The debt ceiling crisis

Tuesday morning quarterbacking

Aug 2nd 2011, 8:24 by Buttonwood

The Economist

WHAT lessons can be learned from the last minute deal on the US debt ceiling? The first may be that the markets (and some commenters on this blog) were right all along; the politicians would take things to the wire but would eventually do a deal. "It's theatre, folks" as one reader remarked. The trouble with this assumption is that it only encourages politicians to play the game of chicken on the grounds that the other side will blink; this time, the Democrats did but they may adjust their tactics next time.

Indeed, the second lesson could be that the debt ceiling vote has become, like the Senate filibuster, a very useful piece of blackmail for the opposition party to use. One day, a Republican president may need an increase in the ceiling and find that the Democrats hold him hostage.

The third lesson is that it remains much easier to cut spending in abstract than practical terms. Many of the difficult decisions have been punted forward; some for three to four months, others to 2013. The New York Congressional election in which a Democrat successfully campaigned against Paul Ryan's deficit reduction plan is a reminder that specific cuts in benefits are still unpopular.

A fourth lesson is that it will take a lot to destroy the safe haven status of Treasury bonds. Long-dated yields were still falling as the deadline approached. Admittedly, this was due to weak economic data. But investors still have few alternatives to the liquid Treasury market.

But the crisis still leaves us with a lot of questions to be resolved. In part, this was because both sides in the debate were partly right; action needs to be taken in the long term to tackle the US's fiscal burden but too much austerity in the short term risks damaging an already fragile economy.

The wider issue, of course, is the effectiveness of Keynesian stimulus. Some would deny that it is ever effective, on the grounds that government spending either crowds out private sector investment or that the prospect of higher taxes in the long-run prompts consumers to increase their savings rate.

Paul Krugman describes the debt deal as a disaster on the grounds that austerity in the economy's current state is folly; Edward Glaeser of Harvard, in contrast, is backing the call for a balanced budget amendment, an approach that would force the government to take a procyclical approach, forcing the government to cut spending at a time of recession. Mr Glaeser argues that

The best argument for balanced budgets is that forcing governments to pay for their spending with current taxes will produce less wasteful spending.

Japan provides an example of how wasteful spending (concreting river beds) has failed to revive the economy. But again, we don't have the benefit of counterfactual analysis; what would the Japanese economy look like if the government had balanced its budget on a regular basis? Richard Koo's book "The Holy Grail of Macroeconomics" argues that the Japanese had little choice in the face of the deleveraging of the private sector.

At the heart of these arguments is the question of whether government spending has a positive or negative multiplier, ie create more or less bang for each buck. Keynesians think the former; neoclassicists think the latter. It seems (to this blogger, at least) intuitive that the impact of a stimulus will be dependent on the initial conditions of the economy; factors such as the size of the output gap and the overall level of government debt will play a role. For example, a government will find it easier to finance a deficit if it starts from a low debt-to-GDP ratio; if it starts from 100%, its borrowing costs will rise, offsetting any fiscal stimulus. This study from the National Bureau for Economic Research illustrates the point; it says that factors like exchange rate flexibility and openness to trade play a role. It also finds that

“During episodes where the outstanding debt of the central government was high (exceeding 60 percent of GDP) the …fiscal multiplier was not statistically different from zero on impact and was negative (and statistically different from zero) in the long run.”

Of course, the US and Britain would fall into that category. However, Paul Krugman interpreted the paper (admittedly on the basis of a slightly earlier version than the link provided above) as favourable to the Keynesian case, arguing that

“this piece by Ilzetzki et al is interesting, and offers a wide range of multipliers depending on a country’s situation. The question for the United States is which estimate is most relevant. I’d say it’s the fixed exchange rate estimate. Yes, I know, we have a floating rate. But they explain the relatively high fixed-rate number by pointing to Mundell-Fleming, which says that fiscal policy is effective under fixed rates because it doesn’t drive up interest rates (capital flows in). We’re in a similar position for a different reason: fiscal expansion doesn’t drive up rates because we’re at the zero bound.”

Oh, we’re also relatively closed. The thing is that both the fixed rate and closed multipliers are around 1.5 — which so happens to be just about the number assumed by Christina Romer in her analysis for the Obama administration. Just saying.

Anyway, we may have more of a test case of Keynesianism over the next couple of years. The authorities have thrown both monetary and fiscal stiumuls at the problem since 2007, so it is hard to tell which policy has had what effect; indeed, hard to tell whether the effects are combining positively or cancelling each other out. But now the US has joined the fiscal austerity club, monetary policy will have to do all the work. It is hard to see the Fed (or the Bank of England) raising rates in the next 12 months. We will be able to compare the Anglo-Saxon experience with that of the euro-zone which is enjoying/enduring fiscal and monetary tightening.

UPDATE: On the US joining the fiscal austerity club, see the IMF's latest  report, dated even before this package.  "Under the staff projections, expiration of temporary stimulus programs, lower defense spending and new deficit reduction measures will help reduce the federal deficit by 3¾ percent of GDP over the next two fiscal years, subtracting roughly 1 percentage point from GDP growth in both 2012 and 2013." (The reference is on page 17). And if you look at the IMF's June fiscal policy monitor (see page 3), the US is closing its cyclically-adjusted deficit at a faster pace than the euro area over the next year (1.4% reduction against 0.6%). The problem, as I outlined in this week's column, is that fiscal policy is all about the direction of change; cutting the deficit from 10% of GDP to 8% is deemed to have a contractionary effect.

By the way, the trouble with a commitment to balance the budget over the cycle is that no-one knows how long the cycle will last. In Britain, Gordon Brown had a version of this rule but kept redefining the cycle