Tuesday, July 21, 2009

Under What Conditions Would I Conclude That Deficits Are Bad? Part 2

Last Thursday, in a post extending the analysis of my most recent FindLaw column, I asked whether the arguments that I regularly make in opposition to the conventional wisdom about federal budget deficits might have become my own version of conventional wisdom. The best way to answer that question is to ask whether there are any circumstances in which I would change my position and agree that budget deficits are bad. If not, then these arguments would be little more than a catechism, uncritically accepted as true.

In that post, I confronted the first of the two arguments that I outlined in the FindLaw column, examining the arguments for and against deficit spending during an economic downturn. I concluded that the real issue is whether deficit spending would tend to reverse the momentum of the economy, slowing job losses or (more optimistically) adding jobs as the economy changes course in response to the stimulus created by (certain types of) government spending and (certain types of) tax cuts. Near the end of the post, I wrote: "One should never, therefore, be 'pro-deficit,'" suggesting that the deficits are a side-effect of the only appropriate policy responses to a recession, not the preferred policy itself.

I should make clear that a parallel point is also true: One should never be "anti-deficit," either. If the choices that we face suggest that the best policy involves running a deficit (or a larger deficit), then so be it. Today, I will add that even when the economy is not in a recession, the choices that we face will literally always lead an open-minded policymaker acting in the interests of current and future citizens to enact policies that will result in deficit spending. In that sense, therefore, good policy will always involve some deficit spending. Again, however, the deficits are a consequence of good policy choices, not the policies themselves.

This analysis, by the way, in no way implicates the arguments in my work on intergenerational justice (discussed here, among other places), in which I call into question the twin beliefs that current generations are obligated to make sacrifices for future generations and that we are not currently meeting any such obligation. The issue here is much more simple: If the economy is relatively healthy (not in a recession, roughly speaking), then there will be spending programs uniquely available to the federal government that will have long-term payoffs, such that borrowing to finance those initiatives will increase future living standards notwithstanding the debt that we take on in the process.

Put differently, some things are so valuable that it makes sense to borrow money to buy them. Again, the logic of this proposition is so obvious that it is simply shocking to see how willfully blind politicians and pundits are willing to be when it comes to deficits. The late, great economist Robert Eisner often wrote about giving speeches to civic groups in which he would first ask whether the people in his audience thought that borrowing is a bad idea. Everyone would raise their hands, and he would then ask how many people in the room had borrowed money to buy a house, how many had borrowed money to send their kids to college, how many had borrowed money to finance a life-saving operation, to start or expand a business, etc. Did anyone think that their purchases had been foolish, given that all of them involved running deficits? Of course not.

The federal government, of course, is different from a family and different from private businesses; but the differences actually strengthen the case for deficit-financed spending rather than weakening it. Unlike people (but like businesses), governments have no expected date of death, meaning that there is no need to wind down debt in anticipation of retirement. More importantly, governments can operate under longer time horizons that allow them to engage in investments that might pay off in decades rather than during the next quarter or fiscal year, and they can make those investments without worrying (as businesses must) about preventing the benefits that will flow from their investments from being enjoyed by other members of society.

Thus, for example, while businesses and families certainly understand that they will be better off if everyone has a minimum level of education, private actors must use the government to overcome group action problems and other barriers to investing in mutually beneficial projects. Basic research in the arts and sciences, public health initiatives, transportation improvements, etc. all fall into this category.

To return to the question motivating these posts, then, when would deficit spending be unacceptable? Again, a simple cost-benefit approach is really all we need to answer that question. If there were no investment opportunities available to the federal government that promised rates of return greater than the cost of borrowing, then deficit spending would be a bad idea. Even if some such projects exist, of course, that is not a license to run deficits to finance projects that do not have sufficiently high returns.

Of course, as the government expands its borrowing during prosperous times, it does so at the expense of possible investments by private businesses. That, however, is what financial markets are for. If lenders (domestic or foreign) begin to require a higher rate of return from borrowers, fewer investments -- both private and public -- will make sense. Governments will finance only those projects with rates of return that continue to exceed borrowing costs, as will private businesses. The worry that "the Chinese" will stop lending to us, or that government crowds out private business, is not a separate concern. Such concerns will be mediated by fluctuations in interest rates, and the resulting allocation of borrowing between private and public uses will be sensible so long as both government and business apply cost-benefit rules appropriately.

Not all government investments will pay off. Not all private investments pay off. The fact is, however, that there will always be government projects available with rates of return that exceed borrowing costs (which are a proxy for the rates of return of the private investments that would be crowded out). That means that there will always be a reason to borrow money to finance those projects. Doing so does not burden future generations, because it makes them more than rich enough to pay for the inherited debt.

I wish that something in this post were breathtaking or innovative. The fact, once again, is that some deficit spending is good. Other deficit spending is bad. The issues are complicated enough that demagogues can play on people's fears with unfounded claims of economic ruin. People should not allow those fears to undermine sound economic policy.

-- Posted by Neil H. Buchanan

14 comments:

Michael C. Dorf said...

I would offer what I think is a friendly amendment: There are circumstances in which a prospective borrower--whether an individual, business, or government--must forego borrowing even for a cost-justified project because it will lack the liquidity to service the debt over some portion of the lifetime of the loan. Suppose that Bill is an average-looking single adult man of modest means. Suppose further that plastic surgery to turn Bill into a very handsome man would cost $100,000, and that the improvement in his well-being as a result of the surgery (his self-esteem, his ability to attract a mate, etc.) would greatly exceed $100,000 if monetized. However, Bill cannot afford the debt service on the $100,000, and he cannot use the expected improvement in his well-being to pay the resulting interest, because that improvement, though monetizable in theory, is in fact illiquid. In such circumstances, borrowing is simply impossible. Likewise for governments, some net-welfare-enhancing investments do not produce income streams, and thus cannot be debt-financed without finding some other funding source for the debt service.

Paul Scott said...

There is, in addition to the liquidity argument with which I also agree, an additional logical argument against this reasoning.

The core of your argument is that there is always something on which a government's best choice, as reflected by long term wealth, will be to borrow. I assume for now you are simply ignoring the additional taxation route - or more likely you are assuming taxation is at its optimum level and distribution and that when it is the government will still have more "net positive worth" projects on which it should spend its money.

The result, as you put it is "the choices that we face will literally always lead an open-minded policymaker acting in the interests of current and future citizens to enact policies that will result in deficit spending."

This conclusion seems impossibly wrong unless your also argue that resources are infinite. Is that your position? Or, probably better restated, "resources are finite, but sufficiently large that they have no foreseeable, practical end."

Michael C. Dorf said...

Paul, isn't your last point subsumed by my point? That is, if the proposed project to be debt-financed will generate an income stream larger than the interest payments, then the govt will have enough revenue to pay for it, without resorting to taxes, because the new project generates wealth. Govt doesn't need infinite resources. Whatever resources it has are supplemented by the money produced by the new project. The problem arises when the net benefits arising out of the project are illiquid, but that's simply my point.

204 said...
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Jonathan Noble said...

Also I would think that any benefit from a deficit-funded govt investment must also be weighed against the benefit of occasionally demonstrating your ability to paying off your debts. What else could be the impetus behind the push during the Clinton years to erase the deficit?

Paul Scott said...

Yes, actually, I suppose it is. It certainly is. I posted it because I think it takes no imagination to see the problem when stated in terms of the limitation on resources. Debt can't grow indefinitely unless resources can also grow indefinitely.

Neil H. Buchanan said...

There are some interesting ideas in these comments, raising issues that are complicated enough to address in yet another post rather than on the comment board. I already have a post planned for this Thursday on a different topic, but my post next Tuesday will return to the issues raised here.

egarber said...

I was also thinking about the taxation route. I think it's one thing to say that there are times when deficit spending will be necessary. But it's quite another to err on the side of deficits, simply because it's too political difficult to make changes in the tax code.

In private business, strategic decisions are often made to pay for investments in real time via increased fees -- for example, when ESPN.com decided to charge extra for on-line access to its magazine.

Governments should also go through that exercise. If after the recovery (whenever that happens), we were to simply let the tax rates of the 90's fall back into place, the country's fiscal flexibility would be greatly enhanced.

egarber said...

But it's quite another to err on the side of deficits, simply because it's too political difficult to make changes in the tax code.

"politically", I mean.

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