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GEORGE MAYNARD BUSH
Sep 1st 2005
Most American liberals are now fiscal conservatives. But not all
LIKE all the fiercest debates in American politics, the fight over the
budget deficit has its hawks and its doves. But on fiscal matters, it
is now the American left that brandishes talons and the right that
carries an olive branch in its beak.
One exception is James K. Galbraith, of the University of Texas,
Austin. "A card-carrying member of the Texas left", he is also the
whitest of fiscal doves. That makes him a rare bird indeed these days.
He shares not only his famous father's initials, but also his sharp
pen and his passion for the economics of John Maynard Keynes. In a
recent pamphlet*[1] on the budget deficit, Mr Galbraith argues that
members of the present Republican administration are unwitting
disciples of the Cambridge master.
That administration ran a deficit of $412 billion, or 3.6% of GDP, in
the most recent fiscal year. The deficit this year will narrow to $331
billion, according to the Congressional Budget Office. But under some
plausible assumptions about congressional budget-making, America's
deficits will average about 3.5% of GDP over the next decade, estimate
William Gale and Peter Orszag of the Brookings Institution.†[2]
By 2014, they project, America's public debt will amount to 55% of its
GDP. By 2030, on present trends, debt could reach 139% of GDP.
How much will this matter? Messrs Gale and Orszag think that chronic
deficits will eat away at the pillars of American prosperity like
"termites in the woodwork", as Charles Schultze, former chairman of
the Council of Economic Advisers, once put it. The coming decade of
big deficits will reduce national saving by 2-3% of GDP. As a result,
American households will accumulate fewer assets, yielding
$1,500-3,000 less income a year.
The deficits serve only to divert resources from investment to
consumption, they argue. When taxes are cut, households spend up to
80% of the proceeds, they find. But this extra consumer demand must
compete with other claims on a fully employed economy. In their view,
extra household spending crowds out investment, dollar for dollar.
Ah, a Keynesian might ask, but what if the economy is not fully
employed? Then, says Mr Galbraith, a budget deficit adds to demand in
the economy, bringing into play labour and capital that might
otherwise have lain idle. These resources might not be put to their
best use, to be sure; but what matters is that they are put to some
use. The economy is bigger as a result, so even if the deficit reduces
investment's share of GDP, it might (at least in principle) raise the
actual amount of investment that takes place.
Few could disagree with this logic: it is the basic case for a
counter-cyclical fiscal expansion. Even the administration's critics
concede that its 2001 tax cuts were impeccably timed (if fortuitously
so), boosting consumer demand at a time when many workers were at risk
of forced idleness. But as the economy nears full employment, those
same critics believe, budget deficits become more damaging.
DOOM OR VERDOORN?
Mr Galbraith thinks otherwise. America's sustained deficits will help
it outgrow the liabilities they leave in their wake, he believes. And
if that fails, they will help inflate those liabilities away. As an
economy approaches full employment, any fiscal stimulus is dissipated
by higher prices. In this case, the stimulus may add nothing to real
GDP. But, Mr Galbraith points out, it still adds something to nominal
GDP. This will ease the government's debt burden, since it is out of
nominal GDP that the government must repay the nominal claims held by
its creditors.
Inflation, like devaluation, is a tried and tested way for an indebted
government to escape its obligations. It is because it is so tempting
that macroeconomic stability is so hard-won and so easily lost. It may
be true, as Mr Galbraith suggests, that America would rather let its
inflation rate multiply than its debt-to-GDP ratio explode. But why
would anyone want either?
In fact, Mr Galbraith is confident that a sustained fiscal stimulus
will yield more than just inflation. When demand is strong, innovation
quickens, he argues. He cites Verdoorn's law, named after the Dutch
economist Petrus Verdoorn, which holds that the pace of productivity
growth picks up as the economy nears full capacity. If a government
deficit adds to the demands on an economy at full stretch, the economy
may find ways to stretch a little further.
There may be a grain of truth to this observation. But Mr Galbraith
presumably does not believe in a world without any supply-side
constraints, in which the only check on the ingenuity of the American
economy is the timidity of its fiscal authorities.
In so far as there is any truth in Verdoorn's law, its practical
implications are more modest. It suggests that America's policymakers
must test the economy's limits before they can know precisely where
they lie. The American economy might, for example, learn to cope
surprisingly well with a tight labour market, as it did in the late
1990s. At that time, the Federal Reserve seemed to take the view that
faster productivity growth had allowed the unemployment rate
consistent with stable inflation to be temporarily reduced. More
generally, the Fed knows that it cannot be quite sure exactly where
America's natural rate of unemployment and its neutral rate of interest lie.
But if the Fed can be trusted to explore the economy's limits and
respect them, Congress cannot. Fiscal policy is made in a spirit of
political point-scoring, not macroeconomic inquiry. Given too much
licence to roam, Congress would soon reach the economy's outer
frontiers--and carry right on over the edge.
* "Breaking Out of the Deficit Trap: The Case against the Fiscal
Hawks[3]". The Levy Economics Institute. June 2005
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† "Budget Deficits, National Saving, and Interest Rates[5]"
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[1] http://www.economist.com/#footnote1
[2] http://www.economist.com/#footnote2
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Jim Devine "Segui il tuo corso, e lascia dir le genti." (Go your own way and let people talk.) -- Karl, paraphrasing Dante.