Counter Cyclical Fiscal Policy, National Debt, and the Role of Government

This is a pretty long and pedantic post.  Nobody should undertake to read it unless he or she happens to want the thoughts of an out of date student of economics.

The discussion of the deficit and national debt that has been going on in Washington DC has conflated the title elements of this post to the detriment of the discourse.  Hopefully the important players know very well all that lies below, but they make precious little effort to display such understanding or to try to educate their constituents.  So here's a shot at getting some things straight.

The government is not like an individual.  If you hear someone say it is, watch out.  The speakereither is trying to deceive you or just doesn't know what he or she is talking about.  The most important difference for this discussion is that whereas an individual's earning stream is limited to something like 50 years at most, the future income stream for a government is essentially unlimited.  100 years from now the government will probably still be here and it will still be collecting taxes. That is a real difference from individuals and what it means is that while an individual has to balance his spending and earning over a term of about 50 years a government does not.  In this way a government is much closer to a corporation than to an individual. It is fairly difficult for a person of 65 to find a bank that is willing to make a 30 year loan since the borrower's income stream, and indeed his life, is unlikely to go on for 30 more years.  A more or less immortal government or corporation has no such constraint.  Furthermore for a corporation to be continuously in debt for 100 years is not necessarily a sign of weakness. It could be a sign of strength; a sign that lenders have  continuously viewed it as a safe bet.

There is no right answer to the question "Is debt bad?"  Much depends upon what is to be done with the borrowed funds.  Here a government is more like an individual.  Borrowing  to invest in something that will increase productivity may be extremely wise.  For a government it might be a highway, or a vaccine.  For an individual borrowing to finance higher education or the tools of a trade can pay off well.  Borrowing to go on vacation on the other hand clearly lacks the same justification.  A government equivalent might be Amtrak subsidies or food stamps or health care for retired people.  I think most government expenditures go to things the sponsors can argue will benefit future generations.  Those who are troubled by our national debt bemoan the burdens we are placing on our progeny.  But think about this.  If we borrow some money from China and use the funds to provide a better education, or highway system or renewable fuel source for our children to live with and use, have we done them wrong?  I don't think it is obvious.  Though they may have to pay back the debt they may well have a higher level of production out of which to make the payment. Borrowing to finance a war that preserves a nation may not be so bad for those who come later.  The basic point is that the virtue or vice of debt depends to large degree on how the borrowed money is used.

Perhaps the most powerful truth in economics is that specialization in production beats generalization.  No individual, no matter how talented or how endowed with resources can, working alone, provide for himself the necessities and comforts of life that the humblest workers enjoy in even a modestly specialized economy.  But specialization in work requires trade which in turns implies interdependence.  The more specialization and trade that takes place, the more bounty and the more interdependence there is.  At some point a couple of hundred years ago specialized, interdependent economies reached the place where they became subject to periodic  breakdowns; dislocations that left resources, especially labor unemployed.  If resources are left unemployed total output is less than it might have been.  There are less goods available to satisfy the people's wants.  This shortage is disproportionately borne by the unemployed.

Counter cyclical fiscal policy refers to governmental taxing and spending activities designed to dampen the variation in economic activity.  One reason for a modern economy to go into a slump is a lack of demand for the stuff that workers produce, and falling demand has a self reinforcing aspect.  Stuff builds up on retail shelves.  Orders go down.  Workers get laid off.  Having lost their income they buy less and more stuff builds up on the shelves.  Government spending adds to general demand for the output of the economy.  Taxing is thought to reduce demand by drawing purchasing power from the hands of consumers.  Therefore deficit budgets, those with expenditures greater than taxes, are considered to be stimulating.  Conversely surplus budgets are thought to dampen economic activity.  In other words in periods of high unemployment counter cyclical fiscal policy consists of running deficits, i.e. increasing the national debt.  If fiscal policy is in fact efficacious then an economic downturn is no time to reduce the national debt.  Debt reduction should be done when the economy is piping along and perhaps needing some cooling down. 

It must be said that not all economists believe that fiscal policy works as described above.   But what ought to be understood is that the efficacy of fiscal policy is a question of fact not of choice.  The answer should be the same for a big government lefty or a small government loving righty.  It doesn't have to do with the desirable size and role of government.  It has to do with how market economies work.  It is really a shame that the study of the workings of a market economy is so difficult that this fundamental question is not well resolved.   There is one big historical example that makes it look like fiscal policy does work.  By 1938 there had been some recovery from the depression of the previous nine years.  The Congress and FDR agreed to some tax increases and spending cuts to get the federal budget nearer to balance.  It seemed prudent.  What followed was a downturn in the pace of economic activity.  That's half the example.  The other half is that starting three years later a really big war was financed with really big deficits and simultaneously the economy became robust.  Does fiscal policy work?  It certainly seemed to in that instance. 

It is also notable that what was produced in this greatest of all deficit periods was not productive assets for future generations.  We built a ton of stuff that was then destroyed.  Except for the fact that a political system we are fond of was saved, the exercise was really an example of over consumption done at the expense of future generations.  We were not creating a lot of infrastructure or manufacturing capacity that would enhance the lives of those who came later.

The capacity to borrow means that there is not a one to one link between raising money and spending money.  That makes counter cyclical fiscal policy possible, and to the extent counter cyclical fiscal policy is efficacious, it is a good thing.  However the loose link between taxing and spending has other results that may not be so good.  In particular unhooking spending and taxing allows government to hide the cost of its activities.  If you have a government activity that you don't want people to feel the cost of providing be it a war or a subsidy for the arts, then pay for it with debt.

There is an independent, hard headed, self interested indicator of whether or not the  nation's debt is too large.  It is one that should be particularly appealing to those who revere private markets.  It is the interest that lenders demand in order to hold the debt issued by the government in question.  If the U.S. were borrowing too much and using its borrowing capacity frivolously rather than prudentially, then the cost of borrowing should go up.  It should go up proportionately to the ill advised behavior.  I'm not aware of any such paucity of would-be lenders to the U.S. Government.  In fact U.S. government debt is regarded as one of the safest investments to be found.  When the U.S. credit rating was reduced a while back it was due to Congressional threat to default on the debt by not raising our totally arbitrary debt ceiling.  We were basically threatening lenders that we might not pay our bills.  Not that we couldn't, but that we wouldn't.  The financial markets don't seem to be all that worried about the debt at the present time.

What is a matter of choice and judgment is the size and role of government.  I don't believe there is anything wrong or stupid about thinking that government is inefficient, corruptible, or potentially despotic.  I personally believe there are lots of important ways that markets fail including imperfectly defined property rights, unenforceable property rights, corruption and perverse income distributions.  It is through the government that we might solve such problems collectively.  People who believe otherwise are not prima fascia stupid, or evil.  Whatever amount of government we choose to have, we should pay for.  However we should probably not work on balancing the budget during periods when the economy is weak.