Krugman's Fiscal Fallacy: A Guide for Policymakers

Basic Keynesian fiscal policy suggests that the government should spend when the private sector cannot or will not. The government’s ability to spend is thought to be limited only by the interest rate it must pay on its borrowing. Until the cost of additional debt becomes unaffordable, or generates high real interest rates for borrowers in the rest of the economy, the government should continue spending and running large deficits until the economy returns to full employment. This is the basic premise of Paul Krugman’s new book, which urges the “government to spend more until the private sector is ready to carry the economy forward again.” With interest rates at record lows, the argument follows, what does the government have to lose by pursuing a more expansionary fiscal policy?

This Keynesian framework is especially troubling not because it’s necessarily wrong in an absolute sense, but because it cannot be invalidated without a crisis. The government (again, it is argued) should spend more and run larger deficits in all cases where interest rates are low and an output gap persists (i.e. unemployment exceeds 5% for a long period). But what if the subpar economic performance and low interest rates are themselves caused, in part, by the unsustainable fiscal policy? In this case, the expansionary fiscal policy would continue to depress economic activity until it led, eventually, to a public debt or currency crisis.

Keynesians interpret low interest rates on Treasury securities as a sign that the government should spend more. If debt and deficits were “too high,” the government would face higher borrowing costs as investors demanded compensation for increased default risk (think peripheral Eurozone countries). Low interest rates are thought to measure the government’s capacity to provide the economy with added fiscal support.

Yet, could low interest rates on Treasury securities instead be caused by excessive deficits and debt? It depends on whether taxpayers regard government debt issued to fund deficit spending as net wealth.

To unpack this, let’s consider the following hypothesis for today’s low interest rate malaise:

1. The deficit and debt projections rise to an unsustainable level that will result in either a crisis or substantial future adjustments to tax rates, outlays, or both;
2. This unsustainable fiscal policy generates anxiety among households, business managers, and entrepreneurs who recognize that a large scale fiscal adjustment is required, but do not know who is going to bear its cost.
3. This anxiety causes households and businesses to reduce current spending and postpone investments until there is more clarity concerning the future path of fiscal policy. This boosts savings rates and leads to a decline in current economic activity, which increases the deficit.
4. The depressed condition of the economy causes policymakers to postpone deficit reduction, which increases required adjustment costs by increasing debt-to-GDP ratios.
5.  Households and businesses become concerned not only about distortionary future taxes but also the nontrivial probability of a financial crisis caused by excessive borrowing. The need to plan for this contingency, even if remote, leads businesses to hold more cash than they would otherwise and causes investors to shift portfolios towards more conservative, liquid instruments like Treasury bills and notes.
6. The resulting decline in Treasury interest rates from increased saving and more conservative portfolio allocations is seized upon by policymakers and Keynesian commentators as evidence that the unsustainable debt and deficit policy should be continued indefinitely, or expanded, which further reduces private sector spending and investment.

This is not a novel interpretation of current events; this basic critique has been around for nearly four decades. It also helps to explain how policies that can help the economy recover in one state can have the opposite effect in another. For example, it is perfectly reasonable to believe large deficits helped avoid a much deeper recession in 2008 and 2009 even as they slow growth today. The question is not simply how government activity impacts economic aggregates, but how that government activity impacts the saving, spending, and investment decisions of households and businesses.

Empirical research finds that once public indebtedness exceeds some arbitrary boundary expansionary fiscal policy no longer has the same effect on output. As debt levels rise, more deficit spending creates expectations of higher distortionary future tax increases but provides no guidance on who is going to be impacted by them. It is reasonable to think that many of the so-called “rich” – a class comprised largely of entrepreneurs who found and finance new and small businesses – may be overestimating the extent to which their taxes are likely to be increased. This depresses the expected after-tax rate of return on potential investments and leads to the postponement or cancellation of projects that would otherwise occur.

The Federal Reserve’s influence over interest rates also makes Treasury rates an unreliable indicator for fiscal policy. The Fed’s control of reserve balances not only sets money market rates, but also influences rates on longer-dated notes through expectations of future policy rates and outright purchases (Operation Twist). The Fed’s ability to print money to ensure Treasury securities can always be redeemed at par also makes these instruments credit-risk-free even if the build-up of unsustainable debt levels eventually creates expectations of future inflation or causes investors to shift to alternative currencies or forms of payment.

The Keynesian framework has a basic rationality that helps to explain its appeal. The problem is that Keynesians counsel deficit spending even in cases when the private sector is not willing to spend precisely because of the size of current debt and deficits. To make matters worse, Keynesians often cite the low interest rates generated by business cash accumulation and investor portfolio shifts as evidence in favor of even more deficit spending. This creates the potential for the large scale public policy disaster that is unfolding today because the negative effects of the unsustainable deficits appear to actually help make the case for additional deficit spending.

Policymakers would be wise to question this charade – put an end to it – and then create the conditions for private sector growth through a sustainable fiscal policy with permanent and predictable tax rates.