Austerity is in vogue. For some time now, countries in Europe have been raising taxes and cutting government spending because they are worried about their national debt. They have hit on the word austerity to describe these tax increases and government spending cuts. The US is now following suit.
But the trouble with austerity is that it is contractionary—that is, austerity tends to slow down the economy. In bad economic times, people can’t get jobs because businesses aren’t hiring, and businesses are not hiring because people aren’t spending. So in bad economic times, it adds insult to injury when the government does less spending, less hiring, and taxes more money out of the pockets of those who would otherwise spend.
The contractionary effect of austerity creates a dilemma, not only because a slower economy is painful for the people involved—that is, just about everyone—but also because tax revenue falls when the economy slows down, making it harder to rein in government debt. This dilemma has fueled a big debate. There are four basic positions:
1. Arguing that austerity can actually stimulate the economy, as long as it is implemented gradually. That is the position John Cogan and John Taylor take in their Wall Street Journal op-ed, “How the House Budget Would Boost the Economy,” which I questioned in my column, “The Stanford economists are so wrong: A tighter budget won’t be accompanied by tighter monetary policy.”
2. Arguing that debt is so terrible that austerity is necessary even if it tanks the economy. This is seldom argued in so many words, but is the implicit position of many government officials, both in Europe and the US.
3. Arguing that the economy is in such terrible shape that we have to be willing to increase spending (and perhaps cut taxes) even if it increases the debt. This is the position taken by economist and New York Times columnist Paul Krugman. Indeed, Krugman is so intent on arguing that the government should spend more, despite the effect on the debt, that in many individual columns he appears to be denying that debt is a serious problem. A case in point is his reply, “Another Attack of the 90% Zombie,” to my column emphasizing the dangers of Italy’s national debt, “What Paul Krugman got wrong about Italy’s economy.” (In addition to this column, I responded on my blog.)
4. Arguing that there are ways to stimulate the economy without running up the national debt. This is what I also argue in my column on Krugman. For the US, the most important point is that using monetary policy to stimulate the economy does not add to the national debt and that even when interest rates are near zero, the full effectiveness of monetary policy can be restored if we are willing to make a legal distinction between paper currency and electronic money in bank accounts—treating electronic money as the real thing, and putting paper currency in a subordinate role. (See my columns, “How paper currency is holding the US recovery back” and “What the heck is happening to the US economy? How to get the recovery back on track”) That is, Ben Bernanke is all too familiar with the limitation on monetary policy that comes from treating paper currency as equivalent to electronic money in bank accounts. He said in his Sept. 13, 2012 press conference:
If the fiscal cliff isn’t addressed, as I’ve said, I don’t think our tools are strong enough to offset the effects of a major fiscal shock, so we’d have to think about what to do in that contingency.
Without the limitations on monetary policy that come from our current paper currency policy, the Fed could lower interest rates enough (even into negative territory for a few quarters if necessary) to offset the effects of even major tax increases and government spending cuts.The price of debt
Since I see a way to stimulate the economy without adding to the national debt—and even in the face of measures to rein in the national debt—I face no temptation to downplay the costs of high levels of national debt. What are those costs? The most obvious cost of high levels of national debt is that at some point, lenders start worrying about whether a country can ever pay back its debts and raise the interest rates they charge. (This all works through the bond market, giving rise to James Carville’s famous quip: “I used to think that if there was reincarnation, I wanted to come back as the president or the pope or as a .400 baseball hitter. But now I would like to come back as the bond market. You can intimidate everybody.”) One can disagree with their judgment, but lenders are showing no signs of doubting the ability of the US government to pay its debts. But there can be costs to debt even if no one ever doubts that the US government can pay it back.
To understand the other costs of debt, think of an individual going into debt. There are many appropriate reasons to take on debt, despite the burden of paying off the debt:
- To deal with an emergency—such as unexpected medical expenses—when it was impossible to be prepared by saving in advance.
- To invest in an education or tools needed for a better job.
- To buy an affordable house or car that will provide benefits for many years.
There is one more logically coherent reason to take on debt—logically coherent but seldom seen in the real world:
- To be able to say with contentment and satisfaction in one’s impoverished a old age, “What fun I had when I was young!”
In theory, this could happen if when young, one had a unique opportunity for a wonderful experience—an opportunity that is very rare, worth sacrificing for later on. Another way it could happen is if one simply cared more in general about what happened in one’s youth than about what happened in one’s old age.
Tax increases and government spending cuts are painful. Running up the national debt concentrates and intensifies that pain in the future. Since our budget deficits are not giving us a uniquely wonderful experience now, to justify running up debt, that debt should be either (i) necessary to avoid great pain now, or (ii) necessary to make the future better in a big enough way to make up for the extra debt burden. The idea that running up debt is the only way to stimulate an economic recovery when interest rates are near zero is exactly what I question in my previous column about Italy’s economy. If reforming the way we handle paper currency made it clear that running up the debt is not necessary to stimulate the economy, what else could justify increasing our national debt? In that case, only true investments in the future would justify more debt: things like roads, bridges, scientific knowledge that would still be there in the future yielding benefits—benefits for which our children and we ourselves in the future will be glad to shoulder the burden of debt.
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