Bound and determined to shoot ourselves in the foot

These days the media is filled with pundits declaring that government deficits and debts are out of control and austerity measures must be implemented to avert disaster. These pieces are all basically the same: governments can't borrow indefinitely! Austerity must be imposed! Here is a typical piece for Nouriel Roubini, the economist who famously predicted the financial crisis of 2008:

Return to the Abyss by Nouriel Roubini

And here is the point of the piece:
While such fiscal stimulus and bailouts may have been necessary to prevent the Great Recession from turning into Great Depression II, piling public debt on top of private debt carries a high cost. Eventually those large deficits and debts need to be reduced through higher taxes and lower spending, and such austerity – necessary to avoid a fiscal crisis – tends to slow economic recovery in the short run. If fiscal imbalances are not addressed through spending cuts and revenue increases, only two options remain: inflation for countries that borrow in their own currency and can monetize their deficits; or default for countries that borrow in a foreign currency or can’t print their own.
Notice that he assumes that austerity, inflation, or default are the only options for countries with "large deficits and debts." He assumes, without explanation, that dealing with a deficit by simply printing money must necessarily lead to inflation. But does it?

A simplistic description of a recession is that a significant portion of the work force is sitting idle because people, on average, are not spending enough money to keep everyone employed. A simplistic description of inflation is too much spending chasing too few goods. A simplistic description of why people think that deficits financed by printing money will lead to inflation is because they think the spending of freshly printed money will outstrip the supply of goods causing inflation.

Here is the question that pops into my head whenever someone talks about the horrors of printing money during a recession: If a significant portion of the population is sitting idle because there is not enough spending, how exactly will printing money to cover a deficit cause inflation?

To think this through, think about what it means for a government to borrow money to finance a deficit during a recession. During a recession people are, by definition, saving too much and spending too little. When the government runs a deficit because of increased spending to counter the recession, and they borrow it from the private sector, they are basically borrowing the money that the private sector should have been spending and spending it for them. Sure there would be a nice accounting balance in the process if the government borrowed this idle money from the private sector and then spent it. But logically, wouldn't the resultant deficit spending be the same whether the government borrowed the money or just printed it? The private sector money that the government otherwise would have borrowed will still be sitting idle because of the recession whether the government borrows it or not.

The only possible difference between a borrowing vs. printing situation is that in a borrowing situation the borrowing demand from the government will increase interest rates, attracting more saving at the expense of private spending, which would make the downturn in private spending worse. That doesn't seem like a good idea.

But isn't all the un-borrowed private money going to cause inflation once the economy turns around?

The savings left in private hands when the government prints instead of borrowing will only cause inflation if it is used for spending. And spending will only cause inflation if it exceeds the available supply of goods and services. Leaving money that otherwise would have been borrowed in the private sector will help accelerate the recovery once the economy starts growing. If and when inflation actually becomes a problem it is easy to choke it off by raising interest rates.

But what if the government keeps printing money even after the economy recovers, that will surely cause inflation!

Remember, the reason the government is running a deficit is because the recession has reduced tax revenues and increased spending on automatic stabilizers (unemployment benefits, etc). Once the economy returns to health the deficit will naturally dwindle as tax revenues increase and automatic stabilizer payments decrease. In short, the government won't have much need to print money once the economy is back to full capacity.

But what about the stagflation of the 70s? Doesn't that prove that you can have inflation during a recession?

The inflation of the 70s was triggered by a huge oil supply shock; there wasn't enough oil to meet even the reduced demand during the recession. We are not currently facing any sharp reduction in the supply of any commodities.

To me the solution to the deficit and debt problem is obvious. Governments should just start liberally printing the money (i.e. have their central banks buy government debt) to finance their deficits during the recession and simply stop adding to their debt burdens. If and when inflation actually starts to creep up above 2-5% have the central bank stop buying public debt, start selling the public debt they bought to soak up the excess money, and start raising interest rates. Easy peasy. No crisis required. No grinding years of austerity measures that throw the economy back into recession and lead to political unrest.

Speaking of austerity measures, whenever someone proposes solving deficit problems during a recession by imposing austerity measures I wonder how exactly triggering another recession through austerity measures can be expected to solve a deficit caused by a recession. Isn't austerity going to lead to a downward spiral of austerity, reduced tax revenues, increased deficit, more austerity, etc.?

To me the fear of printing money to ameliorate a recession seems like ignorant superstition. And the fact that people are advocating prolonging high unemployment and reduced benefits for people in need on the basis of this superstition seems tragic and bizarre. Real people are really suffering right now, and many would have that continue indefinitely rather than run a hypothetical risk of inflation for which there is little or no empirical evidence.

1 comment:

  1. The money that gets printed when things are slow speeds things up... but that money is still in the economy where, in a speeded-up economy, it can cause inflation. (Anyway, this was the objection many people had, I think, when the Federal Reserve created an extra trillion during the crisis.)

    Yeah, economists insist that it's the excess demand -- increased spending -- that is the cause of inflation. Anna Schwartz, for example. Well, that was probably true in 1960 but it's not true now and it has not been true for a long time. That notion is definitely incomplete and outdated.

    Andy: "If and when inflation actually becomes a problem it is easy to choke it off by raising interest rates."

    But choking off growth is part of the problem, too.

    Roubini: "Piling public debt on top of private debt carries a high cost."

    Me: It's the private debt that stifles growth, not the public debt. The solution is to reduce private debt, so the economy can grow again.

    Anyway -- Good post, Andy.