Friday, March 19, 2010

Tea Parties and T-Bills

By Robert Hockett
Neil has been so persistent, so lucid, and so thorough in addressing current fears -- which for the most part have struck me as what I'll call 'crocodile' fears -- about the longterm U.S. fiscal position that I have felt no need to comment on the subject here thus far.  That has been the case notwithstanding some awareness of and even more interest in the subject at my end.  I've nevertheless intended to offer a few cents of my own on the matter for a while now, and so, with Neil's blessing, I post on it now.

What I wish to highlight and address is a curious gap that I find in much current discussion of U.S. federal expenditures and the federal deficit.  Specifically, I find it remarkable that while tax-cutting is widely acknowledged -- particularly by Republicans and 'Tea Party' types -- to be capable of generating higher tax revenues and hence reduced deficits in the longer term, the counterpart claim that can be made on behalf of expenditures -- what I'll call 'the public investment' claim -- seldom if ever is made or so much as acknowledged.  Why do Republicans and Tea Partiers never acknowledge this possible claim?  And why do the Democrats not remind them?  That's what I want to explore here. 

Let me begin my elaboration by acknowledging this much at the outset: Recent growth in (a) the U.S. national debt, (b) U.S. government debt, and (c) the rate at which those magnitudes are growing has drawn concern from a number of even mainstream economists, policy analysts, pundits and members of the lay public. It is widely observed – even, remarkably, by some in the credit rating industry now (not that they've proved reliable of late!) – that current trends are not indefinitely sustainable, and might not even be sustainable for much longer than the present.

Although it has not yet occurred, and although great uncertainty attends the question of just when a proverbial 'tipping point' might be reached, continued federal borrowing at current rates of course must eventually reach a point at which lenders will no longer be willing to finance U.S. government operations – at any rate, not without exacting much higher interest charges than currently prevail in the credit markets. If and when that point is (eventually) reached, the debt service burden will begin seriously to crimp the material standard of living of American citizens: severe 'belt-tightening' could be imposed very suddenly. Should that occur while the financial and real economies remain in their still only tentative emergence from slump, full recovery from our recent contraction could be stopped in its tracks: a Japan-reminiscent 'lost decade' – or more – could be in the offing.  So the ultimate stakes here admittedly are high, even if timing, and even probability-weighted timing, remain for the time being out of reach.

And there is more:  The prognostications I've just recited are rendered all the more worrisome, in the view of many, by imminent demographically-wrought increases in entitlement spending on behalf of aging and retiring baby-boomers. This is of course one reason why health insurance reform is so widely understood to be urgent. Because the size of the pool of workers whose taxes fund entitlement expenditures pursuant to our 'paygo' system of entitlement finance is projected to shrink dramatically relative to that of the pool of beneficiaries well into the future, entitlement spending presented a significant projected challenge to U.S. public finance even prior to the recent contraction. Hightened federal expenditures responsive to that contraction have accordingly served simply to render that much more urgent what was already a significant looming -- even if remotely looming -- fiscal challenge.

Now in response to these and related concerns, a number of the aforementioned economists, policy analysts and pundits have begun urging retrenchment on the federal government.  And Republicans and Tea Party types have echoed and amplified such calls in particularly shrill tones.  Expenditures of various sorts, these people have admonished, must be drastically cut. By the same token, some -- albeit curiously fewer -- have argued, federal revenues might have to be boosted through the imposition or re-imposition of higher rates of taxation.

The dilemma posed by such recommendations, of course, is that any such measure -- expenditure cutting or tax hiking -- might itself put an end to the currently tentative recovery mentioned a moment ago just as surely as would a sudden rise in interest rates reflective of suddenly contracting demand for U.S. government debt instruments.  So addressing the deficit in the short term could itself result in a recovery-squelching, Japan-style 'lost decade' just as surely as doing nothing to address the deficit could.  The U.S. accordingly looks, at least prior to more careful reflection, to be caught between the proverbial rock and hard place.  What, then, to do?

I am of course not unsympathetic to, or unware of the theoretical underpinnings of, the concerns just rehearsed, as these appear in current discussion of the U.S. fiscal position -- particularly when they are raised by serious people rather than Congressional Republicans and Tea Party types. I do note, however, a conspicuous absence -- the lacuna I noted at the outset of this post.

It is a commonplace of all disciplined analysis of public finance that some fiscal measures which decrease revenues or increase expenditures in the short term will tend in the longer term to do the reverse. The familiar observation that well targeted decreases in marginal tax rates can, through Keynesian-mulitplier-amplified stimulative effects on the macro-economy, ultimately increase federal revenues is an obvious case in point. Indeed it was explicitly appealed to by members of the Reagan, Clinton, and Bush economic teams over the course of the 1980s, 1990s, and the first decade of the new millennium.  (It is what Reagan's 'Laffer Curve,' so far as I understand it, was all about; and I think that it is what candidate George H. W. Bush is said to have derided as 'voodoo economics' back in the 1980s.)

But while the idea that forgone tax revenues now can bring larger such revenues later is common, its equally if not more plausible counterpart – that greater expenditures now also can bring greater revenues later – does not seem to be as widely discussed these days. This is surprising. Any businessman or –woman, and indeed any household, knows that there is a distinction to be drawn between consumption on the one hand, and investment on the other. The same people know also that investment will often be best financed, not out of accumulated savings or retained earnings, but by borrowing. That is particularly so when interest rates are particularly low – as they remain for the present and look apt to remain for a while – and prospective future earnings, such as those that some investment multipliers are apt to produce, are high. Not to finance high-yield projects through debt when borrowing rates are low is to 'leave money on the table' by failing to arbitrage the spread between borrowing costs and project yields. Such opportunity costs are just as much 'costs' as are explicit borrowing costs.

It seems to me, then, that projections and prognostications based, as all current such projections and prognostications seem to be based, on various possible federal borrowing scenarios alone, with no account taken of what that borrowing is used to finance, are inherently incomplete. No determinate predictions, or even probabilistically weighted such predictions, can be made on such incomplete bases. One might as well try to utter a sentence without using a verb.  Everything rides upon what debt-financed federal expenditures are spent upon – in particular, whether they are spent upon productive public investments on the one hand (e.g., transportation and communications infrastructure, green technologies and infrastructure, educational facilities, etc.), or ultimately sterile or even destructive undertakings (as many wars and "nation building" projects embarked upon by past 'superpowers' like Spain, the Netherlands, and the United Kingdom, for example, have proved historically to be) on the other.

I accordingly believe that all who are seriously -- rather than what I shall call 'gimmickly' -- concerned about the federal deficit right now will add value to the current discussion over the U.S. fiscal position only when they begin seriously aiming to fill this gap. That is to say, I think we can all usefully sharpen the current debate by taking explicit account of the distinction between long-term revenue-enhancing expenditures on the one hand, and merely revenue-draining expenditures on the other hand. Doing so will afford a much fuller and more nuanced portrait of the options actually available to – as well as the dangers actually facing – our nation than is currently in circulation. It will also supply a badly needed counterpart, on the expenditure side of public finance, to the regularly encountered tax policy arguments heard so tiresomely often in connection with the revenue side of the same.

I'm even inclined to say something like 'by their fruits ye shall know them' here:  Henceforth, if you hear anyone whinging about the deficit, ask whether they are so much as mindful of the distinction between productive and unproductive debt-financed expenditure -- or between consumption and investment.  If they are not, take their expressions of concern with considerable salt.  They are crocodile tears that express crocodile fears.


Neil H. Buchanan said...

As Bob (and other regular DoL readers) might well imagine, I enjoyed this post enormously. Indeed, my next law review article -- destined to be perused by literally tens of readers -- discusses a way to get the federal government to take into account the difference between government consumption and government investment.

Lacking any major or minor points of disagreement, I will instead offer two friendly comments:

(1) Bob's use of the term "entitlements" in his post, with respect to the long-term financing challenges caused by the aging of the Baby Boomers, is over-inclusive. Entitlements are generally understood to include Social Security, Medicare, and Medicaid (even though Medicaid's financing is now restricted below levels to which people would otherwise be entitled). The long-term problems that Bob describes are entirely based on challenges facing Medicare and Medicaid. Social Security is not in the same category. It's long-term financing problem is either small or non-existent.

(2) Bob is correct that government investment will (via an effect that, as he says, is much more certain than the so-called Laffer Curve effect of tax cuts) result in increased government revenues in the future. As a financing matter, that's both true and interesting. I would add, however, that the truly important fact about government investments is that they increase the real standard of living in the future. The focus should, I think, be on that primary effect, not on the secondary effect on the long-term deficit. This is not a criticism of Bob, of course, because his point here is to respond to the hypocrisy of those who shed crocodile tears about deficits but who ignore the salutary effects on deficits of government investment.

As I said, I thoroughly enjoyed this post.

Bob Hockett said...

Thanks a million, Neil, and count me among those tens! On Social Security, yep, I should have made clear that the fund is doing fine, notwithstanding the frightfully amusing proposals made by some truly oddball Republicans that we put an end to Social Security since it's 'in crisis' and 'just IOUs.' (Glad that A. Hamilton never said that in those early requests for loans from the Dutch.) On the most important effect of government investment, thanks a million for drawing that out too. I did feel compelled to keep the focus narrowly on the deficit effect for present purposes, but felt sort of cheesy about that in light of how small that helpful tendency is in comparison to the longterm GDP effect -- especially in time of slack private sector contribution to aggregate demand. (There's surely not been so much opportunity for the government literally to 'add [multiplier-multiplied] value' since the 1930s!) Felt a bit as if I were celebrating the brilliance of a candle while the sun shone overhead -- in Ithaca, no less!

Thanks again,

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