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Deficits and the Future

By Paul Krugman

Right now there’s intense debate about how aggressive the United States government should be in its attempts to turn the economy around. Many economists, myself included, are calling for a very large fiscal expansion to keep the economy from going into free fall.

Sounds good.

Others, however, worry about the burden that large budget deficits will place on future generations.


But the deficit worriers have it all wrong. Under current conditions, there’s no trade-off between what’s good in the short run and what’s good for the long run; strong fiscal expansion would actually enhance the economy’s long-run prospects.

No, under any conditions coincident with a shortage of aggregate demand.

The claim that budget deficits make the economy poorer in the long run is based on the belief that government borrowing “crowds out” private investment — that the government, by issuing lots of debt, drives up interest rates, which makes businesses unwilling to spend on new plant and equipment, and that this in turn reduces the economy’s long-run rate of growth. Under normal circumstances there’s a lot to this argument.

Not true. There is never anything to this argument.

But circumstances right now are anything but normal. Consider what would happen next year if the Obama administration gave in to the deficit hawks and scaled back its fiscal plans.

Would this lead to lower interest rates? It certainly wouldn’t lead to a reduction in short-term interest rates, which are more or less controlled by the Federal Reserve. The Fed is already keeping those rates as low as it can — virtually at zero — and won’t change that policy unless it sees signs that the economy is threatening to overheat. And that doesn’t seem like a realistic prospect any time soon.

What about longer-term rates? These rates, which are already at a half-century low, mainly reflect expected future short-term rates. Fiscal austerity could push them even lower — but only by creating expectations that the economy would remain deeply depressed for a long time, which would reduce, not increase, private investment.

Both true.

The idea that tight fiscal policy when the economy is depressed actually reduces private investment isn’t just a hypothetical argument: it’s exactly what happened in two important episodes in history.

The first took place in 1937, when Franklin Roosevelt mistakenly heeded the advice of his own era’s deficit worriers. He sharply reduced government spending, among other things cutting the Works Progress Administration in half, and also raised taxes. The result was a severe recession, and a steep fall in private investment.

Yes, taxes were raised to pay for the new social security program and kept off budget. After the immediate economic setback they changed the accounting and put social security taxes on budget where they remain today. The lesson of public accounting for the government was and is that it best serves public purpose when it’s on a ‘cash basis’.

The second episode took place 60 years later, in Japan. In 1996-97 the Japanese government tried to balance its budget, cutting spending and raising taxes. And again the recession that followed led to a steep fall in private investment.

Yes, they kept pushing consumption taxes that set them back.

Just to be clear, I’m not arguing that trying to reduce the budget deficit is always bad for private investment. You can make a reasonable case that Bill Clinton’s fiscal restraint in the 1990s helped fuel the great U.S. investment boom of that decade, which in turn helped cause a resurgence in productivity growth.

No you can’t. The deficits of the early 90’s recession fueled the subsequent expansion, and the resulting surplus killed it, and we are still feeling the effects of those surplus years today.

What made fiscal austerity such a bad idea both in Roosevelt’s America and in 1990s Japan.

And the US in the late 90s- he conveniently bypasses that one?

were special circumstances:

No, fiscal austerity necessarily reduces aggregate demand.

in both cases the government pulled back in the face of a liquidity trap, a situation in which the monetary authority had cut interest rates as far as it could, yet the economy was still operating far below capacity.

Yes, because monetary policy- changing interest rates- doesn’t actually work as theorized by the mainstream.

And note that in the last year interest for savers has come down about 4% while interest charges for borrowers are about unchanged, or, in many cases, higher, as the spreads widened as the Fed cut rates. And in any case the non government is a net saver/net receiver of interest payments to the tune of the government’s outstanding treasury securities. So the largest consequence of last year’s rate cuts has been a cut in private sector interest income.

And we’re in the same kind of trap today — which is why deficit worries are misplaced.

At least he gets to the right place, even if it is via faulty logic.

One more thing: Fiscal expansion will be even better for America’s future if a large part of the expansion takes the form of public investment — of building roads, repairing bridges and developing new technologies, all of which make the nation richer in the long run.


Should the government have a permanent policy of running large budget deficits? Of course not.

Why not, if demand is chronically weak, which it has been for a long time.

Although public debt isn’t as bad a thing as many people believe —


it’s basically money we owe to ourselves —

Wrong reason 🙁

in the long run the government, like private individuals, has to match its spending to its income.

Wrong. He misses the difference between issuers of non convertible currencies with uses of those currencies.

The funds for us to pay taxes to come from government spending (or government lending). So government is best thought of as spending first and then collecting taxes or borrowing.

And every dollar of cash in circulation has to be from government deficit spending- funds spent but not yet collected for payment of taxes.


Rookie mistake for a Nobel Prize winner not to see the difference between issuer and user of anything.

But right now we have a fundamental shortfall in private spending: consumers are rediscovering the virtues of saving at the same moment that businesses, burned by past excesses and hamstrung by the troubles of the financial system, are cutting back on investment.


That gap will eventually close,

Not without sufficient deficit spending.

but until it does, government spending must take up the slack. Otherwise, private investment, and the economy as a whole, will plunge even more.


How about a payroll tax holiday where the treasury makes the FICA payments for employees and employers, along with maybe $300 billion to the states for operations and infrastructure projects?

he bottom line, then, is that people who think that fiscal expansion today is bad for future generations have got it exactly wrong. The best course of action, both for today’s workers and for their children, is to do whatever it takes to get this economy on the road to recovery.

And keep it there.

Doesn’t he know about the ongoing ‘demand leakages’ taught in the text books? Tax advantaged pension funds, IRAs. insurance, and other corp reserves, etc. That grow geometrically (most years)?

And that’s why the full employment deficit is something like 5% of GDP, etc?

(If anyone knows Professor Krugman feel free to email this to him, thanks)


21 Responses

  1. What an indictment of the mainstream neo-classical paradigm. There is simply no consistent logic to Krugman’s arguments. It all sounds so seat-of-the-pants, riddled with special cases, and using the rhetorical device of long-run vs. short run to cover up for its theoretical shortcomings. Money is exogenous until the system gets hit with a liquidity trap, then it’s endogenous. Fiscal deficits are efficacious but only in special cases, like Depressions. Krugman himself will apparently let us know when deficits crowd out private savings and when they don’t.

    The beauty of the pure demand side model (of Soft Currency / Post Keynesian Economics) and the pure supply side (small s) model of Hard Currency/ Austrian Economics, whether you support or reject the respective paradigms, is the elegance, logic and internal consistency of the arguments; the former as an extention of Knapp’s State Theory of Money and the latter as an extension of Menger’s Market Theory of Money (Say’s Law, in essence).

    Mainstream economists, and this includes Monetarists, Supply-siders (big S) and neo-Keynesians, are stuck in the middle of these two pure paradigms, cherry-picking ideas from both sides and making a mess of the whole thing.

    Oh, and they use too much math (another device to hide their theoretical shortcomings).

  2. Mike, agreed. he’s confused but at least pushing for a fiscal response

    Knapp- wish i could write like you- well stated!
    by the way, I heard the austrian thing a ‘no govt’ model?

    3,4, think they got it here?


  3. Warren,

    you said “by the way, I heard the austrian thing a ‘no govt’ model?”

    Yes, Austrian economics is non-institutional and that includes government institutions. The state is only introduced exogenously after the fact as a violent intervention against the harmonious workings of the free market. The logical end point is free market anarchy, what Murray Rothbard called anarcho-capitalism. But many Austrians try to distance themselves from that extreme political position. ( I guess they want tenure).

  4. Winslow,

    Thanks for the Makin link.


    Makin says the payroll tax siphons $650 billion annually from personal income. Where did you come up with the $1 trillion?

  5. It’s good that people like the AEI are calling for a payroll tax holiday, but I still don’t trust them. Their ultimate goal is te destruction of SS, so I wouldn’t put it past them to use a holiday to rev up an attack on the program itself. After all, the whole fiction of “private accounts” for SS was put in place by FDR in order to maintain middle class support for what was basically a redistributionist scheme. Even though the tax is regressive and should go, getting rid of it would open up a line of rhetorical attack for the AEI and Cato types…

  6. Isn’t crowding out predicated on the belief that deficit spending raises the cost of money hence preventing the private sector from borrowing?

    How would deficit spending raise interest rates?

  7. It doesn’t. Crowding out a gold standard paradigm that assumes there’s a supply of “national savings” that is reduced if the government borrows.

  8. if they wait too long we will get out of this recession the traditional úgly way- falling tax revenue and rising transfer payments as unemployment soars and the deficit gets large enough to do the trick. (but that usually takes years)

    this all could have been avoided by the right proactive fiscal response in early August, right after it all went bad.

  9. James Galbraith response to David Walker in the National Journal’s forum “Is There Room for Fiscal Stimulus” hits the target much better than Krugman:


    But I wonder why Galbraith doesn’t use such opportunities to state more explicitly that under our current monetary regime fiscal policy is unconstrained. Is it deliberate on his part to avoid ostractism from his less radical mainstream colleagues? Or does he view it as too academic for general policy discussion?

  10. JCM
    Thanks for the update. I go back and forth on whether it’s useful to engage some of these folks that have no understanding and probably never will of monetary ops (thoughts?). Biggs is a complete joke on the issue, sort of like Riedl (though Biggs appears to have some actual expertise in something . . . can’t tell what that would be for Riedl).

    The disappointing thing from an academic standpoint is how little these “experts” are willing to consider the boundaries of their own knowledge. While I understand, say, entitlements or healthcare better than the average person, I would never present myself as an expert on the detailed workings of either in the public arena or to my students. Similarly, Biggs appears to understand the inner workings of entitlements, but he has absolutely no clue about reserve accounting, monetary ops, and so forth–the basic mechanics of sovereign debt. And yet, he travels around the country with his Concord Coalition friends on their “wake up America” tour.

  11. Scott,
    Thanks for the update. I go back and forth on whether it’s useful to engage some of these folks that have no understanding and probably never will of monetary ops (thoughts?). Its fun getting into it with them, but I’m a laymen and a novice relative to you and others, and perhaps there are better ways to allocate time. But I think if one heavyweight chatterbox like a Larry Kudlow could be turned, then maybe you get enough publicity to plant a seed with policymakers. Maybe Mike Norman will get a primetime show on cnbc or fox.

    Similarly, Biggs appears to understand the inner workings of entitlements, but he has absolutely no clue about reserve accounting, monetary ops, and so forth–the basic mechanics of sovereign debt
    I’ll ask him what it would take for someone like him to reconsider his basic assumptions?

    Thanks Scott.

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