Debt Arithmetic and Expansionary Policy: Paul Krugman Vastly Understates His Case

Paul Krugman writes:

Debt Arithmetic (Wonkish): The whole tone of current discussion about deficits is one of urgency: deficits must be brought down now now now or crisis looms. Where is this coming from? Not from the arithmetic.... [D]eficits mean higher debt, which means higher interest payments, which can mean a spiral into bankruptcy.... If you put numbers to it, however, for countries that are not facing huge risk premia, the spiral is very, very slow.

Here’s a sample calculation. The latest IMF Fiscal Monitor predicts that general government in the US — that’s federal, state and local combined — will run a deficit of 7.5 percent of GDP next year, and that net debt will be 75 percent of GDP.... Suppose that we have 4 percent nominal GDP growth, which is actually low by historical standards. This shaves 3 percentage points off the rise in the debt/GDP ratio. So a year later, given those numbers, debt rises by 4.5 percentage points of GDP. What’s the interest burden of that rise? At minimum we should correct for inflation, so use the TIPS yield. That’s currently below 1, but let’s be pessimistic and call it 2. Even so, the added interest burden is less than one-tenth of one percent of GDP. So even with substantial deficits, the pace of long-term budget worsening is very slow. If it’s a debt death spiral, it’s a slooooowww motion death spiral.

But, say the critics, psychology can change suddenly, sharply raising those interest costs. The question then is why psychology should change. Investors can do the same arithmetic I’ve just done; why should they panic over a small rise in the interest burden? Now, investors might well panic over signs of political deadlock — but that could happen regardless of the current year’s deficit. Still, Serious People tell us that investors will turn on us unless we slash the deficit immediately — and they know this because, well, um...

As I’ve often written, we’re in a strange state now where people who actually take textbook economics and simple arithmetic seriously are seen as dangerously radical and irresponsible, while people who believe in invisible bond vigilantes and confidence fairies, who claim to know what the market will want even though there’s no sign of that desire in current asset prices, are viewed as Very Serious...

I think Paul Krugman vastly understates his case here.

First, the Keynesian logic for expansion right now is reinforced by the fact that recessions and austerity programs cast shadows: raise unemployment now via austerity cuts in government spending, and some of that increased unemployment sticks around permanently as higher structural unemployment. Call the share of unemployment that does so s. Then an austerity program today worsens the long-run debt-and-deficit picture if:

mt > (r - g)/(r - g + s)

if m is the multiplier, t is the marginal tax rate, s is the share of the recession rise in unemployment that turns into a permanent rise in unemployment, r is the real interest rate on government debt, and g is the economy's real growth rate. Since right now mt is about 0.5, and r is less than 2% per year, this means that further fiscal expansion is good for the long-run debt-and-deficit right now as long as:

s + g > 2%

As long as the sum of the economy's long-term growth rate--which is now about 3%--and the share of a rise in unemployment that becomes structural is greater than 2%--which it definitely is--fiscal expansion is a good thing.

Second, even if you have no Keynesian effects in the model at all, there is still an overwhelming case for borrow-and-spend right now. Why? Because the thirty-year Treasury inflation-indexed security rate at 1.86% per year is lower than the expected long-run growth rate of the real economy right now of close to 3% per year.

This is a basic topic sometimes taught in intermediate undergraduate macroeconomics: the neoclassical optimizing growth "Golden Rule."

If the economy ever gets itself into a situation in which risk-adjusted long-run interest rates are lower than the risk-adjusted expected long-run growth rate of the economy, it is dynamically inefficient--and government should borrow and spend and keep borrowing and spending until at least it drives long-term interest rates up to and above the risk-adjusted expected long-run growth rate. (And the Keynesian multiplier and the shadows cast by recessions strengthen the case for spending.)

Yet I find none of the classical, semi-classical, new classical, or neoclassical economists who believe in optimizing growth models stepping forward and saying: "Because r < g right now, what we really need is more government spending and an expanded government debt."

It is very odd...