Econ 1: Spring 2012: U.C. Berkeley: Problem Set 9 Answers
I Pulled into Nazareth, Feeling About Half-Past Dead...

Why Condemn the Bush Deficits of the Mid-1980s and Welcome Deficits Now?

Joe Weisenthal asks the question:

Back in the 2000s, you frequently blasted Bush for running large deficits. However in recent posts and interviews, you've said that a country with its own sovereign, un-pegged currency can't ever face bond vigilantes.

What's more, the sovereign currency issue seems to be something of a new line of thinking for you, given that initially you wondered why Italy and Japan were paying different rates given broadly similar economic conditions. Now you seem to have found peace with that question, based on the sovereign currencies issue.

Thus in light of this change of thinking, do you still stand by your comments

Paul Krugman answers:

I was clearly too worried about bond vigilantes back in 2003 -- and I've written on my blog conceding that mistake.

I wasn't wrong, however, to condemn the Bush deficits. Deficits serve a useful function when the economy is deeply depressed, and in particular when monetary policy is up against the zero lower bound. You should not gratuitously increase debt in normal times, when any fiscal stimulus can and will be offset by Fed policy.

And don't you wish now that we hadn't run those unfunded wars and tax cuts? The ratio of debt to GDP would be 20 or 25 percentage points lower, and we'd be feeling a lot more relaxed about current deficits.

Actually, one more point: the Bush deficits were, I though, especially likely to send a bad signal to markets for two reasons. First, they were gratuitous -- they weren't about stimulus, they were just about irresponsibility. Second, they were driven by long-term, quasi-permanent tax cuts -- which is very different from temporary stimulus spending.

And my take:

There will come along times when you want to run deficits: wars, Marshall Plans, other national emergencies, depressions when the economy is at the ZLB and the central bank cannot or will not get you to full employment.

In all of those situations, you want to be able to run large deficits without sending your interest rates sky-high.

If you run large deficits during normal times--when the Federal Reserve is perfectly capable and willing to manage aggregate demand to get us to full employment--you use up the debt capacity that you want to hold in reserve. See Christina Romer "Fiscal Policy in the Crisis: Lessons and Policy Implictions" Figure 2. Thus running big deficits in normal times--especially to fund tax cuts for the rich--is a bad idea.

Http emlab berkeley edu ~cromer Lessons 20for 20Fiscal 20Policy pdf