Wednesday, November 25, 2009

On Deficits

Great post from Tyler Cowen:
There have been many posts on this topic [whether or not having a large deficit is ok] lately, start with Paul Krugman and Brad DeLong if you need to catch up. Today I have a few simple points:

1. Even if "it is fine to borrow more" is the most likely scenario, it is not the only scenario. Let's take a page from Marty Weitzman on climate change. The worst-case scenarios matter too, because they can be very, very bad. We need to think probabilistically about this issue.

2. Are there current intelligent discussions of the implied interest rate volatility embedded in current options prices? If we are looking for market tests, why not start there? Focusing on the point estimate of the market interest rate(s) discourages you from thinking probabilistically.

3. I know less about Belgium but I am not reassured by Krugman's point that "Italy can do it." I and many other observers consider Italy's economy to be a basket case which will only get worse. Nor is Japan in a satisfactory place, economically speaking.

4. Krugman writes: "Belgium is politically weak because of the linguistic divide; Italy is politically weak because it’s Italy. If these countries can run up debts of more than 100 percent of GDP without being destroyed by bond vigilantes, so can we."

I would interpret this evidence differently. A high deficit often is an unfavorable symptom of bad politics, even if you think the high deficit is economically OK on its own terms. It's a sign that you have dysfunctional institutions and decision-making procedures, as indeed they do in Belgium and Italy. I believe that the not-always-swift American voter in fact understands high deficits -- correctly -- in this light. They don't hold theories about "crowding out," rather they sense something in the house must be rotten. And so they rail against deficits, as do some of their elected representatives. It's a more justified reaction than the pure economics alone can illuminate.

When water regularly overflows from your toilet, you want the toilet fixed, whether or not the water is doing harm.

I heard it myself regularly during the first eight years of the decade, from Bush apologists, that running a deficit isn't really bad. But clearly it isn't a good thing. And like Cowen points out, why are we allowing ourselves to settle for an economic situation that is probably or hopefully not bad, but certainly not good, and possibly catastrophic?

Republicans and Democrats alike are terrible about this. Except for Bill Clinton.

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