January 10, 2012
Policy implications
Our policy makers should take several lessons from this closer reading of Reinhardt and Rogoff’s assertions.
First, be very skeptical when someone says “growth slows once debt-to-GDP exceeds 90%.” That finding is based on a limited data set which may have little relevance to the US today. Without an underlying theory, encompassing at a minimum interest rates and the nature of the deficit, the 90% threshold may be nothing more than correlation without causation. Our status as the reserve currency and our ability to borrow at exceptionally low long-term interest rates uniquely distinguish our circumstances.
The nature of the deficit matters. On this point, I am greatly persuaded by Woody Brock, who distinguishes between good and bad deficits. A bad deficit is one that does not lead to economic growth – interest payments and transfer payments from federal to state and local governments are clear examples. Of the $787 billion stimulus plan passed in 2009, $217 billion was for aid to state and local governments, and another $120 billion was for relief, such as unemployment benefits.
A good deficit funds projects that support growth. As Brock has argued, our country needs high-speed rail, upgrades to our electrical grid and other infrastructure improvements. Only about 10% of the $787 billion stimulus was spent on infrastructure, much of it on projects that would not meet Brock’s high-growth criterion. Borrowing money to fund high-growth projects makes sense, but only if they are vetted by an independent source, such as an infrastructure bank, to ensure that they have a high return-on-capital. Spending money on projects that support the agenda of individual politicians or special interests leads to bad – not good – deficits.
If transfer payments are necessary – for example, to avoid painful cutbacks in public services – they can still be done by creating a good deficit. The federal government could stipulate that those payments would be conditional on certain reforms, such as replacing pension plans for newly hired public employees with defined-contribution plans. Public pension plans are a major source of financial instability and are vulnerable to the worst abuses of cronyism and political favoritism. Bond markets would surely react favorably to this type of good-deficit spending, which would signal that the federal government is serious about addressing its long-term problems.
As Brock has said, “without public spending there is no way the private sector can bring things back to where they need to be.”
Lastly, don’t believe those who say there are no good alternatives or that the US faces a series of bad choices that involve painful delevering. There are good options, but they are not easy to implement. We need to heed the lessons of the Industrial Revolution and the Great Depression, and accept that our government must embark on a series of initiatives large enough in scope to restore the country to full employment.
One opportunity stands out – energy. As I have previously written, we need an energy policy that realistically addresses the costs of pollution and the potential for global warming. Cap-and-trade is the ideal solution, and it would remove the uncertainty around pricing that hinders the development of alternative energy technologies. A proper energy policy, supported by good-deficit spending, would position the country for the inevitable decline in fossil-fuel supplies.
Another example of good-deficit spending was contained in the Simpson-Bowles plan, which both Reinhart and Rogoff have supported.
Reinhart and Rogoff’s title, This Time is Different, was intentionally ironic. Their message is that there has been an alarming consistency across financial crises – and that “this time” is never really all that different. A similarly alarming consistency is now shared by those who reject deficit spending and fear that our fate rests in the hands of the bond market vigilantes.
That pessimistic sentiment has descended to the depth of groupthink. Policy makers must recognize that this calls for leadership that questions the prevailing wisdom and embraces unconventional solutions. Let’s hope that our leaders recognize that it is not too late to grow our way out of debt.
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