Will US confirm that nothing bad happens to indebted economies?
• Impending tax cuts could prove the theory — or send the country into a macroeconomic mess
As the Republicans prepare for their big tax-reform push in the US, the issue of deficits and debt is once again coming to the fore.
Many economists realise that tax cuts, especially income tax cuts, tend to increase deficits, which over time lead to increases in the national debt. If adopted, the plan would probably pump up deficits and debt. This is not the first time that has happened — Ronald Reagan and George W Bush also cut taxes and deficits swelled.
So the question is, is more debt good, bad, or does it even matter? And if it’s bad, how serious a problem is it?
The answer is that no one really knows. Like so many things in macroeconomics, there is no reliable, confirmed theory that tells us the effect of government deficits or debt.
In the short term, the big question is whether deficits raise aggregate demand. Aggregate demand isn’t a well-defined concept, but it essentially means how much money people want to spend on all the goods and services in the economy.
Government spending puts money in people’s pockets, while taxes take money out, so if people spend some of the net amount the government puts in their pockets, deficits should give consumption — and therefore the economy — a boost.
This is the Keynesian theory that gets taught in most introductory economics courses. Many have dryly noted that Reagan’s tax cuts in the 1980s looked an awful lot like Keynesian stimulus.
On the other hand, if people save most of what they get from the government, aggregate demand won’t rise much. If people think a deficit today has to be paid back tomorrow, they will expect their taxes to go up in future and this will make them spend less — a theory known as Ricardian Equivalence.
So how much do deficits prompt people to actually go out and spend? It might depend on the type of deficit. There is evidence that the tax rebates in the 2009 American Recovery and Reinvestment Act — the stimulus package under president Barack Obama — didn’t boost spending a lot — direct spending on things such as roads had a bigger effect, but was a small part of the stimulus overall. Perhaps that was because people expected Obama’s deficits to be temporary, and that taxes were going to go back up.
That doesn’t mean the debt incurred by the stimulus was paid back, but any consumer who correctly predicted Obama’s fairly rapid turn back towards fiscal austerity would have realised their increased income was transitory.
That doesn’t mean stimulus is useless. Direct government spending on things such as roads, and transfers to cashstrapped states, seem to have had a sizeable effect. That’s consistent with basic Keynesian theory, and with other more general evidence. But the dubious value of tax rebates shows that deficits created by temporary cuts don’t do much good.
But will the deficits from the Republican tax plan be temporary or permanent? If recent past experience is any guide, the debt incurred won’t be paid back anytime soon.
The last time the federal debt shrank was during president Bill Clinton’s administration, and that period of austerity was short-lived — as soon as Bush came to power, the surpluses were eliminated in favour of a big tax cut.
Lots of economists think that debt can’t keep increasing forever as a percentage of GDP. Most mainstream economic models include a long-term budget constraint, meaning the ratio of debt to output has to shrink to zero in the long run. But outside the world of academia people are starting to wonder whether this is actually true. After all, advanced nations around the world have been running big debts for decades, and for most of these countries, there have been no obvious negative consequences that can be blamed on that debt.
Is there any limit to how high these debt levels can go? If central banks keep interest rates at or near zero forever, governments will never run out of cash, since debt service costs will be minimal. Of course, interest rates could rise if bond buyers stop buying government bonds, causing a solvency crisis and forcing a government default.
But that would only happen if the central bank refused to step in. If the central bank printed money to buy newly issued government debt at a zero interest rate, the government could borrow infinite amounts while paying nothing.
Many think this would result in hyperinflation — if you print enough money, basic intuition says its value would drop. Yet many countries never experienced even moderate inflation despite their central banks’ huge asset-purchasing programmes, causing some economists and policy makers to question this conventional wisdom. If inflation never materialises, central banks can keep printing money and using it to finance government deficits forever.
This idea is the centrepiece of a possibility called modern monetary theory, which was once relegated to the intellectual fringes but is now gaining currency outside academia.
If Republican administrations continue to believe that deficits don’t matter, and if Democrats prove politically incapable of stopping their insistence on tax cuts, there will eventually be no alternative but to test this theory. At some point, if debt increases enough, the Federal Reserve will have to start financing the government with printed money.
That would be a fascinating macroeconomic experiment — although maybe not one we should be looking forward to.
IF CENTRAL BANKS KEEP RATES AT OR NEAR ZERO FOREVER, GOVERNMENTS WILL NEVER RUN OUT OF CASH