Deficits and crowding in private investment

James Galbraith kicks so much ass in this comment about a recent Paul Krugman column that I have to quote it for posterity’s sake (he basically agrees with PK). The question: Is the deficit a threat to future recovery. The answer:

No.  The question is grossly  misconceived.  Right now and for the immediate future, the budget deficit is the only source of demand that can fuel a recovery.  Our present problem is not that it is too big, but that it is too small.   Far too small.

In principle, economic growth can come from household consumption, business
investment, government spending, or exports.   This is a tautology, indisputable and known to everyone who has ever opened a textbook.

Household consumption depends on incomes and on credit.  The collapse of credit, rooted in the decline of housing values, is at the root of the crisis.  In parts of California home values have fallen 50 percent already, which would place them far below the debt owed on the homes in most cases.

Quite apart from the fact that the banking sector is in deep trouble, borrowing power has collapsed. For this reason, rescuing the banks, though necessary, has not and will not produce recovery.

Business investment depends on the expectation of profit. But with consumption falling, there can be no expectation of profitability for the time being.  So business investment will follow consumption down.

Thanks to a low dollar, exports were the one bright spot in the growth picture for most of 2008.  But the flight to quality that rescued the dollar will clobber the competitiveness of American exports.

For these reasons, the entire private sector, across the entire country and indeed the world,  is pulling the economy downward at the present time.  This is an unprecedented event in my professional lifetime.  Previous deep recessions, for example in 1974 and 1981, were caused by external shocks or policy shocks.  This one is driven by an internal collapse of the credit system, the first in almost eighty years.

In normal times, after a passage of time, as cars and appliances age and people are born, married, move around and die, pent-up demand grows in the household sector.  Once that has happened, a sharp fall in interest rates is normally sufficient to kick-start the resumption of sales of durable goods, home construction and then a general credit expansion.  There should be no expectation of this for the foreseeable future, because of the condition of the banks and the vast excess inventory of housing.   These are not normal times and the normal mechanics of a credit recovery cannot be counted on.

Meanwhile, as consumption, investment and exports decline, so will tax revenues.  The government budget deficit is destined to rise, by a lot, on this account alone.  This is helpful: a falling tax burden in a progressive tax structure keeps money in private pockets.  But it is a weak device to promote expansion, since tax savings will be used first to try to pay down debt, a slow process.  A major tax cut, focused on working Americans such as by remitting the payroll tax, would help sustain after-tax incomes and provide funds to pay mortgages and buy cars.  But even these effects are uncertain in a debt deflation.

In these conditions, only government spending can pull the economy out of the ditch.  Government must spend.  It must do so by as much as necessary in order to maintain a high level of employment.  Aid to states and localities, an infrastructure fund, increased social security benefits, foreclosure relief,  loans or grants to industry, a green jobs program — all can be useful in coping with the crisis.  All will, of course, add to the public budget deficit.

There is no harm in seeking out wasteful or unnecessary programs to cut as the President-elect proposes.   The war in Iraq is a huge waste of money with minor benefits to employment. Missile defense is a vast waste of construction, engineering and scientific resources with no benefit to security.   Bridges to nowhere and roads to the wilderness add nothing to
the value of the national capital stock.  But the point of cutting waste and boondoggles is not to reduce the deficit, but to release real resources for better uses.  The obligation to use those resources, and to deploy the public funds necessary to ensure that they are used, remains.

Will the projected future deficit “crowd out” future private investment as so many claim?  This is absolutely improbable. To the contrary, a successful program of public expenditure will create profit opportunities that will encourage private businesses, many of which will otherwise close, to stay open and eventually to expand.  A general improvement of economic conditions can only lower, not raise, the presently prohibitive risk premiums on interest rates being charged private borrowers!   There is no way that present or future public spending, even in very large volumes, would under these conditions raise long term interest rates generally  by enough to offset the positive effects of an increase in activity and a reduction of risk.  Quite the contrary!   Public spending will crowd in, not crowd out, private investment.

Whether they know it or not, those who argue a “crowding out” model are working from a mental construct under which the economy is always operating at or near full employment, and under which there is a fixed supply of credit resources, a pool which government and the private sector must share.  This is not the case!   We are far below full use of available
resources now and will certainly fall very much farther in the months ahead, whatever the new administration does.  And there is no fixed pool of credit!   The entire purpose of the capitalist banking system under the Federal Reserve Act, ever since 1913,  has been to create an “elastic currency” not subject to fixed limits to the supply of finance. With due respect to those who continue to have reservations about “crowding out”, please stop.  This is a moment when an unfamiliarity with the most basic economic and financial facts can be very dangerous to national well-being.

Finally, there are those who have argued, in times past, that projected future deficits might have a psychological or other effect, detectable in statistical data, on long term interest rates and therefore on private
business investment.   But whatever the merits of the statistical case,
there is no risk under present conditions that something so remote and ethereal as a psychological fear of deficits in the distant future is going to drive up the long-term interest on public debt.  We are in a full- fledged flight to safety!  That is a flight to cash and to Treasury bonds and bills, not merely here but worldwide, as witnessed by the rising dollar.  Right now and for the foreseeable future Uncle Sam can borrow, for whatever term, on whatever scale, for practically nothing.  In fact, he has suddenly become a creditor to much of the world — notably the European Central Bank — because of a worldwide shortage of dollar assets!

Finally, there is the question of whether it is possible to go too far.
The answer is yes. Maybe my diagnosis is wrong.  Maybe private credit will recover faster than I think likely.  But even allowing for this possibility, action now should be on a grand scale.  It is far easier to trim back tax relief in an expansion, than it will be to repeat the political effort of passing a large expansion package if the first one is too small.  For this reason, the conditions call for error on the side of action, not of caution.  “Wait-and-see,” in an emergency,  is the worst possible advice.

Official Washington and many economists have for many years “known” that Americans save too little, spend too much, and that governments should work toward balanced budgets. It is hard to unlearn these convictions when conditions change. But we now see the consequences of a forced-draft attempt by beleaguered households to reduce spending and pay down debt: it is a decline in economic activity bordering on collapse.

In these circumstance, large budget deficits are essential, and preoccupation with budget balance is counterproductive. In very simple terms, it means reducing incomes in the private sector, just when it is most  necessary that those incomes be supported, through public spending and tax relief.  Those who hang on to simple views of economic virtue in present times need to rethink: time is short and action is needed.


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