## Fiscal Expansion That Is Deficit Neutral in the Long Run

Mark Thoma is alarmed by our president:

Economist's View: Obama's Wrong-Headed Thinking on the Deficit: Edward Harrison catches this quote from Obama....

Obama warned the United States' climbing national debt could drag the country into a "double-dip recession," though he said he's still considering additional tax incentives for businesses to reverse the rising unemployment rate. "There may be some tax provisions that can encourage businesses to hire sooner rather than sitting on the sidelines. So we're taking a look at those," Obama told Fox News' Major Garrett. "I think it is important, though, to recognize if we keep on adding to the debt, even in the midst of this recovery, that at some point, people could lose confidence in the U.S. economy in a way that could actually lead to a double-dip recession."

I hope his economic advisers set him straight, though I suppose there's a chance that this nonsense is coming from them. We needed a larger stimulus package to begin with, and the economy could still use more help, labor markets in particular. Let's hope that this doesn't turn into a call to actually start balancing the budget before the economy has fully recovered as that would increase the chances of the double dip recession that he is so worried about (something we should have learned from the 1937-38 experience where an attempt to balance the budget prematurely plunged the economy back into recession)...

One way to interpret this--which may or may not be wrong--is that right now we are really and truly fracked beyond previous imagining. Let's go back to the old ca. 1960 standard macroeconomic diagram, with the interest rate on the vertical axis and the economy's level of spending on the horizontal axis. We then have:

• A red curve the IS curve, which tells us what the economy's (real) spending level is--the sum of household spending on consumption, business spending on investment, net exports, all functions of this real interest rate, plus government purchases) as a function of the current value of the (real, long-term, risky) interest rate (and also of lots of other stuff that affects the position of the curve)...

• A blue curve, the LM curve, which tells us what the (short-term safe nominal) interest rate is as a function of the (nominal) spending level that is consistent with households' and businesses' being willing to hold the economy's current money stock...

• A double-headed orange arrow, the spread, the difference between the short-term safe nomina interest rate and the long-term risky real interest rate--the difference between the two being the sum of a term premium, an expected inflation rate, and a risk and default premium...

In this framework, the problem with credit easing--the central bank increasing the money supply now and moving the blue curve to the right without changing expectations of what the money stock will be in the long-term future--is that the curve has flat because cash and short-term Treasury bonds are close substitutes, so you expand the money supply by a lot while doing little to boost spending and employment and land yourself with the problem of unwinding the money stock increase in the future in a way that does not hurt spending and employment when you do so:

(Quantitative easing--pouring a whole bunch of cash in the system with the idea of never reversing the money stock expansion could boost spending and employment considerably by creating expectations of inflation and so reducing the spread--but the Federal Reserve is not going there, and regards the idea with horror, shock, and shame.)

In this framework, banking policy--recapitalizing banks further and issuing government guarantees to shrink the spread--boosts spending and employment even when, as now, cash and short-term Treasuries are close substitutes. The problem with banking policy today is that no member of congress of either party of any political persuasion wants to get out in front supporting it.

In this framework, the problem with fiscal expansion--the government purchasing a bunch more things right now and so shifting the red curve to the right--is that it boosts the supply of government bonds in the future and so may raise the double-headed orange arrow that is the spread, getting you absolutely nowhere:

So what can we do? Looks like we are well and truly fracked.

Well. maybe not. My position on further fiscal expansion is twofold:

• The claim that further government purchases would widen the spread might be true. It might now. Let's try it and see. The debt held by the public on Monday was $7,632,033,766,420.46. The debt held by the public a year and a half ago was$5,218,570,776,014.84. We have managed to boost the debt held by the public by \$2,413,462,990,405.62 in eighteen months without materially moving the term premium significantly. (The risk premium has moved--there is a financial crisis on, after all.) So let's try it and find out.

• This is an opportunity. We really need to reduce the deficit after 2030. We really need to have more government purchases now. So raise spending now, and raise taxes and impose spending caps starting in 2013 so that by the end of the 20-year budget window the projected debt is unchanged. Thus we move the red line without increasing the spread: there's now increased supply of bonds in the long term to push up the interest rate on them. And we solve both our current near-depression problem and our post-2030 structural deficit problem.