I. O. Me

Twenty-five years ago, I wrote an exam essay explaining why public debt is fundamentally different from private debt. It’s time to dust off that lesson again – not to say public debt is good, but to weigh in against glib analogies to household overspending.

The biggest difference applies to the 72% of federal debt held by Americans – all those Treasury bills and bonds in U.S. investment portfolios, safe deposit boxes and grandkids’ sock drawers. We hold both the I.O.U.s and the things we bought with them. With private debt, the borrower buys stuff, and someone else holds the I.O.U. The borrower has stuff plus debt. The lender has less stuff plus an I.O.U. With domestically held Federal debt, we have the stuff, plus debt and the I.O.U.

This is what economists mean when they say public debt is money we owe ourselves. Our debt is offset by our securities – plus whatever we bought with the debt. Even intergenerationally, this difference still holds. Future generations will have debt plus offsetting securities plus the highways and technological innovations and well-schooled kids. It’s so different from private debt that it’s bizarre and hard to wrap our brains around (which might be why so many people don’t).

The second biggest difference is that the federal government does not have a capital budget. That is, our annual deficits include the full cost of investments in the future for future benefits, such as building levees and hospitals or fighting wars to protect our values. That’s like individuals buying cars and houses cash-in-full.

The reality is that we usually make our budgets by comparing our annual income to just that year’s monthly payments for our house and car and other expenses. A person with $30k left over after all other expenses isn’t limited to buying a $30k house, but rather a house whose mortgage payments add up to $30k a year. After all, why should we pay for a house all in one year when we'll be using it a little bit at a time over 20 or 30 years?

When the federal government buys a house, the full cost hits a single year’s budget. Running a deficit and covering the deficit with bonds is how the government takes out loans and mortgages to pay for long term investments and for durable goods. Of course, there’s a temptation to run deficits to pay for others things, too, that may not have long term payoffs. But that doesn’t change the fact that investments hit current budgets and current deficits.

Finally, the 28% of debt that is foreign owned does not give the foreigners any control over the US. Treasury bonds are not stocks, which confer ownership. Nor are US debts collectable in the way that private debts can be collected by seizing assets and garnishing wages. Besides freezing a piddling amount of overseas banking account balances, foreign holders of US bonds can’t do anything with those bonds if the US refuses to pay. They can threaten to stop doing business with the US in the future, but there’s no collection mechanism for past debts. Very different from private debts. Foreign debt holders must play nice to be paid back.

Much was made in the 80s about how Japan could sink the US by dumping bonds. Now it’s China. But think of it from China’s perspective. If it tries to dump US bonds, it would lose hundreds of billions of dollars out of the $1 trillion in bonds they hold, tanking its own economy like a reverse stimulus package. It would also drive the US dollar down, which is exactly what the Americans – both conservatives and liberals – have been hounding China to do. This would add to the Chinese collapse by stopping exports and shutting down all those Chinese factories humming along for Wal-Mart and Nike and Sears.

The effect of public debts on interest rates, inflation and expectations is complex, and borrowed funds can be used well or squandered. But, for better or worse, public debts are quite different from private debts and we should not judge them in the same light.

Tax or Spend

There is a reason Reagan called tax cuts "Supply Side" economics, and that reason undercuts the rationale for tax cuts as a stimulus during a demand recession. There are many pros and cons of tax cuts versus government spending, but here's the economics angle.

The theory behind tax cuts is that taxes reduce the incentive to work and start businesses, because taxes reduce the reward a worker or investor earns from an increase in effort. That's why advocates of tax cuts are so wedded to tax cuts for the rich. Rich people own the businesses and create the most jobs. If we reduce the "penalty" on higher profits (i.e., taxes), rich people will want to earn more profits and grow their businesses. Workers will also want to work harder and longer hours if they take home more of their salary, but the primary way workers benefit under supply-side tax cuts is through rich people growing their businesses and profits from those businesses "trickling down" to workers.

I'll share the math below, but here's a summary of the problem with tax cuts. In a demand recession, the problem is not that workers don't want to work or businesses aren't big enough. The capacity to produce (i.e., supply) is fine. Too fine. The problem is that nobody is buying. If you cut GM's taxes, it's still not going to build a million cars that no one will buy. If you cut our unemployed friends' taxes, that still doesn't help them find jobs.

That's why even supply-side mainstream economists call for fiscal stimulus (government spending) in the current crisis. When the government builds a bridge, it employs people. It buys concrete and steel. It creates demand. If the government bought a million GM cars (just 1% of the bailout package), GM factories and supplier factories would reopen. Economically, it doesn't really matter much how the money is spent, as long as it is used to buy things, not just given to people. Ironically, Sarah Palin's "bridge to nowhere" would help close the demand recession just as much as a homeless shelter.

So why not just give the money to people? Doesn't a tax cut stimulate demand, also, since it puts money in shoppers' and business owners' pockets? Here's where the math comes in.

Aggregate demand is:

GNP = G + C + I + (X-M)

where

G = Government spending
C = Consumption
I = Investment
(X-M) = Net exports

When government spends $1M, G goes up by $1M and therefore so does aggregate demand. The $1M is spent on goods and services and becomes income for households and businesses. Some of the income is stashed away, but some -- for this example, 80% -- is spent on other goods and services, so C+I goes up by $800,000. That is the workers and business owners that get the $1M in turn spend $800,000 on food, gas, movie tickets, computers, painting services and so forth. The $800,000 they spend is income for the people and businesses they buy from, and 80% of that -- or $640,000 -- gets spent.

So the impact of $1M in government spending on aggregate demand is:

$1M (initial government spending)
+ $800,000 (multiplier effect, round 1)
+ $640,000 (multiplier effect, round 2)
+ $512,000 (multiplier effect, round 3)
etc.

...which, using the formula for the sum of a geometric series, all adds up to

1,000,000 / ( 1 - 80% ) = $5M

Now, let's say the government cuts taxes by $1M instead of spending $1M. Incomes go up by $1M, of which 80% gets spent, generating $800,000 in C+I. That's income for others, who then spend $640,000 to boost C+I more, etc.

So the impact of $1M in tax cuts on aggregate demand is:

$800,000 (initial boost in C and I)
+ $640,000 (multiplier effect, round 2)
+ $512,000 (multiplier effect, round 3)
etc.

...which adds up to

800,000 / ( 1 - 80% ) = $4M

That's $1M less impact on demand. In fact, it doesn't matter what the assumed propensity to spend (80% in this example) versus stashing money away is. The impact of $X in government spending is always $X greater than the impact of an $X cut in taxes.

Intuitively, it's easy to see why. When government gives out $1M in tax cuts, nothing is bought that requires workers and businesses to produce. There's just as many new cars on the dealership lots. There's just as much gravel in cement company stockyards. There are just as many carpenters waiting for the phone to ring. All the stimulus in demand starts when -- and IF -- people and businesses spend some part of the $1M.

On the other hand, since GNP = G + C + I + (X-M), when G (government spending) increases, GNP goes up directly because government spending programs buy cars and trucks and cement, and they hire carpenters and project managers.

The math can get more complicated, but the point holds.

For example, government spending can "crowd out" private investment by driving interest rates up. So G increases and I decreases, leaving C+I+G+(X-M) unchanged in the long run. But interest rates are irrelevant right now in our liquidity trap. Businesses are freezing investments because no one will buy what their investments produce -- not because interest rates are too high. Also, the "crowding out" effect is driven by deficits and is therefore the same whether the government spends more or cuts taxes.

Another wrinkle is that when incomes go up, (X-M) tends to go down. However that's a small drag that also affects tax cuts and government spending equally. At least, with government spending, the government can choose to direct the first round of demand (the +G) at domestic producers if it chooses to.

Government spending may take longer than tax cuts to ramp up. Tax cuts, though, might never even make it to the economy if people sit on the money or pay off debt

So, there are political arguments about how big government should be and whether rich people should be taxed more than others, but if economic stimulus in a demand recession is the goal, a dollar of government spending has more impact than a dollar of tax cuts.

Give Me Liberty or Give Me Competition

As recriminations fill Republican airwaves, one question the party should ask itself is whether it is the party of competitive markets or the party of free markets. When the dust settles from the 2008 elections, one casualty will be the automatic alliance between economic libertarians and advocates of the Invisible Hand.

The Competitive Markets Point of View

The Invisible Hand operates in perfectly competitive markets to guarantee that the pursuit of individual profit will lead to economic efficiency, national growth and the distribution of riches according to each person’s (marginal) contribution to creating those riches. However, as nature abhors a vacuum, business abhors competitive markets because competition is the enemy of profit. That is why both Adam Smith and Milton Friedman advocated strong government intervention to maintain competitive markets and roll back the tendency of free markets to concentrate power, collude, conspire and even corrupt (Enron, WorldCom, big tobacco, Three Mile Island…).

Adam Smith and the “freshwater” economists who evangelize “free market” capitalism are actually advocating “perfect competition.” The “free” in “free market” refers to freedom from concentrated market power and from a government menu of prices and outputs levels. It refers to markets where all workers and all businesses face a full and identical range of choices and where none can influence the choices of its competitors. In particular, perfect competition requires:

• infinitesimally small businesses selling things and services that are perfect substitutes for their competitors’ products
• perfect information about what things and services are worth, now and in the future
• prices that reflect all the downstream impacts of products and services
• some mathematical niceties, like rationality and free disposal

Game theory and behavioral economics have added complexities but have not changed Adam Smith’s proposition that perfect competition requires active and robust government intervention. Even if we set aside do-gooder interventions motivated by distributional, environmental, political or other ethical objectives, we are still left with a competition-based case for government interventions such as:

• product labeling and corporate disclosure requirements
• laws against insider trading of securities
• antitrust, anti-predatory practices laws
• product liability laws
• standards setting
• inspections
• compensatory tariffs
• etc.

The Free Market Point of View

In contrast, the libertarian meaning of “free market” capitalism is that government should leave workers and businesses alone. It is primarily motivated by the ethical belief that private entities have a right to do whatever they choose unless there is a compelling reason for governments to restrict their choices in order to protect other people’s choices.

Under the libertarian approach to free markets, there is no rigorous theoretical connection between libertarian ideals and economic efficiency except through “natural law” arguments that are sometimes more hortatory than theoretical. Even if Mussolini could make the trains run on time, the argument goes, that wouldn't make it right. Libertarians generally observe that when governments meddle, they make things worse. This observation overlaps with the Invisible Hand economists’ desire to get the government out of setting prices and outputs.

The Split

For a long time, examples of inept and ineffectual government interventions, contrasted against steady growth in wealth and income in the private sector, papered over the fundamental incompatibility of the two approaches to free market capitalism and allowed them to coexist in the Republican party.

Two things have changed, recently. One is that the financial crisis has proven once and for all that private entities left to themselves do not reliably make economically optimal or even selfishly smart choices. Unregulated markets are far from perfectly competitive, as market power is highly concentrated, some private entities hide and distort information unless corned like rats, and they daily make decisions with societal impacts far beyond their own bottom lines (“externalities,” in economics-speak).

The second change is that for most of the past decade or so, corporate profits and income among the wealthiest individuals have risen strongly while middle and lower class incomes have fallen in inflation-adjusted dollars. The increasingly stark contrast between the growth in national output and stagnation in worker bee incomes and security has made it harder for the Joe the Plumber argument to stick: that we should help the business class because their success will trickle down, or at least because we are likely to join their ranks one day.

Now, Samuel Joseph Wurzelbacher notwithstanding, the Joe the Plumbers of the Republican party have begun to divide over the choice between the right to be left alone and the right to a fair fight.

Our schoolroom pledge to uphold “liberty and justice for all” takes on new meaning. One persuasive (for some) line of argument is that there is no justice without personal liberty, so we must get government out of our private economic lives. Another persuasive (for others) line of argument is that being stuck at the losing end of an uneven playing field is its own sort of prison, so liberty and justice require government to level that playing field by negating the anticompetitive tendencies of private enterprise.

Both are legitimate Republican points of view, up to now mashed together with faith in the integrity, intelligence and efficiency of private enterprise acting as the glue. But that glue dissolved in the 2008 elections. As free markets appeared to be neither efficient nor benevolent, some of the Republican electorate stuck with free markets as intrinsically just and an end in itself, while others turned to government intervention to restore competitive markets and enable stable and efficient outcomes. The Republican party needs to confront that schism and decide where it stands between free markets and competitive markets.

Is Keynes Dead in the Long Run?

It may turn out that the erstwhile discredited John Maynard Keynes’ key error may have been that, in the long run, he is not dead after all. What both the left and the right identify as today's problems and their solutions stir dusty memories from my generation of economists.

My generation entered the “dismal science” during the twilight years of Keynesian economics, but ripened in graduate school under the full force of the conservative, neoclassical revolution. Now, much of what my professors – including Martin Feldstein, Greg Mankiw and Larry Summers – taught us to cast away is coming back for a reprise. However, like George Carlin’s seven dirty words, the old Keynesian lingo still seems banished. Are these Keynesian terms below rising from the dead, only unspoken and invisible as ghosts?

Liquidity trap. We've relied on monetary policy to manage business cycles since Reagan – in particular, interest rates. Keynes posited a condition where confidence and interest rates might be so low that reducing interest rates further would have no effect on borrowing and economic activity. People would be just too fearful, and interest rates would be too low to matter. He called this condition the “liquidity trap,” and used it as an argument against those who advocated monetary policy instead of government spending (“fiscal policy”). If our current state is not a liquidity trap, then what is? Our recent death spiral began when the Fed slammed its foot down on the interest rate gas pedal but the lending community completely failed to respond.

Fiscal multiplier. Keynes prescribed government deficit spending in economic downturns. He argued that supply-side interventions would fail due to the liquidity trap, plus the slowness of supply-side policies (thus the “in the long run, we are all dead” quote). He predicted that supply-side stimuli wouldn’t work as long as aggregate demand stayed low and nobody had the confidence to buy things. Therefore, he favored direct government spending over tax cuts, because buying roads and bridges and hiring people would “prime the pump” and get production started again. Sound familiar? Both left and right say the next stimulus package has to include direct federal spending. Feldstein declared last spring's fizzled tax rebates a miscalculation on his part and on the part of his fellow neoclassicists.

Automatic stabilizer. Keynesian economists taught that governments should embrace deficits during downturns because a downturn is the worst time to cut spending and raise taxes. It is the time when people need the most safety net spending, such as unemployment benefits. Also, tax revenues naturally decline as the income base falls. The last thing people need during a recession – Keynesians said – is for higher taxes to cut their take-home pay even more. Now, even most Republican fiscal conservatives are willing to use deficit spending as a stabilization tool.

Neoclassical theory predicts that government spending will just “crowd out” private business investment, resulting in zero net growth. True, the size of the economy is the sum of government spending, consumer spending, private investment and net exports, so increasing government spending seems like it should grow the economy. But deficits would drive up interest rates and drive down the private investment part of the equation. Government spending would also drive up inflation, decreasing the consumer spending part of the equation (in inflation adjusted dollars) and exports. Rational expectations could even make these mechanisms cancel the stimulative effects of government spending sooner rather than later.

Are the Keynesians right, after all? We’ll know in four to six years. Are the neoclassicists right, after after all? We’ll know that in two to twenty years, as the pipers come calling. Place your bets.