What Size Fiscal Deficits for the United States?

November 21, 2016 1:15 PM

The US government can borrow at interest rates very close to zero. Surely the long-term benefits of public investment are greater than zero. Isn’t it obvious that the case for more government borrowing is overwhelming, that we can and should run much larger deficits?

The answer? Not so fast.

True, US government borrowing costs are very low. Indeed, when inflation is taken into account, the US government can borrow at negative real rates. Such rates are substantially lower than the (low but positive) US growth rate. Even long-term rates are low, so by issuing long-term debt, the government can lock in low interest rates for a long time.

True, if interest rates were to remain lower than growth rates forever, this would have a dramatic fiscal implication: The government could issue debt, never repay it, and still the ratio of debt to GDP would steadily decline. No taxes would ever be needed to achieve debt sustainability. Even if the inequality reversed at some time in the future (which might well happen), the taxes needed to maintain the debt-to-GDP ratio would be small. The more distant the time of reversal, the smaller the amount of required taxes.

True, if the economy were operating far below potential, the case for large deficits would then be a very strong one. Surely public investment should be increased and financed by debt under such circumstances. And even an increase in current spending, say direct budget transfers, would be justified: It would increase aggregate demand and bring the economy back to potential, all with no or little fiscal cost.

So is it an open and shut case? No.

The US economy is operating close to its potential. Judging from the nascent inflation pressure, we are close to full employment. The US growth rate, which has hovered around 2 percent, is close to current estimates of potential growth. Inflation is still below target, but it is forecast to get there soon.

This implies that if US policymakers wanted to avoid an overheating economy, greater public spending would have to be offset by a reduction in some component of private spending (which, presumably, would be achieved by an increase in interest rates by the Federal Reserve). To the extent that the reduction came from private investment, the relevant opportunity cost of public investment would not be the rate on government bonds but the marginal product of the private capital that would be crowded out. Given the poor state of public capital in the United States, the case is still there for an increase in public spending, and a corresponding higher deficit, but it is clearly weaker.

Is there a case for doing more? The answer is a qualified yes.

There is a case for temporarily overheating the US economy. The reason goes under the ugly name of “hysteresis” (something Larry Summers and I have worked on in the past and are again exploring). The term, borrowed from physics, refers to the notion that the long period of low growth and high unemployment has led to some permanent damage, which can be partly undone by a period of overheating of the economy. The most obvious case here is labor force participation, which has dropped since the beginning of the crisis by more than can be explained by demographic and other factors. Most likely, some workers who could not find jobs have become discouraged and are no longer looking for work. A period of very low unemployment may lead some of them to come back into the labor force. Thus, a larger fiscal deficit and some overheating may do some long-run good.

If overheating is indeed justified, it could in principle be achieved through monetary policy: The Federal Reserve could delay the increase in interest rates and allow the economy to overheat for some time. There is, however, a case to be made for using fiscal rather than monetary policy. Larger deficits and stronger demand would allow the Fed to increase interest rates faster. To the extent that prolonged low interest rates are increasing risks in parts of the economy, higher rates would decrease those risks. Higher rates would also take the economy further way from the zero lower bound on interest rates, giving the Federal Reserve greater room to maneuver if faced with another recession.

What is the bottom line? There is no case in the United States for all-out fiscal deficits. But there is a case for a fiscal expansion, based on carefully targeted public investment. Two remarks are needed here. Maintenance of existing infrastructure for example, which has been badly neglected, may be less glamorous and less politically attractive than brand-new projects, but it is where the government is likely to get the best bang for its buck. Public-private partnerships, which have been mentioned by the Trump program, may not be the right tool: By aiming at projects that can at least partly pay for themselves financially, they may generate the wrong kind of public investment. Maintenance and the most useful public projects may have high social returns, but they are likely to have low financial returns.