How large a deficit is appropriate?

( A comment of mine   which appeared on the NYT site in response to an article by Carl Hulse on April 9, 2010.

Harold R.Chorney
Montreal
April 10th, 2010
6:33 pm

The way to resolve the problem of how large a deficit you are willing to run or how austere, versus how generous a society you wish to have has to begin with an analysis of the way in which the real economy actually operates. People can and obviously do disagree about values. For example, if you decide to stop spending money to help the long term unemployed there are many who would say this promotes additional unnecessary misery in a society and since the unemployed are almost always unemployed through no fault of their own, it is unjust not support them and the children dependent upon them.

Others argue that people should be more self reliant. They prefer to blame the victim of unemployment rather than help them. Perhaps they also believe that smaller government somehow solves the unemployment problem in the longer run by acting as an incentive for private investors to create more jobs. They argue that labour markets once wages are allowed to drop will clear and unemployment that remains is somehow voluntary. But this classical laissez-faire view did not work in the 1930s. Instead it reinforced the depression.

But the macro-economic question is somewhat different from the values question. My motivation for exploring the theoretical problem of how the real economy actually works is partly an ethical one- I dislike unemployment on moral grounds- but it is also driven by a desire to design a policy that makes the economy work better by increasing both growth and efficiency. Unemployment undermines both.

So we ought to design a policy response that sharply limits the damage that a deep recession and financial crash causes and helps reverse it as quickly as possible.

That is precisely the role of deficit finance or economic stimulus . When someone is unemployed they are not going to be spending as much of their income and wealth as they did in the past. The subtraction of their spending undermines the economy as a whole and affects businesses who depend on people's spending to sustain their business.

So unemployment undermines business confidence and contributes to excessive pessimism on the part of investors. As unemployment rises investors will postpone investments and instead sit on cash and thereby withdraw it from total aggregate demand for goods and services. This aggregate demand which consists of consumption expenditures, investment expenditures and the difference between exports and imports has one other additional component.

That is government expenditures on consumption and investment. This government portion of consumption and investment has to subtract taxation because taxation removes spending power from both individuals and businesses. G for government minus T for taxation is also a measure of the government deficit. If because of the shock of a crash and a deep recession private spending and private investment has diminished then we can compensate for this by spending on the government side using the mechanism of a deficit to transfer savings held by businesses and consumers while they are not spending to governments who spend the money on stimulus. the G-T deficit stimulates the economy so long as interest rates do not rise to choke off private investment. The Fed by keeping the rates low accomplishes this.

The money to finance the deficit is borrowed by governments who pay a low rate of interest on it because interest rates are very low in a recession. To make sure that the rate stays low for some time the Federal Reserve ensures a loose monetary policy by buying more of the treasury debt than they would in booming times. The vast bulk of the U.S. public debt is borrowed from American savers including pension funds and institutional investment funds. China only finances under 10 % of the American debt.

As the economy recovers and grows the ratio of debt to the GDP will begin to fall again so long as the interest rate charged on the debt is less than the growth rate in the economy. As the unemployment rate drops tax revenues will rise and expenditures on the unemployed will drop and budget balance will be easier to achieve. The key is to set a consensual target on how low of an unemployment rate you as a society wish to have , what state of repair of your infrastructure you feel is acceptable and then having achieved these goals strive for a balanced budget.

It also helps to separate out out capital expenditures from current ones in terms of accounting for them in the budget. Investments in human capital for example bear fruit over many years . They should be expensed accordingly.

Treasury bills and U.S. government bonds are sound investments. The historical record shows this. At the end of the second world war, a war which could not have been won without using the tool of deficit finance, the ratio of the debt to the GDP was far higher than today. it was over 120 % of the GDP.(121.7 % in 1946 table 7.1 , p.126,Budget of the U.S.Government historical tables, 2008)