Project Syndicate: A Teaser for what might possibly be in J. Bradford DeLong and Lawrence H. Summers (2012, forthcoming), "Fiscal Policy in a Depressed Economy", Brookings Papers on Economic Activity 2012:1 (Spring), pp. ???-???:
As recovery from the recession of 2008-9 continues to be sluggish and halting, all over the North Atlantic world what was readily-curable cyclical unemployment is turning into structural unemployment, and what was a brief hiccup in the process of capital accumulation has turned into a prolonged investment shortfall that means a lower capital stock and a lower level of real GDP not just today while the recovery is incomplete but for perhaps decades into the future.
The experience of the 1980s in Western Europe gives us the following rule of thumb: lower labor-force attachment and the reduced capital stock from reduced investment together mean that every year production is depressed $100 billion below normal carries with it a future productive potential at full employment some $10 billion below what would otherwise have been forecast.
The conclusions that then follow for what government fiscal policy should be are striking.
Suppose that the United States or the Western European core economies boost their government purchases for next year by $100 billion, and suppose that while their central banks are unwilling to extend themselves further in unconventional monetary policy they are also unwilling to step on the toes of elected governments’ policies by offsetting them. Then our simple constant-monetary-conditions multiplier tells us that we can expect roughly $150 billion of extra GDP from that fiscal boost. And alongside that $150 billion of extra GDP comes $50 billion of extra tax revenue, so that the net addition to the national debt is only $50 billion.
What is the real interest rate that the United States or that Western European core economies will have to pay on that extra $50 billion of debt? Is it 1%? 3%? 5%? If it is 1%, boosting demand and production by $150 billion next year means that $500 million of taxes must be raised each year in the future to keep the real debt from growing. If it is 3%, that means $1.5 billion a year. If it is 5%, that means $2.5 billion a year.
At a 10% shadow cast on future potential output levels by continued subnormal output, that extra $150 billion of production means that in the future when the economy is recovered there will be an extra $15 billion of output—and an extra $5 billion of tax revenue.
That $5 billion of tax revenue will more than cover the $500 million or $1.5 billion or $2.5 billion interest cost of financing the added debt.
Governments will not have to raise taxes to finance extra debt taken on to fund fiscal boosts: instead, the supply-side boost to potential output over the long run from an expansionary fiscal boost program looks highly likely to pay for not just the added debt needed to finance the fiscal boost but to allow for additional future tax cuts while still balancing the government’s budget.
Now this is, to say the least, a highly unusual situation. In a usual situation the multipliers applied to expansions in government purchases are much less than 1.5, for in a usual situation the central bank does not maintain constant monetary conditions as government purchases expand but rather acts to keep the economy on track to meet the central bank’s inflation target, and a more usual multiplier is the monetary-policy offset multiplier of 0.5 or 0. And in a usual situation governments—even the U.S. and Western European governments—are not able to run up their debt and yet pay a real interest rate of 1% or 3%. In a usual situation the math of increasing government purchases tells us that a small or dubious boost to production today brings with it a heavier burden of financing government in the future that makes debt-financed fiscal expansion a bad idea.
But the situation today is not usual. Today the global economy is, as Ricardo Cabellero of MIT stresses, still desperately short of safe assets. Investors worldwide are willing to pay extraordinarily high prices for and accept extraordinarily low interest rates on core-economy debt, for they value having a safe asset that they can use a collateral as an extraordinary benefit.
Right now, given this preference for safety on the part of investors that makes financing additional government debt so cheap, and given the long-run shadows cast by prolonged subnormal production and employment that make our current sluggish recovery so very costly not just in the short run of idle resources but in the long run of reduced productive potential, a larger national debt would indeed be, as the first U.S. Treasury Secretary, Alexander Hamilton, said, a national blessing.