The conventional wisdom on government budget deficits is that they have to be paid for eventually: To repay the debts incurred because of today’s deficits, some future government will have to either raise taxes or cut spending. You’re hearing a lot of that talk in the fight over the debt ceiling.
But the eat-your-spinach argument isn’t always correct. Olivier Blanchard, a former chief economist of the International Monetary Fund, pointed out in 2019 that a big debt will shrink as a share of gross domestic product over time if the interest rate the government has to pay on the debt is lower than the growth rate of the economy. The government could get away with running deficits in perpetuity, as long as they’re not too big, he said.
Now some other economists have demonstrated a second mechanism by which a government could run deficits and never have to pay for them. Unlike Blanchard’s mechanism, it doesn’t depend on the relationship of interest rates to economic growth. Their research came out last month as a working paper released by the National Bureau of Economic Research. It’s by George-Marios Angeletos of M.I.T.; Chen Lian of the University of California, Berkeley; and Christian Wolf of M.I.T.
“Can Deficits Finance Themselves?” is the paper’s provocative title — evoking, to me anyway, the Laffer Curve theory that tax cuts can pay for themselves. The economists concluded that “deficits contribute to their own financing via two channels.” First, they can accelerate economic growth, which generates more tax revenue. Second, they can cause inflation to rise, which shrinks the effective cost of debt. (Tax revenues rise with inflation, while interest payments are fixed.)
“A large degree of self-financing is not only theoretically possible but also quantitatively relevant,” they wrote. The longer tax hikes are put off, the longer the deficit-fueled boom can run, the paper said.
I interviewed Angeletos and Wolf on Tuesday. They warned that their research shouldn’t be understood as justifying any size of budget deficit, and they had no comment on the current fight over the debt ceiling and Republicans’ proposed spending cuts.
“I wouldn’t dare present this paper in Greece, where I’m from, because I don’t want to give excuses for running bigger deficits” there, Angeletos said. He added in an email, “I would also hope that our work informs the ongoing policy debate in Europe (especially the German side) about how quick fiscal adjustment should be: Slow adjustments can be fiscally prudent.”
The Laffer Curve argument about taxes focuses on the supply side of the economy — that is, the people, machines, structures and software that produce goods and services. It says that if taxes are too high, people won’t want to work or invest in new equipment, so cutting taxes from that prohibitive level can produce more economic activity. The flaw in the Laffer Curve logic is that in reality, taxes are far below the point on the curve where cutting them would make tax receipts rise.
The Angeletos-Lian-Wolf argument, in contrast, focuses on the demand side of the economy. It requires two key assumptions, which seem reasonable to me. One is that consumers aren’t perfectly farsighted or can’t borrow cheaply. If they get a windfall from a tax cut, they will spend at least some of it, juicing growth, rather than save all of it to cover future tax bills when tax rates go back up. (The theory that people do save tax cut windfalls is called Ricardian equivalence.) The other assumption is that prices and wages are sticky: They don’t go up right away when demand rises or down right away when demand falls. When prices and wages don’t go up right away, a bigger deficit translates into stronger growth.
Running bigger budget deficits is a no-brainer when there are lots of unemployed people and resources that can be put to work through the stimulus. It’s not so great when the unemployment rate is low (as it is now), because the stimulus will end up creating inflation rather than growth. True, the inflation will help the government self-finance by making its debt payments effectively smaller, but it will hurt the owners of the government’s debt, such as pension funds.
“This is not a free lunch in all conditions,” Angeletos said. “It’s a pretty cheap lunch in a recession.”
To economists, Wolf said, the trick in the paper is demonstrating how the self-financing works in an extremely simple model of the economy and then constructing a mental bridge to show that it also works in a more complicated model of the economy. “People get on board relatively quickly,” he said. “They see it’s a feature they hadn’t appreciated.”
Elsewhere: What Copper and Gold Are Telling Us
Copper is an industrial metal. Gold isn’t. Some traders use the ratio of the red metal’s price to the yellow metal’s price to predict interest rates: When the ratio falls, long-term Treasury yields also tend to fall, perhaps because the relative weakness of copper is a signal of weakening industrial output. (Copper and gold are both affected by inflation, so it can’t be changing inflation expectations.) On the basis of that pattern, David Rosenberg, the president of Rosenberg Research in Toronto, wrote Friday that “we can expect yields to fall further from here.”
But the ratio isn’t a perfect predictor of Treasury yields. Gold has risen lately for an unrelated reason: Central banks are selling dollars to buy it. Also, Treasury yields are affected by other factors, including movements in the dollar, in different ways at different times, Victor Xing, the founder of the research company Kekselias, wrote in a blog post for the C.F.A. Institute in March.
Quote of the Day
“The dollar is widely used because it’s widely used.”
— Paul Krugman, New York Times newsletter (May 2, 2023)
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