Breaking out of the Deficit Trap: The Case Against the Fiscal Hawks

From this paper's Preface, by Dr. Dimitri B. Papadimitriou, President: For some time, Levy Institute scholars have been engaged with issues related to the current account, government, and private sector balances. We have argued that the existing imbalances in these accounts are unsustainable and will ultimately present a serious challenge to the performance of the U.S. economy. Other scholars are also concerned, but for reasons that we do not share. They argue that the interest rate is determined by the supply and demand of saving.When the government reduces its saving, the total supply of saving falls, and the interest rate inevitably rises. The result, they say, is that interest-sensitive spending, and investment in particular, falls. Finally, these scholars say, less investment now necessarily implies less output in the future. In this new brief, Senior Scholar James K. Galbraith evaluates a recent article by William G. Gale and Peter R. Orszag, two economists who regard this view of deficits as plausible. He forwards an alternative, Keynesian view. This alternative suggests that deficits can increase overall output, possibly enabling the government to spend more money without increasing the ratio of the debt to GDP. He casts doubt on the notion that the interest rate is determined by the supply and demand of saving, arguing that monetary policy plays a much larger role than Gale and Orszag allow for. Moreover, he writes, strong demand for goods and services is more important than the supply of capital in determining the pace of technological advance and the rate of growth of output per worker. Though he is skeptical about Gale and OrszagÕs theoretical framework, Galbraith calls attention to some important econometric findings in their paper. Gale and Orszag calculate the effects of deficits on the interest rate. Consistent with GalbraithÕs view, monetary policy turns out to be a major determinant of long-term interest rates. When interest rates are measured as the current cost of funds, Gale and Orszag find that deficits have no significant impact on interest rates. GalbraithÕs theoretical view of interest rate determination, together with Gale and OrszagÕs empirical findings, constitutes a powerful rebuttal of the reflexively antideficit view. Recent economic history suggests that this rebuttal is plausible. The recent increase in the U.S. federal deficit has not yet resulted in high interest rates. Interest rates in Japan, where deficits have been very large, remain at rock-bottom levels. The Levy Institute continues to believe that, together, unsustainable economic imbalances amount to one of the nationÕs most pressing issues, as we believe our Strategic Analysis series has documented. As Galbraith demonstrates, however, some observers are placing an undue emphasis on government deficit reduction, as if the government were the source of all that ails the economy. A more balanced approach would take into account the pernicious effects of excessive private debt and the need to devalue the dollar. We believe that our readers, especially those who follow the Strategic Analysis series, will find this brief to be a helpful look at another facet of the complex and knotty deficits problem.