Is Stockman right about deficits, after all?

Greg Hannsgen | April 25, 2011

Many Americans interested in economics will recall David Stockman as the controversial White House budget director who swam against a tide of increasing deficits during Ronald Reagan’s administration in the first half of the 1980s. Ultimately, while Reagan supported many high-profile cuts to social benefits and regulatory budgets, he vastly increased military spending and cut taxes drastically, leading to deficits that disappointed fiscal conservatives. Stockman has an op-ed article in yesterday’s New York Times blasting what he sees as weak efforts by the president and congressional Republicans to come up with long-term plans to cut deficits. He disagrees with the Ryan plan’s focus on cuts to programs that help the poor and Obama’s emphasis on ensuring that the rich pay their fair share.  In Stockman’s mind, these approaches to budget cuts leave the federal government’s main fiscal problems unaddressed but go down well politically.

One should take note that while Stockman’s alarms of more than 25 years ago went largely unheeded, no serious U.S. fiscal crisis materialized, though deficits reached nearly 6 percent of GDP in 1983. On the other hand, unemployment touched double-digit levels early in Reagan’s tenure, making high deficits nearly inevitable and certainly justifiable from a policy perspective. Moreover, numerous other serious problems arose largely as a result of Reagan’s economic policies, including his attack on the “safety net” of social programs for the poor.

Finally, we wish to respond to the fiscal disaster scenario that Stockman presents in today’s article. Levy Institute macroeconomists and other strong proponents of Keynes’s theories have argued in recent years that the United States should run deficits in the amounts necessary to ensure full or nearly-full employment, without fear of bankruptcy or other affordability issues connected with high deficits. We argue that unlike individual U.S. states and members of currency unions, the U.S. federal government can run deficits indefinitely without becoming “insolvent” in any sense or being forced to default.  The government has this ability because the United States uses paper money that is not convertible to a fixed amount of gold or foreign currency.

Reading Stockman’s article, it appears that he might not completely disagree with these views. He observes that the Fed and other central banks have been buying huge amounts of dollars, in essence using their printing presses to provide the real “financing” for large portions of the U.S. deficits. We have noted the success of these routine operations in recent years, observing that interest rates paid by the U.S. government remain extremely low, even as it has borrowed amounts equivalent to approximately 10 percent of yearly national output. Stockman does not miss this fact, but argues that the Chinese central bank will soon reduce its purchases of Treasury securities in order to control domestic inflation, and that the Fed will also be forced to reduce its open market purchases in order to avoid destroying the value of the dollar.  Then, in Stockman’s view, the game that he called into question decades ago will be over.

We certainly concede that the use of a sovereign currency cannot be counted on to overcome fiscal problems unless the issuer of the currency is willing to allow its value to change vis-à-vis other currencies. In the case of the United States at the current juncture, this would hopefully involve substantial real depreciation of the dollar against the Chinese currency, known as the renminbi or yuan. We have advocated such a currency depreciation for some time, though Saturday’s blog entry showed that the U.S. dollar may in fact be undervalued relative to some other important currencies. So we do not imagine that the Federal Reserve and the U.S. Treasury possess any magic powers to defy the laws of budgeting that Stockman himself does not acknowledge in his article.  The main difference between Stockman’s views on this issue and ours appears to be that Stockman opposes further declines in the U.S. exchange rate or believes that current budget plans would result in far more depreciation of the dollar than we anticipate.  From a political standpoint, he believes that the Fed will agree with him on the need to support the value of the dollar, even if such a defense results in greatly increased interest rates. Hence, in Stockman’s view, the Fed will ultimately be forced to accept extremely high interest rates as a result of the high deficits of recent years, making mortgages, business loans, and so on unacceptably expensive to U.S. borrowers. In this sense, as Stockman sees it, the Keynesians will finally be proven wrong.

As of now, we feel that the overall value of the dollar may need to fall further and that while rock-bottom interest rates cannot cure the economy’s main problems, they remain desirable for many reasons. A dollar crisis could conceivably unfold, but such an event would not occur without a confluence of multiple adverse events, with the federal debt constituting only a minor factor. (Some examples of the kinds of events that could somehow precipitate a currency crisis would be a big natural disaster, a crash in another key financial market, or an economic depression.) Hence, the fiscal issues that Stockman sees as crucial should not necessitate cuts to programs like Social Security, Medicaid, or Medicare that otherwise contribute to the nation’s well-being or tax increases on families and others with modest incomes. In holding these views, we disagree with most U.S. “fiscal moderates.” Nonetheless, Stockman’s op-ed piece does a good job of establishing some key points, especially the unfairness of the Ryan plan’s attacks on domestic, discretionary, nondefense spending.

Update, April 29: Click “more” link below to see comments on this post:


7 Responses to “Is Stockman right about deficits, after all?”

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  1. Comment by Ramanan — April 28, 2011 at 4:44 pm   Reply

    Reminds of of some positions of the New Cambridge Group from the 1970s.


    I am not sure why the non-convertibility of currencies is asserted constantly. The IMF identifies two levels of convertibility – official convertibility, market convertibility. The latter can be broken into current account convertibility and capital account convertibility. The first is compulsory and the second is being debated again.

    According to the IMF Articles of Agreement Article VIII, Section 4:

    Section 4. Convertibility of foreign-held balances

    (a) Each member shall buy balances of its currency held by another member if the latter, in requesting the purchase, represents:

    (i) that the balances to be bought have been recently acquired as a result of current transactions; or

    (ii) that their conversion is needed for making payments for current transactions.

    The buying member shall have the option to pay either in special drawing rights, subject to Article XIX, Section 4, or in the currency of the member making the request.

    (b) The obligation in (a) above shall not apply when:

    (i) the convertibility of the balances has been restricted consistently with Section 2 of this Article or Article VI, Section 3;

    (ii) the balances have accumulated as a result of transactions effected before the removal by a member of restrictions maintained or imposed under Article XIV, Section 2;

    (iii) the balances have been acquired contrary to the exchange regulations of the member which is asked to buy them;

    (iv) the currency of the member requesting the purchase has been declared scarce under Article VII, Section 3(a); or

    (v) the member requested to make the purchase is for any reason not entitled to buy currencies of other members from the Fund for its own currency.

    So it is a bit incorrect to say that the US can sustain any fiscal deficit. There are subtle differences – sustainable deficits and unsustainable ones.

    Even if convertibility is not in the picture, one can say that any attempt by the US government to quickly achieve full employment could collapse the dollar, though there remains the possibility that there is a smooth depreciation scenario which works well for the US government (a “dream scenario”).

    My reading of Wynne Godley’s work leads me to believe that fiscal policy alone cannot resolve this crisis. His partner Francis Cripps wrote this brilliantly in a 1983 article What Is Wrong With Monetarism

    The conclusion which has to be drawn is that, if a modern economic system is to function properly, a mechanism is required for the management of aggregate demand. Now it happens that the need for management of aggregate demand within a closed national economy can be met rather easily. It is easily met because national economies have an institution called the state which is unique in that it has virtually unlimited powers of credit creation or borrowing (or would have within a closed national economy). Keynesians gave up at this point, thinking that once the need for demand management had been pointed out, and the possibility for demand management by a national government had been understood, the problem of demand management was solved once and for all. Unfortunately, there is no such thing as the state in the contemporary international economy at the international level and the absence of the state as such at the international level is, I believe, a sufficient explanation of why the world economy has run into serious problems of recession. ….

    …. The important point is rather that in an international economy the possibilities of national demand management are strictly limited. They are limited by problems or balance or payments adjustment and international finance. Governments that wish to regulate national demand so as to sustain full employment run into problems of increasing trade deficits and, in economics with liberal exchange regimes, loss or confidence and outflows of capital. It is actual or potential balance of payments crises which have been decisive in breaking the habit or Keynesian demand management at the national level. Many national governments are still trying but they are trying under difficulties and they are frightened of balance of payments problems that would result if they tried too hard.

    To some extent Keynesianism is incorrect. This is due to incorrect understanding of the balance of payments constraint, though I believe Keynes himself understood this to some extent. In the book From Keynesianism To Monetarism: The Evolution Of UK Macroeconometric Models, Peter Kenway writes:

    … There is, however, a greater sense in which the development of the Cambridge Group in that period is more important than the model that came to represent them. That sense stems from the historical significance of those ideas…. the ideas were therefore more ‘anti-Keynesian’ than ‘Keynesian’… what makes the anti-Keynesian views of the 1970s Cambridge Economic Policy Group so significant is that they grew out of the very heart of Keynesianism itself….

    … On the one hand, as far as the goals it espoused are concerned, of full employment, of steady growth and of government’s responsibility to pursue these ends, the Group’s commitment to Keynesianism never wavered. But on the other hand, as far as the practice of Keynesianism was concerned, and especially the conceptualization of the reasons for the increasing and evident failure of that practice, the Policy Group not only was part of, but in some respects actually led the revolution against Keynesianism in the UK….

    In my humble opinion, while the administration is overdoing fiscal austerity, achieving full employment by fiscal policy alone is a distant dream.

    PS: hope my comment is not misinterpreted.

  2. Comment by Greg Hannsgen — April 29, 2011 at 9:00 am   Reply

    Dear Ramanan,
    It is good to get have such a thoughtful and interesting comment. One question on your mind is what I mean by convertibility. Roughly, what I mean is that the U.S. government does not promise to accept its currency in return for another or for gold at a fixed rate of any kind. Nor, of course, is it obligated to do so by international or national law. An example of such a commitment would be a gold standard or a peg to another currency. On the other hand, dollars are obviously convertible now in a different sense: they are readily exchanged for other currencies in currency markets (or at financial institutions, etc., for retail customers in many countries) at largely market-determined rates. Of course, this was not true for the currencies of various kinds of closed economies, including China for example, in the old days. That sort of currency is truly nonconvertible and this definition of the term may be the one you have in mind.
    Of course, the point made in IMF rules regarding convertibility is more subtle indeed, though I suppose your quotation from these rules speaks for itself. Perhaps you could elaborate more, if that seems appropriate to you. However, I intend to respond to your comment at more length, so you may want to wait until I have a chance to think about it more and write a further response, perhaps in a day or two. I apologize for this, but am returning for work after a one-day break yesterday and have much to catch up on. Thank you again. Your comment is helpful in reminding me of the complexity of the legal and economic issues that arise in connection with the term “convertibility.” On the other hand, the definition I have relied upon in my post seems to be the most relevant one for the point I was trying to make, namely that the U.S. government has the ability to run large deficits with little fear of needing an bailout of any kind. I think you will probably agree with me that it is reassuring that Stockman–who is well known as a “fiscally responsible” budgeting expert–seems to understand this basic principle.

  3. Comment by Ramanan — April 29, 2011 at 12:18 pm   Reply

    Hi Greg,

    Thanks for your response. I will wait for your response. Maybe good point to discuss sometime at Levy – I will be attending the conference on May 25th/26th.

    I am still going through Joseph Gold’s “Legal and Institutional Aspects of the International Monetary System: Selected Essays” – will take me a while to read it. Gold calls the article I quoted as “official convertibility”. And others as conversion through the market as “market convertibility”. According to him, the former was kept because it was thought that even post-1971, foreign exchange will be a centralized process and for some reason, this is continued to remain in the article in spite of markets taking up the responsibility for convertibility.

    However since the attitude was that market convertibility will take over, people have forgotten official convertibility which still remains.

    While my emphasis was on technicalities regarding convertibility, the other part was a bit independent of it.

    If the US government wants to bring a speedy recovery to increase domestic output and bring down unemployment through a drastic relaxation of fiscal policy, foreigners will be unimpressed by this strategy and this can put pressure on the exchange rate. Also the situation can create a situation where domestic demand increases faster than domestic output (even though both are rising) which will continue to not impress the foreign exchange markets. A smooth depreciation of the dollar will be very useful but a rapid decline may not be.

    The solution (of course emphasized by Levy authors – that’s where I learned most of macroeconomics) is both a relaxation of fiscal policy and simultaneously concentrate on increase net exports both directly by promoting the industry and negotiating hard with the Asian countries on their exchange rate strategies. If the latter is delayed, the external situation will keep deteriorating.

  4. Comment by Greg Hannsgen — April 29, 2011 at 2:18 pm   Reply

    Hi Ramanan- I still intend to get back to you with the rest of my response. However, I want to add quickly that I am of course in agreement with most of your arguments regarding macro policy. If I understand you correctly, two of the points that we agree on are: 1) fiscal policy is hardly the only component of good macro policy; and 2) the trade issue is also critical to macro-policy efforts, and, moreover, U.S. macro policymakers should make use of measures designed to increase exports. Also, incidentally, I want to add the thought that good financial-market regulation could help prevent some of the adverse macroeconomic scenarios that we have been discussing here and elsewhere on our website. Best, Greg

  5. Comment by beowulf — April 29, 2011 at 4:20 pm   Reply

    Ramanan, there’s nothing to negotiate if US follows Godley-Cripps policy of non-selective protectionism with matching fiscal easing. So long as its goal is balanced trade (as opposed to a trade surplus), its permissible under WTO Article 12.

    Speaking of which, as I mentioned in the food prices thread, Greg should update his “Buffett Plan for Reducing the Trade Deficit” paper with 2011 numbers (perhaps adding oil imports) and forward it to pro-tariff members of Congress. If Donald Trump ends up running (I guess we’ll know by May 16), I’d send it to his campaign as well.

  6. Comment by Tom Hickey — April 29, 2011 at 11:45 pm   Reply

    More “what if” bogeymen. According to MMT, as I understand it, there are three constraints on a monetarily sovereign government with a fiat currency (in addition to political restraints that may be imposed) — the inflation rate, the exchange rate, and the availability of real resources.

    The US is a wise output gap and depression level unemployment so real resources are available for government to purchase without crowding out the private sector. The inflation rate is historically low, which is reflected in historically low interest rates. The exchange rate has been falling, which is in line with the president’s goal of doubling US exports in five years. The US is pursuing a “strong dollar” policy in the sense of low domestic inflation but intentionally driving the exchange rate down to gain export advantage.

    Is this a gamble that will lead to a currency crisis? Join the crowd over at Zero Hedge and buy gold if you think so.

    The major problem the US is facing is demand leakage to increased saving desire (bot saving and deleveraging) and net imports. Fiscal policy is inadequately addressing this, and the result is showing in the first quarter GDP figure. Wages are stagnant. Job creating is not only lagging but higher paying jobs are being replaced by lower paying ones. Housing is double-dipping. The only growth in consumer credit recently has been in student loans, which weigh on the economy like underwater mortgages.

    And we are concerned with the exchange rate? Really?

  7. Comment by Ramanan — April 29, 2011 at 11:55 pm   Reply


    Thanks for your reply. I actually am quite an avid follower of Wynne Godley’s work (he is my hero) and in fact wished to point out that he had tried to point out in the 70s that Keynesianism alone doesn’t work. You have also pointed this out in your articles in Levy.

    I guess what I was originally aiming for is that the impression one gets when saying that high deficits can be run is that by itself it says less about the external sector and you have pointed it out both in the post and in the comments that there are other aspects to policy as well.

    Also, I think what I was pointing out was that those who say that “the Keynesians will finally be proven wrong” are partly correct as per my first comment – very few Keynesians understand the balance of payments constraint and the interrelationship with fiscal policy. Hence others view Keynesianism as simply fiscal policy.

    I think the Levy Institute is the only place which has provided consistent policy strategies to resolve the crisis since .

    Yes, completely agree about financial regulation. It has contributed hugely to sectoral imbalances.

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