Why spending must rise

Often proponents of MMT express a preference for taking the primary mandate for controlling inflation away from the Fed; these proponents even argue that the proper stance of Fed interest rate policy is to hold short-term rates at zero, always and everywhere. Regardless of what one thinks about taking the primary mandate for inflation control away from the Fed and handing it to fiscal policymakers, we should be clear that this would be a big change from the institutional structures that currently exist in the American economy.

Given the existence of these institutions, economic predictions based on the idea that the Fed would not react to a real or perceived excess of aggregate demand over productive capacity by raising interest rates would be wrong. None of the malign effects of deficits happen if they are incurred when the economy has excess productive slack jobless potential workers or excess capital capacity.

In this case, as households rushed out to spend this extra money, there would be idle resources that could be mobilized to produce the extra goods and services that are newly demanded.

This implies that it is output GDP , not prices, that will be pushed up by the boost to desired spending. Since this does not threaten to push up inflation so long as the economy retains productive slack, there is no need for the Fed to raise interest rates, and the channels of crowding out do not operate. In fact, because larger deficits ensure a steadier stream of customers, these deficits can induce firms to make sure their investment in tangible plants and equipment does not fall off the way it would in an economic downturn.

So far we have been discussing how a change in the size of the budget deficit affects aggregate demand. However, the relationship between deficits and aggregate demand and hence the pace of overall growth is decidedly two-way.

If a negative shock to private spending causes the economy to slow or enter recession, then this will mechanically feed back to larger federal budget deficits. As private-sector incomes fall, tax collections fall. And as more people become eligible for safety net programs as the private sector contracts, federal spending rises. This increase in the deficit that results from slowing economic conditions is unambiguously a good thing.

A key issue that fiscal policymakers should strive to address going forward is making these automatic stabilizers larger and longer-lasting as the economy slows. While automatic stabilizers and discretionary fiscal stimulus both worked to support the economy during the 18 months of the Great Recession, fiscal policy turned sharply contractionary far too early in the subsequent recovery.

As we have discussed above, when there is productive slack in the economy, any increase of public spending that is not financed by higher taxes will boost spending and create jobs. If some of this increased public spending takes the form of investment—spending that yields an asset that will make society richer in the future—then so much the better for sustaining economic growth.

Obvious candidates for public investment include core infrastructure and early child care and education. For example, the Supplemental Nutrition Assistance Program SNAP, sometimes referred to as food stamps and Medicaid a program that provides health insurance to poor families have both been shown to significantly increase future health and labor market outcomes for children who benefited from these programs. Furthermore, even when the economy is at full employment, public investments that are debt-financed likely do not damage future economic growth prospects and may well even boost them.

Remember, the key reason why larger budget deficits run during times of full employment potentially damage future growth is because they can push up interest rates and crowd out private-sector investments in productive plants and equipment.

But if the deficits that crowd out private investment are themselves financing productive public investments, then future growth may well not be slower. If the debt-financed public investments are as productive as the private-sector investments they might displace, then they will not drag on growth. Given that the last generation has seen a sharp slowdown in the accumulation of public capital, public investments may well have a higher social return than private investments. The intuition that it might be fine to finance public investments with debt even when there is no economywide demand slack is most clear when the public investments are aimed at slowing greenhouse gas emissions.

If the bulk of these investments are relatively time-limited—e. By all economic forecasts, future generations will on average be far richer than the current generation but for the effects of climate change.

If debt-financing green investments today lets us borrow modestly from future generations but spare them from inheriting a world that has not addressed climate change, then this is a staggeringly good deal for these future generations, and one that allows the current generation to make green investments without sacrificing current living standards.

The textbook economics of running budget deficits when the economy has productive slack is clear: Budget deficits push the economy closer to full employment and are actively beneficial. In theory, this accumulated debt could cause future problems. Hence, governments can always roll over old debts that have been accumulated and are coming due by borrowing more. For a household, this constant rollover of debt would eventually be unsustainable, but this is not the case for a long-lived government.

So long as the rate of GDP growth exceeds the interest rate charged on the debt, then the ratio of accumulated debt to GDP will fall over time, steadily eroding the share of national income that must go to interest payments on this debt.

Over most of U. Interest rates exceeded growth rates for most of the s and s and early s, but fell back below growth rates in the aftermath of the Great Recession. Figure C shows the behavior of both of these variables over the long run.

Source: Data file accompanying Kogan et al. Of course, one cannot make ironclad guarantees that GDP growth rates will always exceed interest rates. But GDP growth rates have far exceeded interest rates on public debt in most of the developed world over most of the past two decades even as public debt has risen substantially. There is very little evidence that secular stagnation is poised to reverse itself anytime soon. If interest rates were to begin rising faster than GDP growth rates, this would hardly presage an economic disaster, but it would begin to impose some costs.

Preemptively raising taxes particularly through steeply progressive taxes, like those our budget plan proposes seems a desirable hedge against the admittedly unlikely event that interest rates begin marching sharply upward again.

Of course, politics would need to allow for these types of tax increases. Given that both deficits and debt will rise steadily over time if they continue on their current path, it seems correct to us that proposals to significantly expand federal noninvestment spending should be matched with corresponding increases in revenue in order to stem the rise of deficit spending. Part of the reason we think it makes sense to slow down deficit spending is that the gap between GDP growth rates and interest rates—while still positive—has shrunk relative to earlier historical periods.

To be concrete about deficit targets that would stabilize overall debt-to-GDP ratios, we can take the gap between the five-year average GDP growth rate and the five-year average interest rate as of representing the five years from to , shown in Figure C. This gap was roughly 2 percentage points.

This may be too optimistic, but even the latest CBO long-term budget outlook projects that interest rates will essentially equal growth rates on average over the next 30 years, with interest rates exceeding growth rates by roughly 0.

Finally, any discussion of the U. The gap between what the U. These high-taxing countries tend to be rich and happy relative to the rest of the world. There certainly seems to be no obvious economic reason why the U. This report has laid out the primary economic challenges facing low- and middle-income households in the United States and sketched out how fiscal policy can help meet these challenges.

The first report in the series describes the key principles for tax reform underlying our plan. See Blair See Engelhardt and Gruber for trends in elderly poverty and their connection with Social Security. The Bureau of Labor Statistics reports that the annual unemployment rate rose from 4. The pre-recession unemployment rate was only regained in when it averaged 4.

Anti-recessionary spending could also be monetized rather than financed with debt, but unless policymakers could commit to making this monetization permanent, this would have no real advantage over debt finance in spurring recovery. Two obvious examples of automatic stabilizers are unemployment insurance and progressive income taxes. Both of these ensure that households are given more resources when their incomes fall as recessions hit either transferred directly to them in the case of unemployment insurance or conveyed indirectly as implicit tax cuts in the case of progressive taxation.

This means they will cut back spending less than cash-constrained households will when their incomes fall, and they will increase spending less when their incomes rise. Bivens and Fieldhouse present a range of estimated fiscal multipliers from the research literature, confirming the fact that multipliers are much smaller on tax changes for rich households and corporations than they are for lower-income households. Importantly, however, government policy can strongly affect market incomes.

Laws that set minimum wages or that make it easier for workers to organize unions can affect the distribution of wage income, for example. And laws that set the terms of intellectual property protection, or regulations that check monopolies, can also affect the profitability of corporations.

Indirect evidence of this is presented in Figure D, which shows how much less the U. For more details, see Blair Uh oh, you are using an old web browser that we no longer support. Some of this website's features may not work correctly because of this.

Learn about updating to a more modern browser here. This vague and subjective condition has led to a lot of debate about when this might happen. This is because MDBs require donors to legally back commitments to protect their own lending operations. In addition, its allocated budget will likely increase in the coming months as new commitments are made on COVID vaccines non-dose sharing like continued support to COVAX as well as climate finance.

Having a situation where budgeted aid activities are greater than FCDOs total aid budget is clearly not viable. Therefore, the UK government will need to look at solutions in three possible ways. For example, there will be a reduction in aid linked to the EU budget in , but this would only provide limited leeway.

Reducing aid spending by other departments could be an option, but with the department of Health and the Home Office already asked to make cuts this year, the extent to which further cuts could be made in is likely limited.

This would likely result in further cuts and disruption to bilateral projects in sectors critical to children that have already seen funding slashed. Therefore, the only viable solution to not have this happen is to return to 0. Beyond solving the challenges outlined above in managing an aid budget linked to 0.

The upcoming Parliamentary summer recess presents an opportunity for key decision makers in Government to reflect on the challenges of maintaining 0.

In fact, the cost may be worse: excessively indebted countries that do not suffer debt crises seem inevitably to end up suffering from lost decades of economic stagnation; these periods, in the medium to long term, have much more harmful economic effects than debt crises do although such stagnation can be much less politically harmful and sometimes less socially harmful. Debt crises, in other words, are simply one way that excessive debt can be resolved; while they are usually more costly in political and social terms, they tend to be less costly in economic terms.

So why is excessive debt a bad thing? I am addressing this topic in a future book. To put it briefly, there are at least five reasons why too much debt eventually causes economic growth to drop sharply, through either a debt crisis or lost decades of economic stagnation:.

Except for economies in which all resources—including labor and capital—are fully utilized and for economies that have no slack unutilized resources and labor , increases in debt can boost current domestic demand, although not always sustainably. When households borrow, for example, they usually do so either to buy homes or to increase consumption. I am not sure how much of home buying in the United States spurs new construction and how much represents sales of existing homes, but, in the latter case, the borrowing creates no new demand for the economy, except to the extent that the seller uses the proceeds of a home sale to increase consumption.

Of course, insofar as borrowing for consumption directly increases aggregate demand by increasing consumption today, the repayment of such borrowing reduces consumption tomorrow.

This is another area that seems to confuse economists enormously. Standard economic theory states that borrowing simply transfers spending from the lender to the borrower, and that repaying debt reverses these transfers. In such instances, no new demand is created by borrowing nor is it extinguished by repaying. But this is only true for an economy that is fully utilizing its labor, capital, and other resources and in which investment is constrained by high costs of capital.

In such cases, borrowers must bid up the cost of capital to gain access to savings and, in so doing, they prevent someone else from employing these resources. This is when borrowing has no net impact on total demand: it simply transfers spending from one part of the economy to another, and the only thing that matters for the health of the economy is how efficient any particular use of savings might be and what impact that use has on long-term growth.

But for an economy with substantial slack whose investors are reluctant to engage in new investment because of insufficient demand, borrowing does create additional demand, while future repayment usually reverses this added demand. Increases in government debt, similarly, do not result in equivalent increases in debt-servicing or productive capacity, except insofar as government borrowing is used to fund investment in productive infrastructure.

If used to fund consumption, household transfers, military spending, and so on, government debt can boost current domestic demand without boosting debt-servicing capacity or productive capacity, an increase in domestic demand that must later be reversed. Increases in business debt, on the other hand, do usually fund productive investment, so these increases usually boost debt-servicing or productive capacity. When businesses borrow capital, however, for stock buybacks, to pay down other debt, to cover losses, or for nonproductive investment projects usually subsidized by governments , this debt functions just like household borrowing for consumption in the sense that it is not self-liquidating.

I have no way of calculating the extent to which recent increases in U. This is because rising debt is needed to keep growth in economic activity high enough to prevent a rise in unemployment.

They tend simply to equate the two. I discuss this issue in a January blog post. While the two may be equal over the long run, however, over shorter periods they are not necessarily equal, given that the former can exceed the latter especially as a consequence of an unsustainable increase in debt. I will not pretend to offer a complete analysis of debt in the U. The first reason is the U. Although these two factors seem like two different things, they work in the same way and for the same reasons.

I have explained many times before including here and here that the United States runs trade deficits mainly because the rest of the world exports its excess savings there. Standard trade theory suggests that, under normal conditions, the United States should run persistent trade surpluses, as I will explain in my next blog post. But because of distortions in income distribution in the rest of the world, developed economies suffer from excess savings and insufficient demand.

The way this works is straightforward although it may seem counterintuitive at first. There are two ways to boost international competitiveness, which in a highly globalized world can lead automatically to higher growth. The high road is to boost domestic productivity, typically by investing in needed infrastructure, education, and technology. The low road is to reduce relative wages, something that can be done directly or indirectly.

The direct approach is to lower wages or wage growth as, for example, Germany did during and after the Hartz reforms of — An indirect way of achieving the same effect is for a country to hold down the value of its currency by doing things like imposing explicit or hidden tariffs, subsidizing production factors at the expense of households, or increasing household transfers to other sectors of the economy. The low road is, of course, easier to embark on quickly, and it effectively entails reducing the household share of what a country produces: directly or indirectly, in other words, households receive less total compensation for producing a given amount.

The problem with this low road approach is that it reduces total demand. As households receive a lower share of GDP, they consume a lower share.

Unless there is a commensurate rise in investment, the result is that a country is less likely to be able to absorb everything it produces. In a closed economy, or one in which international trade and capital flows are limited by high frictional costs, a country that produces more than it can absorb domestically must allow unwanted inventory to pile up until, once debt limits are reached, it must close down production facilities and fire workers.

In a highly globalized world, however, where the frictional costs of international trade and capital flows are extremely low or even nonexistent, it is much easier for such a country to export both the excess production and the excess savings. This is the problem. Policies that increase international competitiveness by lowering the household share of GDP reduce total demand within such countries, but these policies also allow these countries to gain a larger share of foreign demand.

This is the tradeoff that makes this arrangement work for the surplus country: while domestic demand shrinks, the surplus country more than makes up for it by increasing its share of what is left, at the expense of its trade partners. Whether this state of affairs benefits or harms the global economy depends primarily on where the excess savings are exported. In such cases, the net effect on the world is usually positive.

If the increase in investment in the recipient country is greater than the reduction in consumption in the exporting country, the world is better off, although there may still be legitimate disputes about distribution effects.

But if the excess savings are exported to an advanced economy whose domestic investment needs are not constrained by an inability to access domestic savings, these savings do not result in an increase in investment, so the world is left with lower demand. This is a classic case of beggar-thy-neighbor policies, in which one country benefits at the greater expense of its trade partners. It is typically the countries with the most open, most flexible, and best-governed financial markets that end up on the receiving end, mainly the so-called Anglo-Saxon economies and especially the United States.

The United States runs capital account surpluses, in other words, not because it is capital short, but because the world has excess savings and the United States is the leading safe haven into which to hoard these savings. Some observers might object to this interpretation. Not necessarily. While this was the case in the nineteenth century, when the United States imported capital because it lacked sufficient domestic savings to fund its investment needs, it is no longer true in the twenty-first century.

Rather than assuming, as most economists still do, that the United States imports foreign savings because U. This is because a country with a capital account surplus must, by definition, run a current account deficit, and because investment in that country must, also by definition, exceed savings. Most economists see this tautology and mistakenly assume an automatic direction of causality in which foreign capital inflows drive U.

It may seem surprising at first that income inequality has the same economic impact as forced imports of foreign capital.

By itself, income inequality tends to force up the savings rate, simply because rich households save more than ordinary or poor households. But that is not the end of the story. In any economic system, savings can only rise if investment rises.

Again, the point is fairly simple. Total savings cannot rise unless these savings are invested. If savings in one part of the economy rise because of a transfer of wealth from poorer households to richer households, and if this does not cause investment to rise, this very transfer must then repress savings in another part of the economy.

Notice how similar this is to the way the trade deficit works: rising savings in one part of the world are exported to the United States and cause savings in the United States to decline.

There are many ways that the import of foreign savings or the additional savings of the rich can drive down savings in the overall economy. Notice that these numerous methods of driving down the savings rate can be summarized as one of two: either unemployment rises or debt rises.

Because Washington is likely to respond to a rise in unemployment by increasing the fiscal deficit or loosening credit conditions, in the end, the result of rising income inequality and trade deficits is almost always that debt rises faster than it otherwise would. Another way of looking at it is that both trade deficits and high income inequality reduce domestic demand, so returning the economy to its expected growth rate requires a new source of demand, and this new source is almost always generated by debt.

By the way, this explains in part why economists are generally unable to find a correlation between the trade deficit and unemployment, or between income inequality and unemployment. Rather than cause unemployment to rise, these conditions can simply force an increase in debt. This is a purely logical argument, so it would be wrong only if any of the underlying assumptions are wrong. The main such assumption is whether investment is not constrained by savings. The standard argument is that investment is always constrained by savings and that forcing up savings is positive for investment because, even in economies with abundant savings and low interest rates, it lowers the cost of funding, however marginally.

If businesses can borrow at a lower rate than before, the argument goes, there always will be some productive investment opportunity that only becomes profitable at this new, lower borrowing cost. This outcome must lead to more investment, which should lead to more growth over the long run.

Most economists agree that investment levels in the United States are low probably too low and that the United States would grow faster over the long term if businesses could be encouraged to invest more. Given that one of the most efficient ways to boost investment is presumably to make more capital available to businesses at lower costs, tax cuts for the rich would theoretically benefit the rest of the country eventually, as the additional wealth generated by higher investment trickled down.

Can policies that result in greater income inequality nonetheless leave a country better off? It turns out that the answer, again, depends on the availability of savings in the economy. In a capital-scare environment, like a typical developing economy, policies that force up the domestic savings rate can result in a substantial, one-for-one increase in domestic investment for every unit reduction in consumption. In such a case, total demand is unchanged since lower consumption is matched by higher investment ; the economy grows as quickly as ever in the short run while getting wealthier in the long run.

In recent years, the financial system has been awash with liquidity, interest rates have been at all-time lows, and U. In such cases, most economists would agree that every unit reduction in consumption is likely to be matched by a smaller increase in investment, so in the short run total demand would decline. This means that supply-side policies can reduce short-term growth in the United States because these policies cause a drop in total demand assuming that lower consumption is only partially matched by higher investment.

Nonetheless, as long as at least part of the reduction in consumption is matched by an increase in productive investment, it is still possible to argue that the country would be better off in the long run because investment increases productive capacity. In such cases, the rich benefit immediately from tax cuts for the rich, while the rest of society benefits eventually.

But, counterintuitively for most economists, it might be a mistake to assume that, insofar as supply-side policies increase the availability of capital and lower its cost, conditions that force up the desired savings rate must always lead to additional investment. There are conditions under which such policies may actually lead to less investment, and this outcome is especially likely today in most advanced economies. All it requires is that, broadly speaking, all or most investment falls into one of two categories.

The first category consists of projects whose value is not sensitive to marginal changes in demand, perhaps because they bring about very evident and significant increases in productivity, or because the economy suffers from significant underinvestment.

The second category consists of projects whose value ultimately varies as a function of changes in demand. In the early s, for example, China reportedly had only a handful of commercial airports. A country as big as China urgently needed far more than it had, so it could be argued that whether China was expected to grow at 10 percent annually, 5 percent, or even zero percent, it nonetheless needed additional airport capacity. In that case, the need to invest is not sensitive to the expected growth in demand.

At some point, however, once China has filled the obvious airport gap, whether or not the country needs to build more airports depends on its growth prospects.

A rapidly growing China will need more additional airport capacity than a slow-growing China, in which case investment in airports would fall into the second category, which consists of projects whose profitability is sensitive to demand conditions. By dividing investment into these two categories, it becomes clear that policies that aim to force up desired savings and constrain consumption can have two contradictory effects on total investment:. What matters is simple arithmetic: the relative size of these two categories.

But in economies where the profitability of most investments is a function of changes in demand, income inequality can result in less total desired investment, rather than more. Greater capital availability at lower interest rates may cause certain additional marginal investments to be made, but the resulting increase in investment can easily be overwhelmed by a reduction in investment set off by slower consumption growth.

Put differently, if U. With less consumption, businesses that manufacture consumer goods are more likely to close down factories or postpone investment plans. The claim that higher desired savings can lead to less investment may at first sound outlandish, and Marriner Eccles — , a former chairman of the Federal Reserve Board, struggled to make just this point in the s.

This seems to be what happened in Germany after the Hartz reforms as well. As income was transferred from German workers to German businesses in the form of soaring profits, income inequality in Germany worsened. As expected, German savings rose, but unexpectedly investment actually declined, perhaps in partial response to the increase in savings. As an article this week in Reuters reminds us:. The White House had predicted that the massive fiscal stimulus package, marked by the reduction in the corporate tax rate to 21 percent from 35 percent, would boost business spending and job growth.

The tax cuts came into effect in January That compares to 81 percent in the previous survey published in October. Expectations for capital spending for the next three months also weakened.

Given these facts, the expected effects of income inequality and capital account surpluses and the accompanying trade deficits on the U. If policies or conditions that increase savings cause U. If not, these effects will necessarily either increase U.

So assuming that income inequality and capital account surpluses trade deficits are not positive for American growth, what can the United States do to mitigate these effects?

Aside from this blog, I write a monthly newsletter that covers some of the same topics. Those who are interested in receiving the newsletter should write to me at chinfinpettis yahoo. First, debt leaves an economy better off in cases in which productive investment is constrained by low savings if it takes purchasing power from sectors of the economy that save a very low share of their income, or from sectors that save in nonproductive ways by hoarding gold, foreign currency, or other assets , and gives that purchasing power to sectors that save a high share of their income in productive ways.

Second, debt leaves an economy better off in cases in which demand is low and savings excessive if it redistributes wealth from sectors of the economy that save a high share of their income to sectors that consume a high share of their income. Of course, in these cases, the debt itself matters only because of its role in income redistribution, which I address in the next paragraph, and which in principle can be managed more efficiently in other ways, even if these other ways are sometimes politically harder to implement.

In such a scenario, the rich would take money out of the country, for example, while business owners would disinvest and investors would speculate on short-term investments. Meanwhile, workers would organize and become more militant, the middle class would save by hoarding nonproductive assets like gold, collectibles, or foreign currency , and policymakers would shorten their time horizons. It simply means that the repayment takes the form of a hidden tax on monetary savings rather than an explicit tax.

Historically, very high levels of income inequality in the United States and elsewhere in the world have always eventually been partly reversed, either in positive ways or negative ways. Rather than discuss whether or not reversing income inequality is desirable, perhaps it would be better to recognize that it will almost certainly happen eventually anyway. It is, therefore, more important to discuss how it should be done. Carnegie does not take institutional positions on public policy issues; the views represented herein are those of the author s and do not necessarily reflect the views of Carnegie, its staff, or its trustees.