Morris Goldstein's Ten Planks for Financial Sector Reform in the Wake of the Subprime Credit Crisis
Paul Krugman Likes McCain Fiscal Policy Even Less than I Do

Short-Term Costs of Long-Run Fiscal Stupidity

I'm glad I'm not a Republican. Just saying.

J. Bradford DeLong: Project Syndicate: Back in 1981, America’s Republican Party gave up all belief that the government’s budget ought to be balanced. The idea took hold that tax cuts should be undertaken all the time, at every opportunity, because reducing taxes supposedly raised revenue.

Irving Kristol, sometime editor of the magazine The Public Interest and one of the intellectual midwives of this idea, later wrote that he was interested not in whether it was true, but in whether it was useful. Years later, he spoke of his “own rather cavalier attitude toward the budget deficit and other monetary or fiscal problems. The task...was to create a new...conservative... Republican majority – so political effectiveness was the priority, not the accounting deficiencies of government...” Now it has become clear that John McCain – who once criticised George W Bush’s tax cuts as imprudent and refused to vote for them – has succumbed to this potion. He appears to be proposing further tax cuts that promise to cost the US Treasury some $300bn a year, to “offset” them with cuts in earmarked spending accounted for at $3bn a year, and somehow to balance the budget.

We know the consequences: McCain’s fiscal policy is likely to be standard Republican fiscal policy – and since 1981, standard Republican fiscal policy has increased the ratio of gross federal debt to GDP by nearly 2% per year. By contrast, a typical post-WWII Democratic administration has reduced the debt-to-GDP ratio by more than 1% per year. This is one of the issues at stake in this year’s presidential election.

Policies that ignore the level of government debt lead to the currency’s collapse, depression (due to the resulting disruption of the sectoral division of labour), and high inflation – perhaps hyperinflation. Often, the guilty blame the economic catastrophe on the sinister manipulations of foreigners like the “gnomes of Zurich” or the IMF. The US is far from that point. But even in the shorter run – over the next two presidential terms, say – the costs of a high deficit and rapid debt growth would be substantial.

A growing debt-to-GDP ratio would, in the first instance, crowd out investment, as resources that would otherwise go to fund productive investment instead support private or public consumption. Since 1981, the US has been lucky in that inflows of capital from abroad financed the growth of government debt. At some point, this will stop, and increases in deficits will trigger capital flight from the US. Suppose that over the next eight years larger deficits trigger neither extra capital inflows nor capital outflows, and suppose that a lower-investment America is a poorer America, with a gross social return on investment of 15% per year. By 2016, America’s productive potential would be smaller by an amount that would reduce real GDP by 3.6% – $500bn real dollars, or roughly $3,000 per worker. In a poorer America, fewer businesses would find it worthwhile to entice secondary workers from families into the labor force, and perhaps 500,000 net jobs would disappear.

In getting from here to there over the next eight years, a higher-debt America would see productivity growth slow by perhaps a third of a percentage point per year. Average unemployment would then have to rise in order to keep workers’ demands for real wage increases at a level warranted by productivity growth. The gross correlations between productivity growth and average unemployment found in the 1970’s, 1980’s, 1990’s, and 2000’s would increase the economy’s natural rate of unemployment by about one-fifth of a percentage point, costing an additional 500,000 jobs.

And a higher-debt America is one in which savers and lenders would have a justified greater fear that the government would resort to inflation in order to repudiate part of its outstanding debt. The Federal Reserve would then have to fight inflation – putting upward pressure on unemployment – in order to reassure savers and lenders of its willingness to guard price stability. There are not even crude gross correlation-based estimates of the size of this effect, but economists believe that it is very real. Would it cost a negligible number of jobs? A quarter-million? A million?

Add it all up, and you can reckon on an America that in 2016 that will be much poorer if McCain rather than Barack Obama or Hillary Rodham Clinton is elected president. Other countries that are counting on exporting to America would be affected by slower growth and lower employment in the US.

However, under McCain, the wedge between public spending and taxes would be larger, Americans would feel richer, and they would spend more at the expense of “posterity” eight years down the road. Ronald Reagan might have approved. After all, as he put it: “Why should I do anything for posterity? What has posterity ever done for me?” Or was that Groucho Marx?