Fiscal Fantasyland

March 10, 2025

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Based on President Trump’s first six weeks in office, I would say that he has yet to make the transition from campaigning to governing. He is a pretty effective campaigner, for those who can stomach his incessant lying, self-aggrandizement and ugly attacks on opponents. But he is not yet serious about addressing the country’s domestic issues, especially the serious decisions it faces about taxing and spending.

The President’s recent address to Congress was his typical campaign stemwinder, full of bluster and bombast but largely devoid of realism or reasoned argument. On fiscal matters, it repeated the kind of campaign promises one might expect from a campaigner who has not yet had to confront fiscal realities.

First, he would like to make his 2017 personal income tax cuts permanent. The cuts were unpopular at the time because the benefits went mainly to the wealthiest taxpayers. Congress set them to expire after eight years to soften their impact on the ten-year debt projections that accompany every budget. The annual deficits and cumulative debt shot up anyway, but Congressional Republicans have always been determined to continue the cuts, come what may.

On top of the 2017 tax cuts, Trump would like to add trillions of dollars in additional cuts. These include deductions for tip income, overtime pay, Social Security income, and interest payments on car loans for American-made cars, plus restoration of the unlimited deduction of state and local taxes and another reduction in corporate taxes. Despite the lost revenue from all those tax cuts, Trump promised to balance the federal budget “in the near future.”

Sounds fantastic—more tax cuts and a balanced budget! But beware—“fantastic” is the adjective form of the word “fantasy.” Republicans cheered the address, especially when they heard the words “balanced budget.” But they know that they have no intention of passing anything close to that. Their own proposals would take the country in the opposite direction, toward larger deficits and more debt. In fiscal fantasyland, we can cut all the taxes we like, but then balance the budget quickly and rather painlessly. We just need to crack down on “waste, fraud, and abuse,” to use one of the political campaigner’s favorite phrases. Right-wing politicians love to portray the federal government as an overfed animal that would benefit from an austerity diet. Promoting that image is a good way to get people to hate their own democratic government, the government that wastes their money without working very well for them. Leaders who make a big show of fighting waste establish their fiscal virtue, which then gives them a license to cut more taxes. But the adjective form of “license” is “licentious,” defined as “lacking legal or moral restraint.” Isn’t there something licentious about the glee with which the world’s richest man takes a chain saw to our government agencies, so that we can pretend to afford more tax breaks for people like him? Does it really matter to him how much of the alleged waste is real, as long as the show goes on?

Stubborn facts

Those of us who are wary of fiscal fantasies and struggle to live in the real world must acknowledge some stubborn facts.

When tax cuts exceed spending cuts, deficits and debt go up.

The 2017 tax cuts added several trillion to the national debt, and making them permanent would add several trillion more. That’s why Republicans who voted against raising the debt ceiling during the Biden presidency have done a 180-degree turn and are now supporting it. Including any of Trump’s additional tax cuts would further widen the gap between revenue and spending.

So-called “supply-side” economists used to argue that tax cuts pay for themselves by stimulating economic growth and expanding the tax base. Economists have found this effect to be too small to offset the impact of tax cuts on deficits and debt.

Tax-cutters have also held out the hope that the cuts will force Congress to enact offsetting spending cuts. In fiscal fantasyland, Congress can cut taxes first and leave spending cuts to the imagination. In reality, the imagined cuts usually turn out to be too small to make much difference or too unpopular to be carried out. The spending cuts proposed by the House budget resolution are less than half of their proposed tax cuts.

The savings from fighting “waste, fraud and abuse” are disappointing.

Everyone is against “waste, fraud and abuse,” but finding enough of it to offset massive tax cuts has proven to be very hard. Trump claimed in his address that Elon Musk’s Department of Government Efficiency—itself a fantasy department with no basis in law—has already found “hundreds of billions of dollars of fraud.” He must have pulled that number out of thin air, since DOGE’s announced savings at that point were less than ten billion, and that included many jobs and contracts terminated without any charges of fraud. Trump’s equally fanciful claim that millions of dead people receive Social Security checks has been thoroughly investigated and debunked.

Even when fraud is real, the government is often the victim rather than the perpetrator. Defense contractors inflate costs; medical providers file Medicare claims for services they did not actually provide; taxpayers cheat on their tax returns. Taking on the private interests that rip off the government is hard, and firing federal workers usually won’t help. In some cases, adding workers is more productive, such as IRS auditors to catch more tax cheaters.

The DOGE firings and contract terminations are a kind of budgetary side show anyway, since they try to stop agencies from spending money Congress has already allocated. That’s one reason they are facing so many legal challenges. What matters more is what spending cuts Congress is willing and able to write into law. Of course we want our government agencies to be more efficient, but we can achieve that only by careful program evaluation and innovation, not by eliminating workers and contracts indiscriminately. Overly hasty cuts undermine worthy goals, such as medical research, clean energy initiatives, airline safety, global disease prevention, services to veterans, and consumer protection. Every program that benefits a sizable segment of society has its vigorous defenders.

Offsetting large tax cuts is hard without cutting federal insurance programs.

One reason why spending cuts save so little is that they focus on such a small segment of the total budget. The budget cutters go after nondefense discretionary spending (only 14% of the budget), especially what is paid to the civilian labor force (only 5%). Defense spending is larger, but there the administration is sending mixed signals. The President and his Defense Secretary call for spending reductions, while the House budget resolution proposes an increase.

The rest of the big bucks are in the large federal insurance programs, particularly Social Security, Medicare, and Medicaid. Although Congressional Republicans are reluctant to call attention to it, their budget plan calls for the committee overseeing those programs to find large savings there. According to the Congressional Budget Office, they cannot meet their tax-reduction and debt-ceiling targets without looking there.

Medicaid seems most vulnerable to cuts, since it serves a lower-income—and politically less powerful—constituency than Social Security or Medicare. But cutting it would be politically unpopular, since it serves a large portion of the nation’s children, elderly residents of nursing homes, and the disabled. Medicaid payments also keep many rural hospitals in business. Cutting Medicaid would give credence to the charge that Republicans want to cut benefits to the poor to give tax cuts to the rich.

Social Security and Medicare are a different matter, since they are funded by payroll taxes. Some reform is inevitable, to deal with a potential revenue shortfall as the retired population grows. But cost savings should go to keep the programs solvent, not to justify or fund cuts in income taxes.

The federal safety net is popular and necessary.

One may ask why the citizens of one of the richest countries in the world rely so heavily on federal insurance programs to make ends meet. Part of the answer is that the United States has a weakly organized working class and an embarrassing number of jobs with low wages and no benefits. Far too many Americans lack the means to pay for their own health insurance or save for their own retirement. Critics may worry that Americans are too dependent on government, but that may be the flip side of the economic power and privilege at the top. We expect privileged taxpayers to share some responsibility for the wellbeing of the whole society. At least some of us still do.

Let the tax cuts expire

The first step out of fiscal fantasyland is to question whether the country can afford letting the 2017 tax cuts continue. In both 2017 and 2025, the Trump administration inherited a growing economy that did not need that stimulus.

But tax cutting remains the top priority for Republicans, no matter how much they talk about deporting immigrants, fighting inflation, eliminating DEI programs, or anything else that appeals to the MAGA base. With Republicans in charge of the government, the fiscal dilemma is their dilemma. Unless they change their tax-cutting ways, they must either vote for the debt increases they claim to hate, or cut programs that Americans want, or both. No wonder they would rather live in fiscal fantasyland.

I should add that I am not really a deficit hawk, since in recent years the economy has handled federal deficits better than many economists expected. Nevertheless, the debt does have some downsides., especially for government itself. It forces the government to devote a big chunk of its budget to paying interest instead of providing services. And it gives conservatives an excuse to go on periodic cost-cutting rampages that can do more harm than good. That’s what I believe we are seeing now.

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Posted by Ed Steffes

An Economic Case for Building Back Better

May 3, 2021

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Last week, in his first address to Congress, President Joe Biden defended the three legislative initiatives in his “Build Back Better” program. So far at least, the response from the public has been mostly positive. Yet Congressional Republicans seem united in their opposition, leaving the fate of two of the proposals in some doubt. Here I will give a brief overview of the plans, describe how the President intends to pay for them, and discuss some of the pros and cons of implementing them. On balance, I think that the proposals would help rather than hurt the economy.

The Biden plans

The American Rescue Plan is the $1.9 trillion COVID relief and stimulus package that President Biden has already signed into law. It passed Congress very narrowly, without Republican support. Senate opponents could not filibuster the bill because it qualified for passage under budget reconciliation rules.

Included in the plan are direct stimulus payments to households, extended unemployment benefits, a continued moratorium on home evictions and foreclosures, an increased child tax credit (fully refundable for families too poor to pay income taxes), assistance to state and local governments, assistance to schools trying to reopen, and subsidies for COVID vaccination and testing.

The American Jobs Plan is a $2.3 trillion plan to improve infrastructure and create jobs. Some of it relates to infrastructure in the traditional form of roads, bridges, airports, railroads and waterways. It also addresses “community infrastructure”—such things as new schools, VA hospitals, affordable housing, clean drinking water, broadband access for all communities, power grid modernization, and support for energy efficient homes and new sources of energy like wind turbines and charging stations for electric vehicles.

The plan also addresses manufacturing and workforce development, including government investments in research and development, which Biden noted has declined from 2% of GDP to less than 1%. It would also support new jobs in the area of home and community-based care for the elderly and disabled.

Biden defended the plan as an exercise in “public investment,” doing things that only government can do. Private firms will do what is profitable, but they don’t do as good a job providing goods and services that benefit the entire society without regard to ability to pay, such as public education or clean water. The low wages and shortages of eldercare workers suggest a public need greater than the private market can meet.

The American Families Plan is a $1.8 trillion plan to address the health, education and wellbeing of families. It includes $800 billion in tax cuts, especially an extension of the rescue plan’s child tax credit for four additional years. This is intended to cut child poverty in half.

The plan also enables each child to obtain four more years of free public education, two in the form of free preschool and two in the form of free community college. It subsidizes high-quality affordable child care, with payment caps for parents adjusted for income level. It finally does what other industrial countries do, moving from unpaid to paid family and medical leave. The plan makes changes to the Affordable Care Act, lowering deductibles and prescription drug costs, and allows Medicare to negotiate lower prescription drug prices with pharmaceutical companies. As it is, American often pay more than people in other countries for the same drugs, at least partly because the power of large drug companies is not challenged by the countervailing power of government.

Whether they pass Congress this year or not, these plans represent a fundamental reversal of the trend to disparage and reduce the role of government in the economy and society. Although the current national situation is not as dire as the Great Depression, the proposals are already being compared to those of Franklin Roosevelt and the New Deal.

Economic costs and benefits

The goals of these plans are fairly popular. Most of the debate over them concerns their economic implications. Democrats say they will help the economy, while Republicans claim they will hurt the economy. Who has the better argument?

The American Recovery Plan is very different from the other two plans because of its obvious benefits and costs. It is responding to a national emergency, but since it is not paid for with new taxes, it does add to the federal deficit, a potential burden on future taxpayers. Last year’s deficit was already $3.1 trillion, or 15.2% of GDP, the largest percentage since 1945.

However, I am not losing too much sleep over that, for two reasons. By its very nature, emergency spending is mostly temporary. But also, deficits and debt normally rise during economic contractions and fall during economic expansions. At the end of World War II, the deficit was 21% of GDP, and the accumulated public debt was 106% of GDP. By the early 1960s, the deficit was down to zero—the budget was balanced—and by 1974 the public debt had fallen to 23% of GDP. The postwar economic boom had boosted GDP and tax revenues, and made the debt relatively smaller and more manageable. Similarly if less dramatically, economic growth in the 1990s eliminated what had been a 5% deficit and brought public debt down from 48% to 32% of GDP. Deficits and debt do matter, but so do economic stimulus and economic growth.

The Jobs Plan and the Families Plan are in a different category, because the President proposes to pay for them by undoing some of the Trump tax cuts on corporations and the wealthy. To the extent that we do that, the plans have the potential to stimulate growth without adding to deficits and debt. Biden would increase the corporate tax rate from 21% to 28%, which is still lower than the 35% rate before the 2017 tax cut. He would also impose a 15% minimum rate to stop corporations that have been using tax loopholes to avoid taxes altogether. The Biden plan would go back to taxing personal income over $400,000 at 39.6%, the top-bracket rate before Trump reduced it to 37%. That would affect only the richest 1% of taxpayers. Finally, the plan includes a higher capital gains tax for millionaires. The tax cuts of 2017 did not turn out to be very popular, and a majority of Americans support these increases.

A principal economic argument for these two plans is that the increased spending will stimulate the economy and create more jobs than the 2017 tax cuts did. Government purchases of goods and services boost GDP directly because they are a component of national spending. They also have a multiplier effect, where each dollar spent grows the economy by more than a dollar. Tax cuts, on the other hand, only increase the demand for goods and services to the extent that the increased disposable income is spent rather than saved. As Krugman and Wells say in their macroeconomics text, “In general,…a change in government transfers or taxes shifts the aggregate demand curve by less than an equal-sized change in government purchases, resulting in a smaller effect on real GDP.” Furthermore, the tax cuts that are in Biden’s plans put money in the hands of ordinary families who are more likely to spend it, rather than wealthy families who are more likely to add it to savings. Increasing the child tax credit should boost GDP more than cutting capital-gains or inheritance taxes.

In addition to short-term economic stimulus, the Biden plans are investments in future growth. Addressing our neglected infrastructure, our research and development needs, and our transition to new sources of energy should be good for the economy in the longer run. So should the investments in human capital through wider access to preschool and college education. Addressing parental needs with paid leaves and subsidized child care makes it easier for people to combine parenting with paid employment, adding to the nation’s economic output and income.

Opponents of the plans are almost forced to argue for some form of “trickle-down” or “supply-side” economics. They must claim that low taxes on the wealthy are better for the economy than the proposed government spending. In theory, low taxes on corporations and the wealthy can stimulate the economy from the supply side by making more money available for private investment. Then the benefits trickle down to the rest of us. But that is a tough argument to support when the wealthy are already riding high and the interest rates on funds for investment are already at historic lows. There seems to be no shortage of funds to invest; what is lacking is business confidence because of sluggish growth and weak economic demand. That’s probably why trickle-down economics has not been working and the Trump tax cut was such a fizzle. The tax revenue that we lost by cutting taxes on the already-rich could be better spent “growing the economy from the middle out,” as President Biden said.

Another objection to the plans is that they could produce too much demand-side stimulus and runaway inflation. That is not impossible, and the day may come when we need to cool the economy by raising interest rates or cutting spending. But such policies seem premature when 6% of the workforce is unemployed, many others have dropped out of the labor force, and the economy is running below capacity. Turning from government stimulus to austerity prematurely was the mistake the US and many other countries made back around 2010, when we were still recovering from the last recession.

The Republican alternative

This section can be brief, since Republicans are proposing very little except to keep taxes low and avoid increases in domestic spending. In the official Republican response to the Biden address, Senator Tim Scott rejected all three of Biden’s initiatives, but based his position on worn-out slogans rather than economic arguments.

Senator Scott characterized the American Rescue Plan as a “partisan bill,” ignoring the fact that it is supported by about three out of four Americans. He suggested that it wasn’t needed because Biden had inherited an improving situation from his predecessor. America had already “rounded the bend” on the pandemic and the associated recession.

Scott described the American Jobs Plan as mostly “big government waste,” since only a small part of it involved traditional transportation infrastructure. Either Republicans believe that broader objectives like power-grid modernization and broadband access are a waste of money, or they think the private market will do the job alone. As for the taxes to pay for the plan, he called them “job-killing tax increases,” refusing to acknowledge that the additional tax revenue would be used to create jobs. Republicans want us to believe that tax cuts for the wealthy grow the economy more than spending to address majority needs, but the economic evidence does not support that. Basing policy proposals on facts is not something that Republican leaders have excelled at lately.

Scott dismissed the American Families Plan as an effort to put “Washington in your life from cradle to college.” I wonder how many of today’s struggling families would rather keep the government out of their lives than accept free preschool and community college, affordable child care and paid parental leave, not to mention more established programs like Social Security and unemployment compensation.

Having dispensed with Biden’s proposals with a few derogatory remarks, Senator Scott turned to pleasing the Republican base by arguing that America is not a racist society, and that Republicans really support making it easier to vote, just not to cheat. He didn’t explain why cheaters are so much harder to find than eligible voters standing in long lines in poor urban precincts.

For the last forty years, Republicans have been promoting the same one-size-fits-all economic policy. Always cut taxes, in good times and bad; and always call for domestic spending cuts, even if the actual cuts suggested are too unpopular to be passed. Blame the resulting deficits on “tax and spend” Democrats, not on “don’t tax but still spend” Republicans. Offer few constructive proposals for addressing national problems. Instead, deny the problems or blame them on vague conspiracies, trust the markets, and claim you are saving America from the tyranny of liberal elites and the Deep State. Our politics and policies have served the few better than the many, left the economy with sluggish and erratic growth and the worst inequality since the Gilded Age, and neglected many pressing national needs. The case for a new national direction is strong.

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Posted by Ed Steffes

Arguing with Zombies (part 2)

April 7, 2021

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Many of Paul Krugman’s essays deal with the need to combat economic recession by basing public policy on sound economic ideas. Here is where the zombie ideas that “should have been killed by contrary evidence” do the most mischief. Occasionally his arguments get a little technical, but overall he does a good job of explaining his ideas in pretty plain English, and he puts warning labels on his more “wonkish” essays. One essay—his discussion of the determinants of interest rates—sent me scurrying to his macroeconomics textbook for a more thorough explanation.

Interest rates and monetary policy

The most technical essay in the collection describes the “IS-LM” economic model, where IS stands for the relationship between investment and savings, and LM stands for the relationship between liquidity preference and money supply. It is a macroeconomic model describing relationships among some of the most important variables in the economy.

In Krugman’s formulation, the IS-LM model is a way of reconciling two different views of how interest rates are determined. Interest rates are, of course, crucial to the workings of a capitalist economy because interest is the price of financial capital. Businesses pay interest when they borrow money to finance business expansion, and so do consumers when they finance major expenditures. Both views of interest rates rest on the laws of supply and demand as applied to money. We start with the idea that the price of anything varies directly with the quantity demanded and inversely with the quantity demanded. Low prices increase the quantity demanded and discourage the quantity supplied, while high prices do the opposite. In theory, the price mechanism brings supply and demand into balance, making transactions acceptable to both parties.

How does this apply to the interest rate, which is the price of money? The two approaches focus on different forms of money. The first view of how interest rates are determined is the “loanable funds” approach. It says that interest rates are determined by the supply of savings and the demand to use those savings for investment spending. The interest rate has to balance the desire of savers to earn a high return against the desire of borrowers to obtain funds at a reasonable cost. In this context, think of the borrower as a company borrowing to finance business expansion.

The second view of how interest rates are determined is the “liquidity preference” approach. It focuses on the supply and demand of “money”, meaning liquid forms of money like the cash in your wallet or your checking account, which is earning little or no interest. Here we have something of a riddle. How can the interest rate be the price of money for money that earns no interest? In this case, the interest rate is the opportunity cost of money, the price you pay for keeping money in cash instead of loaning it out at interest. The higher the interest rate, the higher the cost of liquidity and the lower the demand for liquidity. In this approach, the supply of money is a simpler concept, since it is just the money placed in circulation by the central bank, which controls the national money supply. The balancing of supply and demand in the money market is not just a matter of reconciling the wishes of buyers and sellers, or of lenders and borrowers. It is a matter of reconciling the conflicting desires of anyone with income—the desire for both money to spend and money to lend. Too much liquidity and spending, and interest rates must rise to attract more money into lending. When the desire to save and lend is very high, interest rates can fall, bringing down the opportunity cost of liquidity.

Can the two approaches be reconciled? Yes, because interest rates balance supply and demand in both the loanable funds market and the money market, the two being interconnected. Suppose the Federal Reserve deliberately increases the money supply—we won’t worry about exactly how—in order to stimulate the economy. That lowers interest rates, encouraging businesses to borrow for expansion. That in turn increases production and national income, which increases the supply of loanable funds when people save some of the increased income. Krugman’s Macroeconomics (with co-author Robin Wells) says, “As a result, the new equilibrium rate in the loanable funds market matches the new equilibrium interest rate in the money market….” The two approaches are focusing on different sides of one adjustment process.

To return to Arguing with Zombies, The IS-LM model synthesizes both approaches by relating both markets to the Gross Domestic Product. The balancing of investment and savings in the loanable funds market implies a negative (inverse) relationship between interest rates and GDP. Low interest rates encourage businesses to borrow for investment, and investment spending contributes to GDP. This can also be looked at the other way around, since high GDP means high incomes, and high incomes provide the supply of savings for investment, which holds interest rates down. This negative relationship between interest rate and GDP is described by the downwardly-sloping IS curve on a graph plotting interest rate on the vertical axis and GDP on the horizontal axis.

However, the balancing of supply and demand in the money market implies a positive (direct) relationship between interest rate and GDP. A growing economy with higher GDP increases the demand for money to spend rather than save, especially if wages and prices are rising. That tends to push interest rates up. That is represented graphically by an upwardly-sloping LM curve, based on the dynamics of liquidity preference and money supply. Put the IS and LM curves on the same graph, and “the point where the curves cross determines both G.D.P. and the interest rate, and at that point both loanable funds and liquidity preferences are valid.”

The IS-LM model is useful for understanding the effects of monetary policy. If the Federal Reserve increases the money supply, that tends to reduce interest rates, stimulating the economy by encouraging borrowing for investment. As long as prices are “sticky”—that is, they react slowly to the increased spending—the IS effect can predominate, and the economy can move to a new equilibrium at higher GDP. But when and if prices rise, the increasing demand for money may force interest rates back up (and eventually GDP back down). Monetary policy can have a stimulating effect, but mostly in the short run.

The analysis does get very technical, but it’s important because it supports some of Krugman’s main conclusions. One is that more than one relatively stable point of equilibrium is possible. Another is that a particular equilibrium does not always represent the most desirable state of affairs, such as full employment with inflation under control. Nations can and do make political choices that affect economic outcomes, for better or for worse. An economy can remain in a less than ideal state for a long time, if the wrong political choices are made.

When an economy is in recession, most economists support an expansionary monetary policy, and some advocate it to the exclusion of fiscal policy (deficit spending by government). However, Krugman emphasizes the limitations of monetary policy in his many discussions of the 2007-2009 recession and the economy’s long recovery. For one thing, the benefits of monetary policy tend to be short-term, easily undone by longer-term rebalancing, as described above. And monetary policy becomes ineffective or even counterproductive once interest rates fall to near zero, as they did during the 1930s, after the 2008 financial crisis, and again in 2020. Then the economy may fall into a “liquidity trap,” where people are hoarding cash because they have no financial incentive to lend. If things reach that point, it’s a sign that economic demand is really depressed. Companies are reluctant to borrow for expansion not because interest rates are too high, but because they don’t see a good market for more of their product. What the economy needs is not looser monetary policy, but aggressive fiscal policy—especially more government spending.

Fiscal policy

Many people, including many political leaders, make the mistake of describing an economy as if it were an individual household, always benefiting from spending no more than it receives in income. Statements like, “People are having to tighten their belts, so the government should tighten its belt too” epitomize that kind of thinking. But in the economy as a whole, everyone cannot run a budget surplus at once; my surplus is someone else’s deficit, and my spending provides someone else’s income. If everyone tries to cut spending at the same time, they just reduce overall production and income. Government is a big player in the economy, and it can help the economy by increasing spending when others are cutting theirs.

Economists have found relationships between GDP, unemployment, and government fiscal policy. Okun’s law states that unemployment varies inversely with GDP. A reasonable rule of thumb is that GDP must go up at least 2% to reduce unemployment by 1%. In our $21 trillion economy—I am updating the number from Krugman’s book—that would mean increasing GDP by $420 billion for each 1% desired drop in unemployment. Fortunately, government spending has a multiplier effect, which Mark Zandi has estimated at 1.5. That means that a mere $280 billion increase in spending should increase GDP by $420 billion and reduce unemployment by 1%.

What about tax cuts? Estimates of their stimulus effects vary, but most estimates put the multiplier at no more than 1.0. In general, a tax cut will stimulate the economy less than a spending increase of the same size, especially if it puts more money into the hands of people who are sitting on cash already. Krugman argues that the Obama stimulus package was less effective than it could have been because it relied too much on tax cuts in order to win conservative votes. It was an economic success anyway, reversing the downslide and saving millions of jobs. Yet Republicans turned it into a political liability for Democrats by declaring it a failure and blaming it for the sluggishness of the economic recovery. That set the stage for Donald Trump, who described the economy as a disaster and proposed even more tax cuts as the solution.

As I noted in the last post, Krugman calls the Trump tax cuts “the biggest tax scam in history.” He says that the “core of the bill is a huge redistribution of income from lower- and middle-income families to corporations and business owners.” He sees it as a continuation of standard Republican policy of cutting taxes mainly for the rich, and then using the fear of excessive government debt as an excuse to cut spending on the social safety net. But more to the point of fiscal policy, he describes the Trump tax cut as a “fizzle” because it didn’t produce the promised boom in investment. Corporations did not use very much of their tax cut to add jobs and productive capacity. What was holding them back was not a shortage of capital, but a lack of market demand for their products.

Krugman wrote the essays in this book before President Biden proposed his $1.9 trillion Covid Relief plan. He has written about it elsewhere, however, such as here. If the estimate based on Okun’s law is at all correct, and it takes only a $280 billion stimulus to reduce unemployment by 1%, we can understand why some economists regard $1.9 trillion as stimulus overkill. Unemployment is currently around 6%, and economists doubt that we can get it down below a “natural” level of 4 or 5% without risking runaway inflation. Krugman acknowledges the “good-faith criticism coming from people who actually have some idea what they are talking about, as opposed to the cynical, know-nothing obstructionism that has become the Republican norm.” Nevertheless, he defends the plan, for two reasons. First, he compares it to fighting a war, when a country just has to spend what it takes now, and worry about the costs later. World War II spending brought us high taxes and inflation, but it also won the war, ended the Depression, and sparked the postwar economic boom. Second, he thinks that the plan’s price tag may exaggerate its actual stimulus, since a lot of the cash benefits will probably be saved by households and state or local governments rather than spent or invested.

The price of debt

How much of a problem are budget deficits and the rising national debt for the future economy? Krugman steers a middle course between minimizing and exaggerating their effects. He reserves some of his harshest criticism for politicians who do both, minimizing their own deficits and attacking those incurred by the other party.

First, the good news. The rate of interest on government debt is normally lower than the growth rate of the economy. That means that even if debt is rising in absolute dollar terms, it can shrink as a percentage of GDP. If the government runs a deficit when interest rates are especially low, and if deficit spending stimulates economic growth, the country can come out ahead. This is exactly what happened to the debt accumulated by the end of World War II. “When and how did we pay it off? The answer is that we never did. Yet…despite rising dollar debt, by 1970 growth and inflation had reduced the debt to an easily handled share of G.D.P.” Krugman calls this “melting the snowball.”

Some economists warn that deficit spending can undermine growth by raising consumption but lowering investment. All that government borrowing siphons off resources that could have been used for private investment. But that argument is least relevant in times of recession, when companies aren’t investing enough anyway, and a boost in consumption is what the economy needs to get it moving. When the economy is running at full capacity, government has to be more careful about borrowing too much.

Krugman acknowledges that debt can become too large under unusual circumstances. He uses an example where the national debt is 300 percent of GDP, and the interest rate is 1.5 percent above the economic growth rate. Then in order to keep the debt-to-GDP ratio from spiraling out of control, the government would have to run an annual surplus of at least 4.5 percent of GDP. That would require politically difficult tax increases or benefit cuts. Right now the debt-to-GDP ratio is about 130% of GDP. Reinhart and Rogoff argued that anything over 90% is a big problem, but other economists have been unable to verify that conclusion.

Finally, Krugman distinguishes among different kinds of expenditures proposed by progressives. First are expenditures that can truly be regarded as public investments, such as infrastructure improvements. He is least worried about paying for them because they should boost future productivity enough to pay for themselves in economic growth and higher tax revenues. “If you can raise funds cheaply and apply them to high-return projects, you should go ahead and borrow.” His second category includes projects where “the sums are small enough that the revenue involved could be raised by fairly narrow-gauge taxes,” like the taxes imposed to pay for Obamacare. These too are easily justified as fiscally responsible. His third category is a “major system overhaul,” such as replacing all private health insurance with Medicare. That type of expenditure could not be undertaken without convincing the public that the gains in universal access and efficiency are worth the additional taxes.

Notice that Biden’s infrastructure proposal, although very costly, falls into Krugman’s first category, the kind of expenditure we shouldn’t worry about paying for. But Biden does propose to pay for it, by reversing some of the tax cuts on corporations and the wealthy. No doubt, opponents will try to argue that such tax increases hurt the economy more than infrastructure spending helps it, but they will not have the evidence on their side. Krugman is especially upset that we have let infrastructure spending fall to historically low levels, when it is one of the best investments a society can make.

Continued

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Posted by Ed Steffes

Forty Years of Reaganomics

July 18, 2018

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When he was running for president in 1980, Ronald Reagan used to ask his audiences, “Are you better off than you were four years ago?” If they were tired of high gas prices, double-digit inflation, and the Iranian hostage crisis, then voters should choose him over the incumbent, Jimmie Carter.

Reagan’s primary domestic policy aim was to shrink the size of government by cutting taxes, spending, and regulation. If only the government would get out of the way, so the theory went, the private sector could flourish. Although Democrats haven’t always gone along with this agenda, Republicans have had their way often enough to bring about a new era of low taxes and limited government. Even Bill Clinton agreed that the era of Big Government was over. Despite all the talk about how Donald Trump is somehow less Republican or less conservative than his predecessors, his tax, spending and regulatory proposals are right out of the Reagan playbook.

Now that almost forty years have passed since the “Reagan revolution,” we may well ask, “Are we better off than we were forty years ago?” I would like to make a modest contribution to an answer by looking at some of the macroeconomic indicators I have been discussing in recent posts. In order to make it easier to compare statistics across the years, I will express the various indicators as shares of gross national income (GNI) when discussing income, or as shares of gross domestic product (GDP) when discussing expenditures. The difference between GNI and GDP is relatively small and should not create any confusion in this discussion. (See my previous discussion of macroeconomic indicators, especially part 2 and part 3.)

Taxes

National income can go to pay taxes, to consume goods and services, or to save, as expressed in the equation GNI = T + C + S. Tax cuts increase the disposable income available for consumption and saving. Generally, more of that increase goes into consumption than into saving. Since consumption is the largest component of GDP, tax cuts raise what is spent on production. That effect includes a multiplier effect as the increased GDP creates additional income and consumption.

[One technical note: In the national accounting system, the T stands for taxes net of transfer payments, which are payments from the government to its citizens. Payroll deductions for Social Security are taxes and count toward T, but Social Security checks are transfer payments and count against T.  The “tax cuts” discussed here could include some increases in transfer payments, but those too would increase disposable income.]

Before the Reagan election in 1980, taxes had been taking about 17-20% of national income. That includes all kinds of taxes—income, sales, payroll, property—and all payers, personal or corporate. Congress passed substantial tax cuts during the administrations of Ronald Reagan, George W. Bush, Barack Obama and most recently Donald Trump. The national tax rate dropped from about 18% to 16% by the end of the Reagan and Bush administrations (1992); then to 14% by the end of George W. Bush’s first term (2004). Then came the global financial crisis and the Obama stimulus package, which lowered taxes briefly to 10% of national income. Now the rate is 12%, which reflects the economic recovery and some initial effects of the Trump tax cuts.

The rate of consumption has risen accordingly, whether calculated as a percentage of GNI or of GDP. It was running about 60-61% of GDP before 1980, but it is up to 69% now. That is well above the rate of most wealthy countries. It reflects the fact that we have become a relatively low-tax nation, with a high priority on the purchase of private goods and services.

Some of that increased consumption has gone into imported goods. We were running small trade surpluses in the 1960s, but the higher price of oil helped produce trade deficits in the 1970s. In the era of lower taxes since 1980, imports have grown dramatically. The trade deficit as a percentage of GDP peaked before the global financial crisis of 2007, but has settled back to about 3% recently.

The federal tax cuts have also made the tax code less progressive, so that the wealthy have benefited more than the middle class. Lower taxes give business owners and managers more incentive to claim a higher share of profits for themselves, since the government lets them keep more of their gains. The distribution of both pre-tax and after-tax income has become more unequal during these years.

Government spending

Another goal of Reaganomics was to reduce government spending. That meant especially domestic spending, since military spending was to be kept high. That task proved to be more difficult and contentious.

Although cutting taxes and cutting spending may seem to go together in a program to shrink the size of government, they are quite different matters. Spending changes can actually have a bigger effect on GDP than tax changes, and the effect tends to be in the opposite direction. That’s because government spending has a direct positive effect on GDP. It counts as spending on productive economic activity. Then, by affecting income, it has multiplier effects on consumption as well. Spending cuts lower GDP, other things being equal. Tax cuts raise GDP, but only indirectly through the disposable income that goes into domestic spending rather than spending on imports or saving for the future.

Recall the equation: GDP = C + I + G + NX.
(Gross Domestic Product = Consumption + Investment + Government Spending + Net Exports)

Government spending is a component of GDP. But taxes only effect GDP through their indirect effects on consumption and net exports.

That means that if Americans are willing to incur an additional $100 billion in the annual deficit, increasing spending has a lot to be said for it instead of cutting taxes. The overall effect on GDP should be greater, and the mix of public and private benefits may add to the quality of life. Cutting taxes increases spending on private goods, but raising spending provides public goods (that’s what government spends on) and private goods too (through the effect on income and consumption).

In any case, Republicans wanted to shrink government, not expand it, and they had some success in cutting domestic spending. Before 1980, government spending was running at 21-24% of GDP, but now it is down to 17%. (Part of that drop, but only part, is a consequence of using percentages to measure the changes. If one component of GDP increases its percentage share, others must go down, other things being equal. Here C went up and G went down, but neither change was just a mathematical adjustment to the other.) We know from the increased deficit that taxes have been cut more than spending. And since consumption has risen substantially, it’s safe to say that the big tax cuts increased GDP more than the spending cuts lowered it.

Saving and investment

Another goal of Reaganomics was to increase saving and private sector investment. Tax cuts would give people more money to save as well as consume, and strong consumer demand would encourage the investment of those savings in business expansion. Economic growth should remain strong, since the rising investment component of GDP would offset the falling government component.

Some of the consequences of fiscal policy flow from well-established economic principles, such as lower taxes—>higher disposable income—>higher consumption. But higher investment does not automatically follow from lower taxes. It depends on whether businesses find the economic demand sufficient to justify expansion. For example, airlines will meet the demand for more air travel by filling empty seats before they will invest in new planes. Businesses invest more when they anticipate a strong market for their expanded production.

I do not see in the macroeconomic indicators a surge of saving or investment since 1980. Before then, saving was running at about 19-22% of national income, while investment was in the range of 16-18% of GDP. Reaganomics got off to an auspicious start, with saving up to almost 23% and investment up to 20% by the end of Reagan’s first term. But since then, saving and investment have generally been no higher than they were before. Saving is now at 19% of GNI, and investment is at 17%.

I’m not sure why the desired surge of investment did not occur, but here are a few possibilities. Some of the increased consumer demand has gone to support foreign production, which made domestic expansion less necessary. The Federal Reserve has also been very quick to ward off inflation by raising interest rates whenever rising demand started to push up prices. Higher interest rates discourage borrowing for business expansion. And although new technologies have been emerging, how to utilize them productively and profitably in a largely service economy has remained a question.

Sector balances

The economy consists of three sectors, each with its own financial balance resulting from inflows and outflows. They are the government sector, the domestic private sector, and the external (foreign) sector.

Ever since the Roosevelt administration engaged in massive deficit spending to combat the Depression and fight World War II, government has experienced more budget deficits than surpluses. Before 1980, deficits were running about 2-4% of national income. Since 1980, deficits of 4% or more have been common, except during the Clinton presidency, which ended in a small surplus. The deficit rose again in the George W. Bush and Obama presidencies, first because of the Bush tax cuts, and then because of the global financial crisis and the Obama stimulus package. The deficit was 9% of national income in 2012, but is down to 5% now.

As I discussed in my post on sectoral accounting, one sector’s deficit is another sector’s surplus. When the government experiences an income shortfall by spending more than it receives, some other sector must experience an income surplus by receiving more than it spends. Before 1980, that other sector was the domestic private sector. Households and businesses were saving more than they spent either on consumption or investment in real assets, with the difference showing up as financial assets. But since the 1980s, we have had a balance of trade deficit (and a current account deficit, which is the balance of trade adjusted for other financial flows between countries). Now about two-fifths of our government deficit winds up as surplus dollars in the hands of foreigners. By running such a large deficit, government is enabling both Americans and foreigners to accumulate financial assets.

While our government has been enabling the accumulation of private financial assets for some time, it used to do it in a more egalitarian way, through public-sector job creation, wages and the expansion of public goods. Now we do relatively less of that, and more with tax cuts aimed at corporations and the wealthy. That’s another reason why the distribution of income has become more skewed.

Gross domestic product

To summarize the changes in component shares of GDP, the consumption share is up sharply, government spending is down, investment has remained about the same, and net exports have fallen as the trade deficit has worsened. In the era of Reaganomics, we have been relying primarily on tax cuts to grow the economy instead of on public spending, business investment, or global demand for our products.

How much growth has our fiscal policy helped to achieve? I used data on real (inflation-adjusted) GDP to compute the cumulative growth for two different periods, 1945-1980 and 1980-2016 (the last year in that data series). Then I calculated the annual growth rate that would yield, when compounded, the cumulative result.

For 1945-1980, GDP grew 191%, which implies an annual rate of 3.1% compounded.

For 1980-2016, GDP grew 159%, which implies an annual rate of 2.7% compounded.

This confirms what others have reported, that growth in the Reaganomics era has been on average slower than in the previous postwar era.

This slower growth has also come with other costs: some neglect of public goods and services such as infrastructure repairs, a larger national debt, a larger trade deficit, and greater inequality.

With regard to the inequality, Piketty has argued that slower growth itself contributes to it, since workers rely on economic growth for real wage increases. Big investors rely more on the rate of return on capital. As the rate of growth falls farther below the rate of return on capital, the share of income going to capital rather than labor goes up. This is in fact what has been happening, a trend Piketty describes as a “drift toward oligarchy.” I think the drift toward economic oligarchy is related to the current threat to democracy, of which Donald Trump’s authoritarian tendencies are only one manifestation.

Government fiscal policy is by no means entirely to blame for sluggish growth. Factors such as slower population growth, an aging population and the difficult transition from a manufacturing economy to a service economy are also involved. But going forward, we do need to think about what combination of public and private initiatives can help.

We have probably gone about as far as we can go with tax cuts as the way to prop up a struggling economy. And government spending cuts without tax cuts would almost certainly be worse. The question for economists and policymakers today is how to make the best use of government spending to give the economy what it really needs. Among the things it needs are enhancements to human capital to keep up with changing job requirements, development of cleaner energy sources, and a twenty-first-century infrastructure. And as Modern Monetary Theory advocates, creating public jobs for anyone who wants them is one of the most direct ways of boosting national output and income.

The anti-government philosophy that has dominated the Reaganomics era has outlived its usefulness. I think that Republicans will either have to change their tune, or tone down the anti-government chorus so that new music can be heard. Democrats need to convince voters that their proposals serve the common good and not just the needs of particular constituencies. Warrenomics anyone?

 

 

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MMT 7: A Full Employment Proposal

July 11, 2018

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This is the seventh in a series of posts about Modern Monetary Theory, based on the text by Mitchell, Wray and Watts. If you have not seen the earlier posts, I recommend that you start at the beginning.

The goal of full employment

The authors argue for full employment on both economic and ethical grounds. Enabling everyone who wants a job to get one maximizes national economic output, providing more goods and services to distribute. Failing to do so not only hurts unemployed individuals and their families, but does lasting damage to economy and society in general:

Persistently high unemployment not only undermines the current welfare of those affected and slows down the growth rate in the economy below its potential, but also reduces the medium- to longer-term capacity of the economy. The erosion of skills and lack of investment in new capacity means that future productivity growth is likely to be lower than if the economy was maintained at higher rates of activity.

The authors are very critical of the dominant trend in recent economic policy, which is to tolerate unemployment while giving priority to fighting inflation. Policymakers came to accept unemployment rates far above the 2% or lower that was normal in the mid-twentieth century. High unemployment has also been accompanied by underemployment, as many workers have been unable to work as many hours as they would like, and also labor force withdrawals, especially by men. The official unemployment rate does not tell the whole story.

The inflation-fighting part has worked pretty well. Sluggish economic growth and high unemployment weaken the bargaining position of labor and help keep wages down. In turn, low labor costs and weak consumer demand keep firms from raising prices. In general, “the use of unemployment as a tool to suppress price pressures has, based on the OECD experience since the 1990s, been successful.”

The authors are troubled by the injustice of making a minority of the population bear the costs of a weak economy. “Joblessness is usually concentrated among groups that suffer other disadvantages: racial and ethnic minorities, immigrants, younger and older individuals, women (especially female heads of households with children), people with disabilities, and those with lower educational attainment.” I would add that the injustice is compounded if those who do make income gains in this economy are mainly the wealthiest 1%. The benefits of price and currency stability are somewhat more widely shared, but “it is doubtful that a case can be made for their status as a human right on par with the right to work.”

The Job Guaranty

Not all countries experienced high unemployment after the end of the postwar economic boom. Some, such as Norway, did more to insure that everyone who wanted to work could find a job.

The idea of the Job Guaranty is fundamentally simple. Since full employment is such a social and economic good, the public sector should take up the slack by employing those who cannot find jobs in the private sector.

“Private firms only hire the quantity of labour needed to produce the level of output that is expected to be sold at a profitable price. Government can take a broader view to include promotion of the public interest, including the right to work.”

The Job Guaranty is also known as the “employment buffer stock approach.” A stock of public jobs provides a buffer to protect the economy from a weak private sector.  Government acts to stabilize employment, spending to hire more labor when the private sector is weak, and reducing spending and public employment when it is strong. That would also have a stabilizing effect on national income and consumption.

The authors suggest that the wages paid in the Job Guaranty program would function like a national minimum wage, since they should be low enough to “avoid disturbing the private sector wage structure when the JG is introduced.” It wouldn’t compete with the private sector enough to drive up wages in general. On the other hand, they also want the wages to express “the aspiration of the society in terms of the lowest acceptable standard of living.” They do not discuss how these goals might be in conflict, but advocates of a “living wage” generally regard today’s minimum wage as too low.

Price stability

Proponents of the Job Guaranty expect it to be less inflationary than traditional Keynesian policies, which recommend government spending in general to stimulate the economy. When government increases its general spending, that runs the risk of driving prices up by competing with private firms for labor and other resources. However:

There can be no inflationary pressures arising directly from a policy where the government offers a fixed wage to any labour that is unwanted by other employers. The JG involves the government buying labor off the bottom, in the sense that employment at the minimum wage does not impose pressure on the market-sector wage structure.

Government would not be involved in a bidding war with private companies for labor, since it would only be hiring labor for which there was no other demand.

The benefits would ramify throughout the economy because of the growth in public works, income, and consumer demand. That should stimulate some expansion in the private sector as well, to meet the increased demand. Private firms could get the additional workers they needed by hiring them away from the Job Guaranty program. That would be fine with the government, which would no longer need to employ them. The program simply absorbs unneeded labor until it is needed again, but does nothing to bid up the price of labor. It supplies a boost to aggregate demand only when there is enough unused capacity in the economy to respond to it. So there is no reason to expect either cost-push or demand-pull inflation as a result of the JG itself.

Effects on public deficit and private surplus

The expected economic effects of a Job Guaranty follow from the macroeconomic relationships described earlier.

GNP = C + I + G + CAB  [see MMT 3]

Gross National Product = Consumption + Investment + Government Spending + Current Account Balance

(T – G) + (S – I) + (-CAB) = 0  [see MMT 4]

These three sector financial balances add to zero:

T – G = Government balance of tax revenue minus spending

S – I = Private sector balance of saving minus investment

-CAB = External sector balance expressed as the current account surplus held by trading partners

Let’s start from the present U.S. situation, where financial surpluses in the private sector and the external sector are balanced by a large government deficit.

Let’s hold the external balance constant, so we can concentrate on the effects of a Job Guaranty on the domestic sectors, public and private.

When the Job Guaranty program starts:

  • G rises
  • GNP rises even more than G, because of the consumption multiplier
  • Government deficit rises
  • Private sector surplus rises

We are assuming that the increase in G is not offset by an increase in taxes. That would keep the increase from showing up in disposable income and block the multiplier effect on consumption. Since G rises but T doesn’t, the deficit (T – G) rises.

According to Modern Monetary Theory, the sovereign government can issue currency to spend beyond its revenue, and this public debt is sustainable. The government can also borrow money by issuing more treasury bonds without “crowding out” private borrowing, as is often alleged. That’s because the private surplus must increase in tandem with the public debt in order for the sector balances to offset. The mechanism by which this happens is the effect of Government spending on Saving due to the saving multiplier. Some of each additional dollar of income is saved, so S rises, and the surplus S – I must rise as much as the deficit T – G, other things being equal.

At the end of MMT 4, I expressed some concern that surplus savings not invested in real productive assets could lead to excess speculation and financial instability. This text does not address that possibility, but it makes me nervous about growing public deficits and private surpluses indefinitely.

Hopefully, the Job Guaranty program stimulates the general economy. As aggregate demand rises, the private sector needs to hire away more of the labor in the Job Guaranty program, so the program can be scaled back. But in order to sustain GNP at a high level, another variable in the GNP equation must increase to offset any reduction in government spending. Presumably that would be Investment, since the firms hiring more labor will also be providing more workplaces, equipment and expanded inventories. That leads to this optimistic scenario:

As private sector demand picks up:

  • G falls, but I rises
  • GNP is sustained at full-employment level
  • Government deficit falls
  • Private surplus falls

Private surplus (S – I) falls because of the rise in investment, which absorbs more of the uninvested saving. I also think that when the private sector is strong, it might be a good time to reduce the public deficit and private surplus by raising taxes on the wealthy, but the text does not get into that.

Necessary but not sufficient?

I like the text’s proposal for a Job Guaranty. I accept the authors’ argument that increasing public debt to fund it is not necessarily bad, since public debt is more sustainable than private debt. I would hope, though, that a period of expansionary fiscal policy might get the economy to a place where public deficits and other sector imbalances could actually be reduced.

One potential problem with the optimistic scenario is that investment in new technologies might displace too much labor, throwing millions of workers back into the Job Guaranty program. As private sector demand picks up and the private labor force moves toward full employment, that would strengthen the bargaining power of labor, according to the author’s conflict theory (see MMT 6). Ideally, investment in new technologies would raise worker productivity and justify wage increases. That would be a long overdue boost in productivity, which has been rather stagnant lately. On the other hand, automated and artificially intelligent systems could replace too many workers, especially those with limited education and technical skills. One can imagine a large underclass of otherwise unemployable workers stuck in minimum-wage jobs in the Job Guaranty program.

In order to develop human potential to the fullest, which is one of the text’s goals, government may need to spend on human capital development as well as the Job Guaranty, although the same program would have some effect on both. General spending to promote education, training, health care, and so forth are also needed.

Writers such as Martin Ford in The Rise of the Robots envision a massive welfare system to support people whose labor is no longer needed. I agree with the authors of Modern Monetary Theory and Practice that paying people not to work is a tremendous waste of human resources. “Providing welfare rather than work to those who want to work is not only an admission of defeat (the labour market fails to provide enough jobs), but also wastes resources and generates social costs.”

I accept the fundamental premise of this economics that “the most important resource in any economy is labour.” I want to enable people to do marketable work of some kind, although new technologies could raise productivity to the point where they wouldn’t need to devote many hours to it. I think that goal is best achieved through a balance of public and private investment. I hardly need to point out that little of this is likely until the present regime is history.

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