouldn’t try to attack the long-term fiscal problem immediately, but he needs to address it soon, in a big way. And it won’t take a line-by-line review of the budget to know where the bodies are buried, with roughly 70 percent of the non-interest federal budget now accounted for by Social Security, Medicare, Medicaid and Defense. This spring, even before the most recent deterioration of the economy and the fiscal outlook, Jason Furman, Bill Gale and I estimated that it would take permanent budget cuts or tax increases on the order of 8 percent of GDP or more to put fiscal policy back on a sustainable path (http://emlab.berkeley.edu/users/auerbach/facing_the_music.pdf). That’s well over a trillion dollars a year, if we were to act immediately. Undertaking expansionary fiscal measures now while showing no interest in dealing with our long-term fiscal problem could lead investors to question our ability to confront that problem later, and that loss of confidence could have an immediate impact. Particularly at the beginning of a new administration, when a reputation has yet to be firmly established, statements of concern may matter, particularly when combined with the appointment of responsible people to the relevant policy-making positions.

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An Undergraduate Error from a Nobel Prize Winner

It is surprising indeed to see Krugman making an undergraduate error in thinking about the effect of a surge in federal spending on our future prosperity. This error helps to perpetuate the rampant neglect of the future that is going to make things very difficult for our children and grandchildren. Deficits really do matter.

In a closed economy, with the US the only country in the world, the size of future US GDP and thus our future collective prosperity is determined by the level of investment. It is therefore true that for a closed economy in which we owe the government debt to ourselves, there is no collective cost to a deficit that does not affect the level of investment. That is Krugman’s world.

But in the real world the US is not alone and relies heavily on borrowing from foreign sources to finance current spending by consumers, business and government. While more spending by the federal government is not likely to pull down current investment, indeed could do the opposite, it seems certain to increase our indebtedness to foreigners.
Thus while the deficits are not likely to have a big impact on future GDP, they for sure will increase the fraction of our GDP that accrues to foreigners through debt service.

It is more accurate and more intellectually healthy to think of ourselves as trading greater prosperity in the next year or two for less prosperity later on. Let’s proceed with handouts and bailouts that greatly reduce the severity of the current recession at the lowest possible future cost. But let’s top throwing cash at anything that doesn’t move, as if being hit with money would get it moving again.

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