The Aftershock Threat

One of the reasons, as I explained in my book, for calling our economic crisis a "depression" is that, as was already clear on February 2, when the book was completed, the government was spending trillions of dollars--on top of all the normal expenses of government--to try to arrest the downward spiral and speed recovery. Since then, the expenditures, commitments, and guarantees--all of which represent costs, actual or expected, though many or even most of them will eventually be avoided or recovered--have increased further, and concern has begun to be expressed that the soundness of America's public finance and currency is being undermined by the growing mountain of public debt. The interest rate at which the government borrows to finance the public debt has been rising, and there is even talk, though surely premature, that the government may lose its triple A credit rating!

Remarks by the distinguished macroeconomist Paul Krugman, at a panel discussion of the economic situation published in the current New York Review of Books (June 11), help to bring the problem into focus.

Krugman has been trying for some time, without success, to correct a misunderstanding by the prominent historian (and author of an excellent recent book on the history of banking) Niall Ferguson. Ferguson, who was also on the panel, argued as he has before that the monetary and the fiscal responses to a recession or depression--that is, reducing interest rates by expanding the supply of money, and increasing demand for goods and services by deficit financing of public works--operate at cross purposes. The cost of public works has to be financed by borrowing, and any increase in borrowing raises interest rates and therefore reduces the effectiveness of the monetary response.

Actually, as Krugman pointed out, the monetary and fiscal responses are complementary. The monetary response, we have learned, is inadequate, since, as I keep saying, you can lead a bank to money but you can't make it lend. Essentially the monetary response involves the Federal Reserve's increasing the balances in bank accounts, which increases the amount of money that banks are permitted to lend. But because many banks are still undercapitalized as a result of the collapse of the housing and associated mortgage-credit bubble, because loans in a depression are especially risky, and because the demand for loans is way down since production is down and consumers feel overindebted and so want to save rather than borrow, most of the newly created money is piling up in bank accounts and other safe savings havens rather than being spent.

Moreover, the lower interest rates are, the more difficult it is to persuade the hoarders of cash and cash equivalents to invest their money productively. We want interest rates to be low, to induce borrowing and lending, which increase economic activity. But we don't want then to be so low that there is insufficient inducement for the hoarders to part with their cash. Cash that is hoarded is inert; it does not contribute to economic activity; and so hoarding exacerbates a depression.

The role of fiscal policy, in the form of Keynesian deficit spending on public works (though that is only part of the $787 stimulus program enacted by Congress, the rest being tax reductions and benefits enhancements, which unfortunately are less effective means of fighting a depression because their effect on employment is indirect), is to make up the shortfall in private demand for goods and services by increasing the public demand for them. Construction workers laid off because of the fall in the demand for new residential and commercial buildings can be hired to build public buildings. The result is to reduce unemployment, thus increasing incomes, and increase confidence by other workers that they will not be laid off; and increased incomes and increased confidence in one's economic prospects reduce the propensity to hoard. The net cost to the government should be lower than the aggregate outlay, moreover, because an increase in employment increases income tax revenues and reduces unemployment benefits.

But assuming that there is a net cost to the program, Ferguson is right that the government will borrow more, and that this will raise interest rates--but probably only slightly. For as Krugman points out, the fall in private demand has been matched (not dollar for dollar, however) by a rise in savings, included hoarded cash. The personal savings rate has risen in the last year from 1 percent to more than 4 percent. To quote Krugman, "that saving ought to be translated into investment, but the investment demand is not there." Deficit spending on public works is a way of using the pool of savings to increase investment and therefore employment. "Keynesian policy...takes excess desired savings and translates them into some kind of spending. If the private sector won't do it, the government will."

The relation between savings and (productive) investment can be seen most clearly by imagining that the government decided to finance the public works program by selling "Victory [over Depression]" bonds to the general public. Because the bonds would be safe (the risk of the United States' defaulting on its obligations is effectively zero), most of the hoarders would be quick to buy them in lieu of holding cash that carries no interest at all; and so the government would not have to pay a high rate of interest on the bonds to be able to sell them. The government isn't financing the public works program in this way, but the economic substance may be very similar. If a money-market fund in which a person has placed some of his savings buys government securities to be able to pay interest on its money-market accounts, the person is indirectly financing the government.

It is not clear that Ferguson would disagree. For from one of his remarks at the panel discussion it appears that his real concern is not with the impact of the stimulus program on interest rates but with the cumulative effect of all current and planned federal expenditures on the long-term solvency of the U.S. government, including expenditures financed by the creation of money by the Federal Reserve. (When the Federal Reserve buys Treasury securities, this does not reduce federal debt, but merely transfers it from one government agency to another.) That is a legitimate concern, but it does not prove that the stimulus program is unwise. The longer and deeper the depression, the larger will be the federal deficit; so if the stimulus program makes the depression shorter and shallower, it may not increase and in fact may reduce the total public debt.

Krugman is an advocate of universal health care and of other costly social programs, and he argues in the panel discussion that the depression has underscored "the importance of a strong social safety net," such as Europeans have. Their generous safety net has reduced the human costs of the depression to them "because Europeans don't lost their health care when they lose their jobs. They don't find themselves with essentially no support once their trivial unemployment check has fallen off. We have nothing underneath. When Americans lose their jobs, they fall into the abyss." But safety nets are costly, and, Krugman continues,"there are people who say we should not be worrying about things like universal health care in the crisis, we need to solve the crisis. But this is exactly the time when the importance of having a decent social safety net is driven home to everybody, which makes it a very good time to actually move ahead on these other things."

So he is saying that the time is ripe in a political sense for a basic change in the management of the American economy. He may be right. For one effect of a European-style safety-net economy is to reduce the amplitude of the swings that we call the business cycle, and at the moment that amplitude, the human costs of which are increased by the absence of a stroong safety net, is hurting many Americans. Because the European-style safety net raises labor costs, in part by making it difficult to lay off workers, unemployment is higher in Europe than in the United States in boom periods; employers are reluctant to hire if it will be difficult for them to lay off workers when the boom ends. But in the current world depression our unemployment rate is higher than the average European rate (after correction for differences attributable to different definitions of unemployment).

Even if the European approach is thought preferable to ours and compatible with our political and social culture, the costs of moving toward it in the present economic setting must be estimated and given their due weight. The costs are of two kinds. The first is increase that a costly and ambitious program of social reform must create in the uncertainty of the economic environment. As Keynes emphasized, uncertainty tends to dampen the "animal spirits" that drive economic activity, and to increase the incentive to hoard, which retards economic activity, as I have been emphasizing. Second, the costs of ambitious social reform, when added to the costs of the depression-recovery programs and the "normal" budget deficit exacerbated by the decline of tax revenues in a depression, may result in a potentially destabilizing level of public debt.

My own heretical view is that Americans are undertaxed, and so if I thought that the increase in the public debt was going to be financed by higher taxes I would not be upset. But Congress and the public seem adamant against tax increases, even when they take the form of closing ridiculous loopholes, and against spending reductions, even in ridiculous programs such as farm subsidies; and this combination of aversions makes it likely that increases in the public debt will be financed by a combination of continued borrowing, but at higher and higher interest rates, and inflation.

A bit of inflation can be a good thing in a depression, because it operates as a tax on cash balances and thus reduces hoarding and stimulates spending. But I am worrying about the inflation that hits after the depression, when the government decides that it can no longer finance the public debt by borrowing, cannot raise taxes, cannot cut spending, and is left with having to debase the currency. I would like to see greater efforts by the Administration and by the economics profession to determine, so far as may be possible to do, the gravity of this danger.