President Biden plans an emergency economic infusion of $1.9 trillion, all of it financed by debt. He hopes to complement that with trillions more for green infrastructure and other urgent needs, financed by tax reform.
So far, the $2.2 trillion CARES relief act of last March, plus the $900 billion approved by Congress in December, plus Biden’s new $1.9 trillion plan, will increase the public debt by $5 trillion, or about 25 percent of GDP.
This would have been unthinkable not long ago. But the debt-financed spending is approved by everyone from the conservative chair of the Federal Reserve, Jay Powell, to the U.S. Chamber of Commerce, and by most mainstream economists.
So several questions arise:
What changed in the structure of the economy to make all this debt financing sensible?
Is there any practical limit to the Fed’s capacity to just keep buying as much debt as the Treasury needs to issue, and at rock-bottom interest rates?
Why is the prevailing climate of interest rates and inflation so low? What might cause rates to rise?
What’s the connection between low inflation and low interest rates? If inflation were to rise, would interest rates need to rise with it? And what, if anything, is left of the Phillips Curve, the supposed trade-off between unemployment and inflation.
Most importantly, assuming that Biden can get more public investment through Congress beyond a first installment as part of the budget reconciliation (which needs only 50 Senate votes), how much should we spend, and on what? How much of that should be debt-financed and how much should be tax-financed?
Among the many bad policy ideas of recent Democratic regimes, both as economic theory and as political strategy, was the conceit that public spending needed to be “paid for.” In other words, new taxes were required to finance all new spending once the Great Recession was over.
A related bad policy, practiced by then–Fed Chair Janet Yellen, was to keep raising interest rates, at a time when wage growth was low and inflation was below the Fed’s own target.
Democratic OMB directors were obsessive on the point that all new spending had to be paid for with new taxes. It would prove that Democrats were “fiscally responsible,” as if anyone other than Pete Peterson cared. Judging by falling interest rates, the bond market obviously didn’t care. But that premise gave Republicans an effective veto over new public outlay: no new taxes, no new spending.
Under Reagan and both Bushes, the Republican antipathy to new deficits did not extend to deficits widened by new tax cuts. Trump’s tax cuts will total $1.9 trillion over ten years. Even without the emergency COVID spending, Trump’s policies increased the all-important debt-to-GDP ratio to about 100 percent, a level that orthodox economists used to insist would trigger runaway inflation or a run on the dollar.
But that was then. One salutary side effect of the pandemic has been to shelve all these assumptions of fiscal and monetary orthodoxy. What now?
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TO SHED SOME LIGHT on these several questions, I consulted several economists.
On the question of what changed in the economy to create long-term low inflation, and by extension low interest rates, most economists offer two basic answers. The first is that the economy had never fully recovered from the Great Recession when the pandemic depression hit.
The second explanation is the demolition of labor bargaining power and the rise of globalization. And of course the two are connected.
In the era of strong unions, effective wage regulation, and mostly national economies, policymakers worried about the supposed trade-off between unemployment and inflation, known to economists as the Phillips Curve. In standard economics, this reflected basic supply and demand: When unemployment is very low, employers have to pay more to attract workers. If wages rise faster than productivity, inflation results, and it then cycles through the economy.
But low nominal rates of unemployment don’t mean the same today as they did half a century ago. Unions are weaker, minimum-wage regulation has lagged behind prices, gig work has devastated worker bargaining power, labor force participation rates are down, and outsourcing has allowed access to an even cheaper worldwide labor pool. Globalization generally, with China as the emblematic example, has led to a world of falling prices, another offset to any inflationary pressures in a high-growth economy.
Debt-financed spending is approved by everyone from the conservative chair of the Federal Reserve to the U.S. Chamber of Commerce, and by most mainstream economists.
Alan Blinder, an entirely mainstream economist who served as vice chair of the Fed, says that structural changes in the economy have led to a low-inflation, low-interest-rate environment, in which unemployment could get lower and the national debt could get a good deal bigger without anything bad happening. “We now have two big episodes—the late 1990s and the late 2010s—when unemployment went very low with no sign of accelerating inflation. If that doesn’t demand a rethink, I don’t know what does. And the potential rewards of very low unemployment are immense,” he told me.
In current circumstances, the debt-to-GDP ratio could well rise to another 50 percent above its current level without anything terrible happening. That’s $10 trillion in debt-financed public investment.
Even Stephanie Kelton, a leader of the school known as Modern Monetary Theory (MMT), does not hold that government borrowing capacity is infinite. It would eventually be constrained by the capacity of the economy to sustain growth.
At some point, also, it would be smart to finance some of the public spending with tax reform, for the sake of greater income equality. Simply repealing the Trump tax cuts would provide about $2 trillion that would make the economy less unequal and provide funds for public investments—which would make it still more equal.
Economist Robert Pollin of UMass Amherst, a sometime adviser to Bernie Sanders, proposes that we raise some $300 billion a year from a financial-transactions tax, which could support urgently needed public outlays such as green investment.
With the Treasury paying just 1.837 percent to borrow money for 30 years, it also would make sense for the government to borrow a lot more money with longer maturities. That way, we could lock in very low interest rates, and there would be no risk of rising rates requiring that a larger share of budget outlays go to pay interest charges—something that fiscal hawks love to warn about.
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The vast bulk of federal debt is in short-term Treasury bills. Why? Because short-term interest rates are even cheaper—effectively zero for six-month debt. The conventional wisdom has long been that it makes sense for the government to save money by borrowing short.
But these are not ordinary times. Whether we call it a green infrastructure bank or just plain Treasury borrowing, it would make sense to lock in low long-term rates just the way a homeowner does with a 30-year fixed mortgage rather than an adjustable one.
As Nobel laureate economist Joseph Stiglitz puts it, “Think of it as an insurance policy. If the economy really strengthens, rates could rise. It’s worth paying a little more now to lock in long-term government borrowing costs.”
The government of Austria has been issuing 100-year bonds. Its most recent offering pays just 0.88 percent. Why would anyone make that investment? Because it’s a better yield than the return on 30-year bonds, which are negative in several European countries.
A related question is whether the government can just keep borrowing as much as it needs, without interest rates rising. In the past century, we’ve had three tests of that proposition.
During World War II, the Fed and the Treasury made a deal. The Fed would simply purchase as much money as the Treasury needed to borrow to finance the war and at interest rates pegged at about 2.5 percent. Despite the immense recovery stimulus and effectively zero unemployment, there was little inflation because of wage and price controls.
In the wake of the financial collapse of 2008, the Fed again bought bonds to the tune of several trillions of dollars. They rebranded this radical program with the disarmingly technical term “quantitative easing.” There were no wage or price controls, but inflation was not a concern because the economy was so depressed.
As Robert Pollin charmingly points out, the idea of a trade-off between inflation and unemployment is one of the few points on which Karl Marx and Milton Friedman agree.
The current borrowing to deal with the COVID depression is occurring in similar circumstances. Simon Johnson, the MIT economist who was formerly chief economist of the IMF, says, “The lack of a recovery is the problem, not the debt.”
Johnson supports more debt financing, both of short-term measures to help people survive, as well as long-term infrastructure investments that the private sector seems incapable of making for a profit.
Due to the weak recovery and the structural changes noted above, inflation and interest rates have remained very low and falling, even after the economy ostensibly recovered and unemployment fell below 4 percent. Why didn’t the higher debt levels and all those Fed bond purchases lead to inflation? Joseph Stiglitz has an intriguing explanation.
“All that borrowing didn’t lead to an increase in productive economic activity. It sat on bank balance sheets,” Stiglitz reminds us. “The Fed’s balance-sheet expansion wasn’t inflationary because it wasn’t effective.”
The banks mostly invested the money in safe securities. Neither the Fed bond purchases not the Trump tax cuts led to growth-enhancing investment.
Though Blinder, Stiglitz, and Pollin disagree on some issues, all three agree on one thing: Because the private financial sector has proven incapable of channeling money to where it will support increased economic growth, the government needs to do the job, via massive spending on infrastructure.
Pollin’s most recent research, in a paper with Shouvik Chakraborty, proposes a ten-year public-infrastructure investment of $600 billion a year, for a total of $6 trillion. According to the report, this would produce about 4.6 million jobs to upgrade public infrastructure and another 4.5 million jobs transitioning the economy to green energy. Complementary private-sector jobs would produce millions more.
The idea that massive public borrowing coupled with progressive taxation should be used to underwrite public investment directly takes us back to a radical idea proposed by Keynes—the idea that savings should be substantially socialized because an unplanned private economy is simply not capable of directing resources to where they were needed, at acceptable cost.
THE PHILLIPS CURVE’S SUPPOSED TRADE-OFF of inflation against unemployment was substantially discredited by events in the 1970s, when joblessness and prices rose in tandem. Yet that trade-off is not quite dead; it’s dormant, most economists agree, due to the slack economy.
If we ever did get full employment and robust growth in the context of a massive public-infrastructure program, Stiglitz points out, you could see some supply bottlenecks and shortages of skilled workers, which in turn could raise wages and prices. But as Stiglitz notes, that’s all the more reason to have a complementary policy that is anathema in a free-market economy—namely, economic planning.
With a long-term economic plan for public infrastructure, we could anticipate shortages of skilled workers, and undertake training programs. And with a shift to a green economy and a reshoring of supply chains, there would be less worry about bottlenecks and price pressures due to vital offshore inputs being in short supply.
As Pollin charmingly points out, the idea of a trade-off between inflation and unemployment is one of the few points on which Karl Marx and Milton Friedman agree. “It was really invented by Marx,” Pollin says. “If workers struggled successfully to increase their wages, corporations would defend profits by increasing their prices.”
In Friedman’s version, there was a natural rate of unemployment—technically a NAIRU, or non-accelerating inflation rate of unemployment. For Friedman, if you removed all market distortions such as unions or wage regulation, the natural rate would be zero, since workers would be compelled to accept whatever employers offered.
This was widely dismissed by most economists as disconnected from the real world, where at least some employers value long-term relationships with their employees and labor markets are segmented. But as Lyft, Uber, and the other sponsors of the gig economy demonstrate, actual labor markets are becoming more like the dystopia of Friedman—leading to the class struggles proposed by Marx.
We are a long way from the kind of robust recovery that would generate wage increases, much less inflationary pressures. But a massive green-infrastructure program on the scale proposed by Pollin—and embraced to a surprising degree by Joe Biden—could move us in that direction. Biden’s own green-infrastructure plan would spend $3 trillion over ten years.
For years, the inflation rate has been well below the Fed’s own target. That’s one reason why the central bank has shown no hesitancy in purchasing massive quantities of bonds. If we ever get back to the point where a strong recovery coupled with restored worker bargaining power and wage increases begins producing some price pressures, wouldn’t that be a nice problem to have.
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