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February 1, 2013

How Much Stimulus?

Steve Stein on End This Depression Now by Paul Krugman and Red Ink by David Wessel

Paul Krugman. End This Depression Now. Norton. 259 Pages. $24.95.

David Wessel. Red Ink. Crown Business. 204 Pages. $22.00.

The u.s. economy has been depressed for over four years and Paul Krugman — Nobel laureate, economics professor, and New York Times columnist — is irked that his remedies go unheeded, especially since they’re also the remedies that John Maynard Keynes laid out over 70 years ago. Keynes would not have been impressed with the halfway measures that have been employed to create fiscal stimulus, and neither is Krugman. Federal spending on the order of what was done in World War II is in order, even though this is peacetime.

Won’t this lead to runaway inflation, and eventually to national insolvency? Won’t it bring the nation into a predicament similar to that of Spain or Greece? Nonsense, says Krugman, and in several chapters of his recent book, End This Depression Now, he answers economists and politicians who say otherwise.

In an early chapter, tellingly headed “Bankers Gone Wild,” Krugman elaborates his view on how we got into the current mess. He traces the path of banking deregulation throughout the last quarter of the 20th century, starting with minor dilutions of the 1933 Glass-Steagall Act and ending with that law’s complete repeal in 1998. Glass-Steagall, which separated the functions of commercial banking and investment banking, was designed to prevent banks from speculating with taxpayer-insured deposits. However, bankers eventually persuaded Congress that the rules made it impossible for them to compete with other financial institutions not bound by similar constraints. Krugman agrees that the mismanagement by commercial bankers wasn’t solely responsible for the 2008 financial meltdown, noting that the collapse of Lehman Brothers, an investment bank, started “a run on the shadow banking system.” But his approach would have been to regulate the shadow banks more, not to regulate the commercial banks less.

Many economists place as much responsibility for the crash of 2008 on the government and the Federal Reserve as on private bankers. After all, Congress pressured the two government sponsored lenders — Fannie Mae and Freddie Mac — to relax lending standards so that lower income borrowers could afford to own homes, while the Federal Reserve facilitated this imprudence by holding interest rates far too low from 2002 to 2004.

Krugman is having none of that. Interest rates were also low throughout much of the world, and the housing bubble was an international phenomenon extending well beyond the influence of U.S. policy. As for blaming the relaxed lending standards on Fannie and Freddie, this Krugman calls “the big lie.” Most of the bad loans were “sub-prime” and, by definition, outside the Fannie and Freddie parameters. He has no use for the argument that Fannie Mae’s practices weakened mortgage lending criteria throughout the industry.

Whatever the cause of the meltdown and recession, Krugman’s cure is a much heavier dose of Keynesian stimulus. He believes the administration’s stimulus plan (the American Recovery and Reinvestment Act of 2009) was woefully inadequate, and that President Obama should have ignored his opponents’ cries of alarm about an out-of-control deficit, since they were motivated by a combination of political mischief and ignorance.

Acknowledging that Keynesians don’t have an intellectual monopoly on economic theory, Krugman takes some time to the review the competing “monetarist” view, associated mainly with Milton Friedman and the University of Chicago. Both Friedman and Keynes found that increases in the money supply can lead to inflation, but Keynes maintained this to be so only when in an economy at or near full employment. Krugman finds the data overwhelmingly on the Keynesian side and sees the controversy a matter of “pragmatism versus quasi-religious certainty.” Despite a steady drumbeat of warnings, the interest rate on the ten-year treasury bond has remained near an all-time low for several years, and core inflation has been contained at about two percent a year.

But hasn’t Keynesian theory run up against significant contradictory evidence of its own, as when high inflation accompanied high unemployment throughout the 1970s? Krugman dismisses this as the result of random “supply shocks” which aren’t likely to be repeated. How he knows this, he doesn’t say.

In any event, Krugman certainly doesn’t fear inflation today. Indeed, he would try to boost the current inflation rate considerably higher — to about four percent, and makes three arguments for that policy: It would compensate for the central bank’s inability to drive nominal interest rates below zero (inflation would make the real rate go down further), and the debt overhang would be eased considerably, since debtors would be repaid in cheaper dollars. Finally, when wage reductions are needed in order to increase employment, inflation will make them more palatable. While workers will staunchly resist direct pay cuts, they’ll more readily accept them when disguised as the same nominal wage, but paid in cheaper currency.

Krugman says this third reason is more applicable to the labor markets and politics of Europe than to those of America, and before detailing his plan to end the American depression, he detours to the Eurozone, where similar economic problems are exacerbated by the fact of a common currency.

Europe’s economic integration began with the Coal and Steel Community in 1951, and expanded into the European Economic Community in 1957, which continued to add members through the 1980s. Ten years later, as closer economic and political ties had become so obviously advantageous, the case for a common currency seemed compelling.

But when countries with widely divergent economies share a common currency, the weaker ones can be worse off during an economic downturn than if they had their own separate money. They can no longer make exchange rate adjustments. Nations with high debt and unemployment, who might otherwise have inflated their way out of those problems, must now depend on the cooperation of others. So, if there is a collective remedy for the euro countries, it looks very similar to the one proposed for the U.S.: more money created by the central bank, and forget about austerity.

Which brings Krugman back to the United States, where substantially raising a deficit that is already over $1 trillion doesn’t faze him, especially when the gdp is over $15 trillion. His Exhibit A is the spending that the U.S. government underwent at the beginning of World War II and the massive debt that the country took on as a result. The nation had been in a depression for over ten years, with unemployment in 1939 still at seventeen percent. The government had undertaken vast public works programs to get the economy on track, but they never seemed to be enough. The war changed all that. In 1940 the annual deficit was 3.6 percent of gdp; in 1943 it peaked at 30.8 percent.

Wars are terrible, and no sane person — Krugman emphatically included — would seek such a “remedy” for economic troubles. But he does see the salutary side effects of wartime spending as a compelling guide to what similar spending can achieve in a peacetime economy.

Krugman envisions roughly an additional $1 trillion of spending, divided among new federal infrastructure projects, more federal money to cities and states, home mortgage relief, and enhanced transfer payments for unemployment compensation and job retraining. Wouldn’t such a set of policies be politically impossible? Krugman thinks not; if a major push gets this stimulus underway, its success will be self-reinforcing.

Is it possible that the 1930s depression was prolonged not by the inadequacy of the government’s response, but by its inconsistency and incoherence? Krugman doesn’t address that point, nor does he really address the political concern that additional government spending means additional government control. People readily accept this in wartime, partly because they expect quick victory and a return to normalcy, but any phase-out of emergency spending in peacetime is much less certain. No recession ever ended at the same time for everyone; there are always groups who want government to stay in the game and governmental agencies that are programmed to oblige. For example, federal money for cities and states may support higher current payrolls, but would also sustain the high public pension costs that made federal bailouts necessary in the first place.

Even in the case of the actual wartime spending, there was disagreement about when and how to wind down the government’s role. Paul Samuelson, later to become America’s leading Keynesian academic, was on the staff of the National Resources Planning Board during the war and had advocated slowing the rate of troop demobilization once the war ended. Samuelson feared that the reentry of so many men into the civilian workforce would reignite unemployment and recession. Delaying demobilization was too much even for the Board, but maintaining other wartime programs had much wider support. The Truman administration wanted to continue wage and price controls through 1947. However, voters had another view of the matter; the Republicans swept both houses of Congress in 1946.

Even if a huge new round of spending does have merit, it is hard to see how the financial markets or the public would accept so much additional public debt unless coupled with a highly plausible plan toward eventually paying it down. Christina Romer, while chairing President Obama’s Council of Economic Advisors, made that very point. Romer’s outlook tends to align with Krugman’s, but on this they differ; she held a key post in the administration that he criticizes for not promoting a larger stimulus package.

Romer’s views are reported in Red Ink, David Wessel’s short book about the mechanics and politics of the federal budget process. Wessel, economics editor of the Wall Street Journal, believes that budget realities are an essential element of political literacy, and pins down the figures on expenditures and revenue. Since 2009, mandated expenditures — mainly Medicare, Medicaid, Social Security, and interest — have accounted for every penny of revenue. This year that amounts to about $2.4 trillion. Everything else, including all defense and discretionary spending, requires about another $1.3 trillion, all of which will have to be borrowed.

Health care costs are by far the biggest expense, accounting for almost a quarter of the total federal budget. As these costs continually rise, it is difficult to reasonably project a scenario for revenue growth sufficient to whittle down the yearly deficit or cumulative debt. Even the Defense Department’s budget is subsumed by medical costs. As former Secretary of Defense Robert Gates put it, “Health care costs are eating the Defense Department alive.” Tricare, the dod’s generous health insurance program, is made available for every veteran of 20 years service. The yearly premium runs about $500 per year for insurance that would cost $5,000 per year on the civilian market. “Why does Tricare survive unscathed?” Wessel asks, then answers, “Mostly because of the enormous political power of veterans’ groups.”

Not that there aren’t bigger line items in the defense budget. After all, the U.S. spends more on defense than the next seventeen countries combined. As Wessel puts it, “The Navy estimates each aircraft carrier costs in excess of $11 billion, more than Medicare spends annually on knee, hip, and shoulder joint replacements for nearly seven hundred thousand elderly.” Meanwhile, the defense budget gets ample political support from both parties, not least because the Pentagon is among the largest employers in the world. Combine that fact with appeals to patriotism and security, and defense expenditures are hard to argue with.

On the revenue side, the tax mix has changed markedly over the past 50 years. Personal income tax as a share of total revenue has remained about the same, but the payroll tax share has vastly increased, and the corporate income tax share has correspondingly diminished. The payroll tax increase was an almost inevitable consequence of the decline in the number of workers now paying in per each retiree collecting — from 16.5 in 1950, to 2.9 today, and a projected 2.1 in 2030. The corporate tax share has been somewhat reduced by various additional exemptions and credits, but the main cause is Subchapter s of the irs code, which allows most nonpublic corporations to be treated as individual proprietorships and pay no corporate tax at all.

“No discussion of taxes,” Wessel writes, “can avoid the money that the government doesn’t collect because of some provision of the tax code, a deduction or a credit or an exclusion or an exemption.” If someone gets a sum of money from the government, that is the result of a spending program that is bound to be unpopular with some portion of the electorate. But if that person receives a voucher that is used to reduce taxes, this will be called a “tax cut,” and will attract little opposition. Certainly the Earned Income Tax Credit has worked this way. Whatever else has occurred in taxation over the last 50 years, the irs Code has surely become more complex.

The most popular of the “tax expenditures,” as these carve-outs and credits are called, is the home-mortgage interest deduction, but there are also provisions relating to the adoption of children, credits for investing in biomass generation of electricity, and other energy subsidies. Together, all these amounted to $1.1 trillion of revenue foregone in 2011.

Since Red Ink underscores the difficulty of discovering plausible long-term debt reduction, it reveals the impracticality of Romer’s suggestion to increase spending now and match it with credible repayment later. Still less does Wessel support Krugman’s approach, which concentrates entirely on increased current spending. However, he does acknowledge Krugman’s position as one of the three that make up the current Washington debate. The second one is Congressman Paul Ryan’s plan, which puts all the emphasis on spending reduction. Finally, there is Pete Peterson’s plan, which insists on roughly equal spending cuts and tax increases. Peterson, a retired ceo of an investment firm, now uses some of his over $1 billion net worth for a foundation dedicated to slaying the deficit dragon.

None of the three groups is particularly good at communicating with the others. It’s as though the Krugman group says, “It’s Unemployment, Stupid,” the Ryan group says, “It’s Spending, Stupid,” and the Peterson groups says, “It’s the Deficit, Stupid.” The fight between the warring camps is sometimes mediated by the Congressional Budget Office and its director, Bob Elmendorf. Wessel writes that “At congressional hearings, Elmendorf is like the referee in a food fight.” He reminds the lawmakers of the stubborn facts of demography: “we cannot go back to the tax and spending policies of the past because the number of people sixty-five and older will increase by one-third between 2012 and 2022.” Sometimes Elmendorf just returns to basic politics: “The country faces a fundamental disconnect between the services the people expect the government to provide . . . and the tax revenues that people are willing to spend.”

There is little in Red Ink to cheer the anti-tax absolutists currently dominating the Republican majority in the House of Representatives. But what if Republicans instead were to argue that serious spending cuts must come first, with tax increases to follow if — and only if — reduced expenditures prove insufficient? They’d find much in Wessel’s analysis to buttress that position.

Meanwhile, what of Krugman? Surely he’s well aware of the data explored in Red Ink, including the profound American demographic differences between now and the decades following 1945. Yet he maintains that we can add more than $1 trillion in new spending with fair confidence that the future will take care of itself. Does he really believe that rapid economic growth, along with inflation — which he once labeled as “implicit default” — can bring the resulting national debt down to a safe percentage of gdp?

Or does Krugman perhaps think the default might actually be somewhere more explicit? He has elsewhere written sympathetically of Argentina’s default in 2001, and has encouraged the Greek government’s consideration of more “haircuts” for its bondholders. Here he writes that “lenders want governments to make honoring their debts the highest priority,” and decries the “continuing urge to make the economic crisis a morality play, a tale in which a depression is the necessary consequence of prior sins and must not be alleviated.”

Krugman’s statement about economics not being a morality play is suspect, in two ways. First, he contradicts himself a few pages later by invoking a “moral imperative” to carry out the measures he advocates; maybe he see economics as a morality play after all, so long as the moral code meets his own criteria. Second, Krugman minimizes the nexus between money, credit, and moral obligation. When various agency bonds are guaranteed, they’re backed by “the full faith and credit of the U.S. government.” If that isn’t a matter of morality, it’s certainly a first cousin. Is the soundness of money and credit society’s highest value? Of course not, but it is a value that can’t be tossed aside as a matter of convenience. Perhaps that’s why David Wessel’s statement of budgetary facts shows that Paul Krugman’s recipe for a way to “end this depression now” doesn’t taste quite right.


Steve Stein is a writer and financial advisor in Marin County, California.