December 23, 2018
There is a popular theme in the media these days that the Trump administration is leaving us poorly prepared for the next recession. The basic story is that high deficits and debt will leave us less room to have a large stimulus when the next recession hits. This is wrong, at least if we are talking about the economics.
Before laying out the argument, let me first say that I do not see a recession as imminent. The recent plunge in the stock market means that the rich have less wealth, not that we will have a recession.
Okay, I realize that not everyone with money in the stock market is rich, but the impact on spending is going to be barely noticeable to the economy. Furthermore, while middle class people are going to be upset to see their 401(k)s fall by 15 percent, they were fortunate to see the sharp rise the prior two years. Long and short, this is just not a big deal.
As far as other factors pushing us into a recession, I don’t see it for reasons explained here. So I am not writing this because I think we are about to see a recession, but rather because I am trying to clear the path for when we eventually do.
The complainers in this picture say that because Trump’s tax cuts mean the deficits are large even when the economy is near full employment, we won’t be able to have even larger deficits when we are in a recession. They also say that high debt levels are leaving us near our borrowing limits. Both claims are just plain wrong.
First, as good Keynesians have long argued, our ability to run deficits is limited by the economy’s economic capacity. This means that if we run very large deficits when the economy is near full employment, we would be seeing higher inflation as excess demand pushes up wages, which get passed on in prices.
We may be close to this point now, but higher interest rates, at least partly as a result of Federal Reserve Board policy, are leading to classic crowding out. Housing is falling and the value of the dollar has risen against other currencies, crowding out net exports. But inflation remains low and stable, so there is still likely room to expand further even with the unemployment rate at 3.7 percent.
But suppose that we see the unemployment rate jump by 2–3 percentage points in another recession. The budget deficit will inevitably rise, instead of being 4–5 percent of GDP, it will jump to 6–7 percent of GDP as tax collections fall and payments for programs like unemployment insurance and food stamps rise. The argument of the complainers is that we will be unable to spend another 2–3 percentage points of GDP on a stimulus because the deficit is already too high.
But why would that be the case? Certainly, we don’t have to worry about inflation when the unemployment rate is close to 6 percent.
Usually, we get a story about investors’ confidence and their unwillingness to buy US government bonds when the deficit or debt (we’ll get there in a moment) get so large. I can’t claim to be an expert on investors’ confidence, but I do feel I can say that, based on experience, the people who claim to know about investors’ confidence don’t have a clue.
To take an old saying from Jewish mystics about the coming of the Messiah: Those who say, don’t know. And those who know, don’t say. The people who tell us what will or will not undermine confidence in the bond market generally don’t know what they are talking about.
But let’s suppose the confidence men are right and investors won’t buy up US government bonds because the deficit and debt are too high. Why can’t the Fed just buy up the bonds as it did with quantitative easing?
The counter-argument is that this would lead to a further loss of confidence and runaway inflation. Taking the second one first, runaway inflation with the unemployment rate at 6.0 percent and idle resources everywhere? What is the mechanism?
Okay, we’re going to take away those folks’ whiskey glasses and deal with the confidence point. Suppose that private investors sold more dollar assets and fled the currency altogether. On the interest rate front, the Fed could counteract the sales.
On the dollar front, we would see the dollar dropping against other currencies making our goods and services hyper-competitive. This will lead to a huge increase in our net exports, which is a perfectly good way to stimulate the economy. In other words, mission accomplished.
But what about the debt picture? If we count publicly held debt in the Social Security trust fund and other government accounts we are close to 100 percent of GDP and rising. Is this too large?
Well, Japan seems not to think so. Its debt-to-GDP ratio is almost 240 percent. The interest rate on its long-term bonds is now 0.04 percent.
But apart from this empirical counter-example, there is also a problem with the basic logic. Why would a high debt-to-GDP ratio be a problem? Suppose we decided to sell off the right to tax in specific areas in order to reduce the debt. We could, for example, sell off the right to tax gas, perhaps raising $100 billion a year or more. (If this sounds strange, imagine selling off toll roads, as some states have done. It would be a similar story, except instead of selling the right to charge tolls on the highway, we would be selling off the right to tax gasoline.)
That should be able to knock at least $1 trillion off the debt. Are we now better able to deal with our debt burden now that it is $1 trillion lower? I hope fans of arithmetic and economics would say no, but let’s move on.
While we don’t directly sell off the right to tax in general, we do something very similar by issuing patent and copyright monopolies. These government-granted monopolies effectively allow their holders to charge taxes on the items to which they apply. And the amounts are substantial.
In the case of prescription drugs alone, we will spend close to $440 billion this year on drugs that would likely cost less than $80 billion in a free market. This is a gap of $360 billion that we can think of as a privately imposed tax.
This is not just semantics. The government explicitly grants patent and copyright monopolies as incentives for innovation and creative work. In other words, this is how the government pays for these activities. The higher prices resulting from patent and copyright monopolies do make the economy run less efficiently. In this way, they are a drag on growth, just as public taxes would be.
The point is that if we want to do a full accounting of the government’s debt then we better add in the increased cost for a wide range of goods and services due to the monopolies the government has granted. My crude calculations put these in the neighborhood of $1 trillion a year, or roughly one-quarter of the federal government’s current tax revenue.
Of course, our deficit hawks never do this. This can be explained by the fact that they either don’t understand economics, which is a good reason not to listen to them, or they are simply not honest, which is also a good reason not to listen to them.
To be clear, large tax cuts to corporations, so that they could give more money back to wealthy shareholders in the form of buybacks and dividends (yep, giving money to shareholders through dividends is no better than buybacks) is not a good use of resources. It means the rich get to spend more money at a time when we should be focusing resources on green infrastructure and energy conservation.
In this sense, the Trump tax cuts leave us less well-prepared to face the future. But as far as being prepared for the next recession, sorry folks, you don’t have an economics case.
The politics are another matter. We know that the tax-cut-loving Republicans will all become huge deficit hawks the next time Democrats are in power. We should not be in the business of assisting their efforts to undermine the economy.
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