Pavlina Tcherneva was interviewed yesterday on Los Angeles public radio about the ongoing debt ceiling face-off and government shutdown. She referenced Ben Bernanke’s “self-induced paralysis” phrase (which he used to describe Japan’s lost decade) as an accurate description of the current US situation and expressed concern that shutdown and debt ceiling standoffs may represent the new procedural status quo — effectively preventing the government’s fiscal power from operating on any normal basis.

(The fact that yesterday’s GOP proposal centered on a mere six-week raise in the debt ceiling — and by some accounts would prevent Treasury from engaging in the “extraordinary measures” it has been using to buy time since bumping up against the debt ceiling — suggests that congressional Republicans may indeed be envisioning permanent hostage budgeting.)

Tcherneva also discussed what we might expect from Janet Yellen’s Fed. Based on Yellen’s past testimony and academic work, Tcherneva argued we should see more of a focus on unemployment and employment issues, at least at the level of shaping the policy discourse — there is a separate question, Tcherneva cautioned, as to whether the Fed has the tools to get us to full employment.

Listen to or download the interview here.

Some commentators and members of Congress have insisted that failing to raise the debt ceiling would not necessarily require defaulting on the national debt. The theory is that Treasury could prioritize payments to bond holders while defaulting only on commitments to other payees (say, Social Security recipients).

Most of the discussion of what might happen if Congress fails to raise the borrowing limit has focused on the financial market consequences of defaulting on the debt. But even if prioritization is possible (there is some debate about whether it’s logistically possible, or even legal), we would still be facing a serious macroeconomic crisis.

This is because failing to lift the debt ceiling would require extreme spending cuts some time after October 17. Essentially, the federal government would be forced to balance its budget. (This is all assuming that trillion dollar coins and premium bonds are off the table.)

What would that kind of radical austerity do to the economy? Michalis Nikiforos uses the Levy Institute’s macroeconomic model to estimate the effects of beginning rapid fiscal consolidation in the last quarter of this year and maintaining a balanced budget through the rest of the 2014 fiscal year (which is to say, through 2014Q3).

The result? A big swing in the expected growth rate, leading to a deep recession:

Nikiforos stresses that if anything this underestimates the economic damage:

(1) the simulation relies on the IMF’s forecast for US trading partners, which currently assumes a reasonably healthy US economy. But “[a] recession in the United States would certainly exert a negative influence on growth in the rest of the world, which would in turn feed back to the States.”

(2) the private sector’s balance sheet is still fragile. If the US enters another steep recession, it could induce “a new round of rapid deleveraging, which would further push down the growth rate” (and, Nikiforos suggests, probably cause problems in the financial sector).

(3) fiscal stabilizers helped place a floor under the economic collapse during the Great Recession, but this time around, automatic and discretionary fiscal stabilizers would be AWOL due to the need to maintain a balanced budget. “In the case of a new crisis originating from rapid fiscal consolidation,” he writes, “it is not clear who would play the role of system stabilizer.”

Read the policy note here (pdf).

As of today, it looks like John Boehner is trying to get House Republicans to agree to a short-term increase in the debt limit, of perhaps six weeks. If this passes and is accepted by the President (it’s not crystal clear right now whether there will be any demands attached to the House’s debt ceiling increase), we’ll be back on the edge of this macroeconomic crisis around Thanksgiving.

Update: No deal

@michlstephens

From Mariana Mazzucato’s “Rethinking the State” video series:

Pavlina Tcherneva discusses the implications of the Great Financial Crisis of 2007 for employment outcomes and fiscal policy. She argues that the current view of Keynesian fiscal policies is based on a misreading of Keynes. Simply boosting demand — through what should be understood as trickle-down fiscal policy — is not sufficient to promote inclusive growth. Keynes originally called for a more targeted approach, including “on the spot employment,” as the means to achieve full employment and equitable and sustainable growth.

[See also her recent working paper on this theme.]

L. Randall Wray argues that rethinking the State requires rethinking the relationship between the State and its currency. His analysis starts with the observation that money is based on State power (“currency sovereignty”): it is an “IOU” from the State — a liability — implying that fiscal constraints are in fact artificially created. In this sense, the State cannot run out of money, as it creates and enforces its own IOUs. Governments could — and should — afford to invest more in innovation and technology development to promote the capital development of the economy.

@michlstephens

Kenneth Rogoff placed an editorial in Wednesday’s Financial Times defending the Cameron government’s austerity policies as a kind of insurance against the possibility of investor flight from UK government debt.

He concedes that the specific form of austerity that was implemented in the UK was ill-advised — public investments in infrastructure, he says, can be stimulative and pay for themselves. Nevertheless, he argues that in retrospect austerity in general was wise because we couldn’t have known for sure that the markets wouldn’t have panicked and ceased purchasing UK debt if the government had run higher deficits.

Now, one thing we might want to recall is that the UK’s austerity policies have not been hugely successful at shrinking the debt-to-GDP ratio.

What we’re looking at here is the “fiscal trap” phenomenon Greg Hannsgen and Dimitri Papadimitriou have written about. Austerity can be a pretty inefficient policy — assuming one’s goal is the reduction of debt ratios. (As Paul De Grauwe and Yuemei Ji recently found, this is clearly the case on the eurozone periphery: “more intense austerity programmes coincide with increasing government debt ratios.”)

But even if UK austerity were more successful at shrinking public debt ratios, we would want a better sense of the probabilities and downsides involved in Rogoff’s “you never know,” market panic scenario. Just how valuable is this insurance? Because we know pretty well what the costs of austerity are (a point Rogoff appears to concede) — high unemployment, heightened insecurity, and all the attendant deterioration in well-being.

What are the benefits? If we succeeded in reducing the UK’s public debt ratio by, say, 5, 10, or 20 percentage points, how significantly would that reduce the risk of market panic for a country that controls its own currency, according to this insurance theory?

More importantly, how disastrous would Rogoff’s market panic be if it came about? His story is that a collapse of the eurozone could have led financial markets to stop buying UK gilts, which would require immediate and harsh austerity (because the government would have to balance its budget absent the ability to borrow). But as Simon Wren-Lewis (no MMTer) points out, the UK already has an “insurance” policy against this kind of market revolt — namely, it issues its own currency:

… [the monetary authority] will buy any government debt that cannot be sold to the financial markets. Rogoff says that, if the markets suddenly forsook UK government debt “UK leaders would have been forced to close massive budget deficits almost overnight.” With your own central bank this is not the case – you can print money instead.

So we should really be comparing the costs of austerity to the costs of printing money in the event that markets turn on the UK (if we generously grant the premise that reducing public debt ratios in the near term would have any significant impact on diminishing the probability of such an event). Absent an explanation as to why printing money under such circumstances would be far worse than the damage already done by budget cuts, it’s hard to see why austerity is an insurance policy worth the hefty price.

Congressional Republicans may or may not suffer politically from the government shutdown and upcoming debt ceiling fight, but in terms of policy they have already secured a significant and lopsided victory in the battle over the budget, whether they realize it or not.

Repeal of the Affordable Care Act seems pretty unlikely (not just because the President is wildly unlikely to repeal his signature legislation in return for something his opponents also claim to want — raising the debt limit — but also because he seems determined to learn from his 2011 mistake and is unlikely to grant any concessions in return for not defaulting on financial commitments). Still, below all the shutdown/debt limit/ACA drama, the discretionary budget number that Senate Democrats are offering to Republicans (the “clean” continuing resolution) represents a near-complete capitulation to GOP demands.

Despite having lost the popular vote for the Presidency, Senate, and House, Republicans were not only able to extract major concessions on discretionary spending, but to exceed even their original demands, as Dylan Matthews observes: “So we’ve been cutting spending at a faster pace than Paul Ryan wanted to when Republicans took over Congress.” This figure by Michael Linden and Harry Stein illustrates the situation (they call this a “compromise,” but I’m not sure that’s the best choice of labels):

What this means is that, even if we avoid a debt limit crisis and a lengthy shutdown — both of which would weigh on the already sluggish economic recovery — tight fiscal policy will continue to limit economic growth. And that’s the best case scenario. (Those who are trying to game out the political consequences of these various showdowns and governing crises should take this into account — the GOP will ultimately benefit from a sluggish economy, even if in the short run the public ends up blaming them for the shutdown.)

The Levy Institute will soon be releasing its newest strategic analysis for the United States (the late Wynne Godley, whose work at the Levy Institute inspires the model used in these economic forecasts, was recently featured in the New York Times). The past couple of analyses have underscored the difficult bind the US economy has been placed in as a result of Congress’s devotion to budget austerity. Aggregate demand has to come from somewhere; if it isn’t from abroad (exports), it will have to come from domestic sources. If government spending increases are not forthcoming — and we’ve every reason to believe they’re not — then the only way to reach even the modest growth numbers projected by many (including the Congressional Budget Office) is through a big rise in household and business indebtedness. In other words, if we continue to run discretionary budgets that out-Paul-Ryan Paul Ryan, we’ll either be stuck with insufficient growth or a dangerous ballooning of private leverage (absent any new developments in the foreign sector).

On Tuesday, the Congressional Budget Office released its new projections (pdf) for the long-term budget. A Bloomberg article titled “CBO Says Short-Term Deficit Cut Won’t Avert Fiscal Crisis” provided a fairly typical summary:

[F]ederal spending will rise from 22 percent of GDP in 2012 to 26 percent in 2038 … The deficit [currently 3.9 percent of GDP] would be 6.5 percent of GDP in 2038, greater than any year between 1947 and 2008 … Even though tax receipts would grow …, the revenue increase wouldn’t be “large enough to keep federal debt” from “growing faster than the economy starting in the next several years,” according to the CBO report.

Here’s another way of presenting those CBO numbers. Spending on actual government programs is projected to fall from its current 19.5 percent of GDP to 18.8 percent in 2023, before rising to 21.3 percent in 2038. And revenues are also projected to rise, from 17 percent to 19.7 percent of GDP by 2038. The result, according to the CBO, is that the primary budget balance (that is, excluding interest payments) shrinks from its current level of -2.5 percent of GDP to -0.3 percent in 2023, and then grows to -1.6 percent of GDP by 2038.

In other words, a quarter-century from now, the primary deficit — the gap between tax revenues and the spending under Congress’s control — will be smaller than it is today, according to the CBO’s numbers. Here’s the relevant Table:

Nonetheless, the CBO’s extended baseline tells us that debt will rise from its current 73 percent of GDP to 100 percent of GDP by 2038. The key here is the interest payments — CBO’s prediction of rising interest rates over the long term (and the near term, for that matter).

This is the sentence from the CBO report that tells you all you need to know about those predictions: “under the extended baseline, interest rates would exceed the growth rate of the economy” (p. 26). To see why that’s significant, look at this equation from Willem Buiter (or skip over it and wait for the explanation):

What this means, as James Galbraith explained in this policy note, is that if the rate of interest on government debt (r) is above the rate of economic growth (g), then any primary budget deficit will lead to an “unsustainable” path for the debt over the long term — in the narrow sense that the debt-to-GDP ratio will rise without limit.

By contrast, if r is below g, then even what would normally be considered a “large” budget deficit (Galbraith uses the example of a continuous primary deficit of 5 percent of GDP — well above what CBO is projecting over the next few decades) will be “sustainable” over the long term, in the sense that debt will eventually stabilize as a percentage of GDP.

For most of the postwar history of the United States, with the exception of the 1980s and part of the ’90s, the rate of interest on government debt has tended to be below the rate of economic growth. Underlying the CBO’s projection of an ever-rising debt ratio is its assumption that over the next few decades, that will no longer be the case; that for some reason, the exception of the 1980s will become the rule.

(chart from Brad DeLong)

The Heritage Foundation presents what one hopes it doesn’t believe is a clever critique of US public finances:

Brad Plumer has the inevitable takedown here. This pretty much sums up the inanity of these government-as-household analogies:

“Anyway, it’s a good analogy. The U.S. federal government really does resemble your typical money-printing family that owns lots of tanks, operates a giant insurance conglomerate, can borrow money at extremely low rates, and is assumed to be immortal.”

The case for being alarmed about the US budget deficit — more specifically, for being worried that it’s too high, or will be too high in the next decade or two — continues to weaken, and this is so even if we limit ourselves to the deficit hawks’ own theoretical turf. These days, you don’t need to have read Abba Lerner to know that we should be moving on to more pressing matters.

Now that the deficit is shrinking fast, the standard fallback is to shift the focus to the long term. The go-to story for long-term deficit anxiety has to do with the prospect of healthcare costs rising much faster than the rate of economic growth (in the medium term, it’s more about predictions of how high the Federal Reserve will raise interest rates).

The problem is that this healthcare story is badly out of date. The last several years have seen a significant slowdown in cost growth in the medical sector. Initially, it could be suggested that the recession was playing the main role here (so cost growth would simply snap back to previous trends when the economy recovered). However, more and more evidence is coming in to suggest that it’s primarily changes in practices and behavior unrelated to the recession that are “bending of the cost curve” (hence the trend may be more likely to persist). From the abstract of a new Congressional Budget Office working paper (pdf) that looks at Medicare spending in particular:

Growth in spending per beneficiary in the fee-for-service portion of Medicare has slowed substantially in recent years. The slowdown has been widespread, extending across all of the major service categories, groups of beneficiaries that receive very different amounts of medical care, and all major regions. We estimate that slower growth in payment rates and changes in observable factors affecting beneficiaries’ demand for services explain little of the slowdown in spending growth for elderly beneficiaries between the 2000–2005 and 2007–2010 periods. Specifically, available evidence does not support a finding that demand for health care by Medicare beneficiaries was measurably diminished by the financial turmoil and recession. Instead, much of the slowdown in spending growth appears to have been caused by other factors affecting beneficiaries’ demand for care and by changes in providers’ behavior.

This figure shows how government spending as a percentage of GDP has evolved since 2000Q1. The numbers reflect the recent 5-year revision of the National Income and Product Accounts (the so-called “NIPA revisions”) and preliminary Q2 numbers, which are due for an update about a week from now.

The figure shows that government consumption (at the top of the figure in blue) and gross investment (farther down, at about 4 percent of GDP in an aqua, or light blue, color) have been on a downward trend when expressed as percentages of GDP. Current transfer payments are depicted in red. They remain higher as a percentage of GDP than before the financial crisis; nonetheless, they are relatively flat. Government interest payments, in green, were well under control, in part because rates remained very low as of the end of Q2. The fixed-investment series is gross in the sense that it does not adjust for depreciation. Adding together all of these figures, total gross expenditures were 37.9 percent of GDP in Q2, less than a tenth of a percentage point (.1%) higher than in Q1. For a longer-term comparison, try a total of 42.3 percent in 2009Q2. Gross (and net) government spending has been falling for a long time. The sequester, whose effects are beginning to be reflected in official data, continues this trend.

We have been advocates of the theory that fiscal tightening is threatening economic recovery (last week, for example).

John Taylor objects to the view that fiscal tightness has been the key to the slowness of growth in the recovery.

In his blog, he states, “As a matter of national income and product accounting, it is true that cuts in state and local government purchases subtract from GDP, but these cuts are mainly an endogenous consequence not an exogenous cause of the weak recovery.”

Taylor’s reasoning is that state and local government spending has been constrained by weak tax revenues. This is certainly true.

However, Taylor’s argument seems to imply and rely upon another false dichotomy—variables are either exogenous causes or endogenous outcomes. Is it not more reasonable to say that these reductions in spending at the state and local level are “mainly an endogenous consequence and endogenous cause of the weak recovery”?

(Note for further reading: This scheme of cumulative causation or positive feedback is part of the fiscal trap thesis advanced in a brief I wrote with Dimitri Papadimitriou last summer and fall: especially in a non-sovereign-currency system, spending cuts and slow growth can be part of a vicious cycle or downward spiral. This 2010 Levy Institute brief, among other publications, assessed the extent to which fiscal stimulus of various types can help to break the cycle.)