James Galbraith on Deficits: Dick Cheney of the Far Left

By :: May 17th, 2010

Ezra Klein interviewed James Galbraith, who argued quite forcefully that “the danger [posed by the long-term deficit] is zero.  It’s not overstated.  It’s completely misstated.”

We now have an answer to the trivia question, “What do James Galbraith and Dick Cheney have in common?”  Cheney famously said, “Reagan proved deficits don’t matter.”

Cheney didn’t try to defend his argument.  He simply offered to take his critics hunting, which ended the discussion.

Galbraith, however, is absolutely convinced that he’s right and almost the entire economics profession is wrong. 

Galbraith is wrong.  To start, he doesn’t understand debt dynamics.  He says that when interest payments hit 20 percent of GDP, government borrowing will create inflation, which will make the debt go away.  He doesn’t account for the fact that a growing share of government spending is in the form of indexed benefits (Social Security, explicitly, and other entitlement programs like Medicare, implicitly).  Also, higher expected inflation translates directly into higher nominal interest rates, since lenders demand a hefty premium so their investment is not eroded by inflation.  The higher nominal interest rate applied to an enormous debt would cause nominal debt levels to explode.  Sudden inflation can devalue the debt, but only temporarily unless there are draconian cuts in real spending levels (to reduce deficits and convince financial markets that inflationary pressures will not persist).  And, of course, high inflation entails huge economic costs.

Later in the Klein interview, Galbraith makes an even more astonishing statement:  “There can never be a problem for the federal government selling bonds.”  Government spending or tax cuts increase the demand for bonds because the money the government spends ends up in banks, which have to invest the money somewhere.  But if investors see a risk of default or inflation, they won’t buy government bonds without a hefty interest premium.  Otherwise, the money will flow into other assets—foreign securities, Eurobonds, or gold for example—pushing up their price (and pushing down the price of treasuries). 

Taken to its illogical extreme, Galbraith’s argument implies that there is no limit to government’s borrowing capacity (and that the money never really has to be paid back).  If that’s the case, why not dispense with the annoyance of taxes altogether?

Galbraith also argues that deficits aren’t a problem as long as interest rates stay low, because that means that markets aren’t worried about future deficits so neither should we.  He acknowledges that markets might not be rational, but says that “there’s no point in designing policy to accommodate … an irrational entity.” 

That’s an odd position for a steadfast Keynesian like Galbraith.  The great insight of Keynes was that markets could fail because of an absence of “animal spirits” that would suddenly undermine confidence and cause consumers and businesses to stop spending money.  Keynesian fiscal policy works because it makes up for the irrational drop in demand. 

I’m concerned that markets are indeed irrational and/or that foreign lenders have ulterior motives for feeding our borrowing habit for a while (because it fuels our demand for imports).  It’s producing a bubble of cheap credit for the government that could burst with disastrous consequences.

Galbraith thinks deficit hawks are all anti-government kooks who want to dismantle the social safety net.  In reality, Galbraith and his fellow Cheneyites are the greater threat to vulnerable populations.  If we accumulate debt until it reaches catastrophic levels, the consequence would be a necessary sudden and drastic cut in government spending (see Greece and Iceland for examples of what happens to spending after a debt crisis) as well as an economic meltdown that could impoverish a generation (see Argentina).

The best way to protect the safety net is to take the steps – including well-chosen tax increases and selected paring down in the growth of benefits – that can achieve fiscal sustainability over the long haul. 

22Comments

  1. Anonymous  ::  7:06 pm on May 17th, 2010:

    Len, this may be hard to take, but it is really you who do not understand. But rather than trade punches, I just suggest that you read “Understanding Modern Money” by Randall Wray. And then go to Bill Mitchell's blog and read for a while. With an open mind, not with the mind of the state inquisitor. Then, when you can truly say you have grasped the perspective and the accounting facts–because in truth, Modern Money Theory is about actual operational reality–then you will be in a position to comment intelligently. I think that is the least that one can do: understand the other's perspective before bashing it. Audiatur et altera pars–the very principle of justice.

  2. Anonymous  ::  7:25 pm on May 17th, 2010:

    There is a school of finance, which is mostly wrong, which believes that all money is produced by fiat. Any money and banking student will point out that some form of security and reserve margin is always part of the equation as well. Money must, in some way, be backed. Further, every loan is eventually paid back or defaulted upon and too many defaults result in deflation (which we are currently seeing in some markets).
    The budgetary impacts of fiscal policy must take into account both deficits and deficit finance. In other words, if you run a deficit equal to the net interest payment – the crowding out effect is zero on the financial markets. If you cut taxes on the savings sector and run a deficit in excess of net interest, you are merely borrowing what you would have otherwise taxed – and indeed must do so if taxes have been cut. When you raise taxes, it is also important to cut deficits or even eliminate them with these funds.
    In the long term, the best fiscal strategy is to progressively tax the savings sector (as soon as possible) while applying the entire increase to debt repayment. This would, of course, require that entitlement spending be balanced – for example – that Hospital Insurance taxes be increased and expanded in scope to cover the additional spending requirements of both the baby boomers and the addition of the prescription drug benefit – with Social Security imbalances being offset by an increase of the money subject to taxes – possibly with benefit increases for the poorest and the creation of personal retirement accounts (funding employee ownership rather than speculation and investment banking).
    There are two separate “contingent liability” issues in FICA. One is promised benefits higher than expected revenue. This can be solved by broadening the revenue base or cutting benefits. I favor the former – as taking off the cap approximates replacing payroll tax funding with VAT funding of at least a portion of the benefits. The second problem is paying back the Trust Fund already accumulated. That is not a contingent liability problem at all – at least not for FICA. That is a problem for income tax payers, who must pay back payroll taxpayers who bankrolled general government for three decades.
    Of course, the ultimate fix for the contingent liability problem is to incentivize bigger families by paying a much larger child tax credit through a business income tax regime – forcing employers to pay lower “base” wages and forcing employees to have larger families to maintain a higher standard of living.

  3. Anonymous  ::  7:30 pm on May 17th, 2010:

    By the way. I ran the numbers a few decades ago when I was a USAF cost analyst. They verified the theory. The Clinton and Bush II eras are also confirming.
    I will leave it to skeptics to investigate further. Use Budget Historical Tables and regress deficit/surplus + net interest, expressed as a percentage of GDP against the GDP growth rate for the following year (to approximate lags and to fully allow the multiplier effect to occur). The R Squared for the first six years of Reagan (FY81-FY86) is One – a perfect predictor with a negative slope – proving the Reagan's growth was entirely Keynesian.

  4. Anonymous  ::  7:44 pm on May 17th, 2010:

    “If that’s the case, why not dispense with the annoyance of taxes altogether?”
    1. Create a demand for USD.
    2. Control demand.
    Len,
    Why in the world would the Federal government need the money they gave you in the first place?
    To make it simple for you, let's say you owed $1B in taxes. You drag a big bag of $1B down to the IRS. They take it and give you a receipt. Then the bag burns to ashes. What would they do? They would make $1B ex nihilio as if the bag had never burned.

  5. Anonymous  ::  7:45 pm on May 17th, 2010:

    “But if investors see a risk of default or inflation, they won’t buy government bonds without a hefty interest premium. Otherwise, the money will flow into other assets—foreign securities, Eurobonds, or gold for example—pushing up their price (and pushing down the price of treasuries). ”
    This is simply wrong, because it misses the accounting reality of the banking system. Sure, individual investors can sell their dollars for Euro, gold, etc., anc that can cause the dollar to fall relative to those commodities. But all that does is move the dollars around the banking system. Once the government has created reserves by spending them into circulation, the only way they can be removed is for the government to tax them away or for it (or the central bank) to exchange them for securities.
    Read that last paragraph again – read it ten times before breakfast – because it is the fundamental operational reality of a fiat money system in a floating exchange rate regime.
    It is because of this “hot potato” nature of reserves that the central bank in a fiat money system can (indeed, must) set interest rates at whatever it wants, no matter what “the market” may say. Collectively, holders of reserves ultimately have only 2 choices – hold the reserves and make no interest (or whatever interest on reserves the central bank is willing to pay) or exchange them for whatever interest-bearing instrument the treasury or CB is selling.

  6. Anonymous  ::  8:18 pm on May 17th, 2010:

    Len, thanks for another great article!
    You may be surprised to learn that there are some people in the blogosphere who believe that taxes really can be replaced by printing fiat money. What they fail to see is that this causes not merely inflation, but rapidly accelerating inflation, followed by total collapse of the economy. You need to avoid wasting time debating these people, because you won't get anywhere. They do not exhibit much ability for logical thought.
    As to your assertion that “The best way to protect the safety net is to take the steps – including well-chosen tax increases and selected paring down in the growth of benefits – that can achieve fiscal sustainability over the long haul.”:
    I have been preaching that for months now, but progressives appear to be in denial about the size of the benefit cuts will be needed. Similarly conservatives are in denial that large tax increases are needed.
    Conservatives fear that tax increases now will be used to avoid cutting benefits to the extent needed to avoid a crash. That would be a complete waste, regardless of your political preference. Progressives have no matching fear that large benefit cuts will be used to cut tax rates from today’s levels. The bond market would not allow that.
    Therefore the conservatives have the better argument: that dramatic spending cuts should come first, before tax increases. Once Medicare and Social Security and the government's new health insurance subsidies are put on a sustainable path, the public will, I believe, support a VAT. However I doubt that any of this can occur until the markets stop lending to the US government and refuse to roll over existing debt. As you have pointed out, it's the inability to roll over debt that's the real killer. Without rolling over debt we'd need to run a surplus in excess of 10% of GDP to prevent default or hyperinflation. The safety net would be completely destroyed, an outcome that would please no one except some Internet nut cases.

  7. Anonymous  ::  10:12 pm on May 17th, 2010:

    Anonymous,
    “What they fail to see is that this causes not merely inflation, but rapidly accelerating inflation, followed by total collapse of the economy.”
    I say you are full of sh– here. Please provide ONE example of where this has happened to a sovereign country that operated a free-floating, non-convertable currency regime like we have here in the US for the last 40 years (btw is 40 years long enough track record for you to establish a successful trend?), you have NO evidence to back up your statement here. TIP: dont waste too many of your brain cycles trying to come up with an example because none exist!

  8. Anonymous  ::  12:41 am on May 18th, 2010:

    Oh, don't worry: printing presses create wealth. Hahahahahahahahahahahaha!!!!

  9. Anonymous  ::  2:56 am on May 18th, 2010:

    Clearly deficits matter. What I find amusing is that deficits only seem to matter to Republicans when a Democrat is in the White House. Bill Clinton saved America for a generation, with endless budget surplusses into the foreseeable future. Bush and company destroyed the surplus because neocons know the only way to shrink the government is to be as incompetent as possible, and proving that “government doesn't work”, while concurrently spending recklessly into a huge deficit so there is nothing left in the piggy bank. It is always up to democrats to be the responsible ones and pay the bills, thus leaving them permanently unpopular as the the american public feels the pain of a balanced budget only when adults are in charge.

  10. Anonymous  ::  3:33 am on May 18th, 2010:

    The comments on this essay are well-stated and on the mark – many thanks to those who have chipped in.
    It would be agreeable to have this discussion conducted without invective. It is, after all, about who is right and who is wrong — and not about who is “left” or “far left.”
    James Galbraith

  11. Anonymous  ::  3:39 pm on May 18th, 2010:

    Prof. Galbraith,
    Keep up the good fight! You are one of the few people with mainstream credibility who understands these issues. As we can see from this article, we have a long way to go in educating people about this.
    As for the left/right divide – I agree absolutely. I myself am a conservative Catholic who's ideas on social issues would probably get me labeled as a fascist in some circles (including this one). But the actual workings of the monetary system are no more value-laden than the laws of physics. If people actually understood how things worked, we could actually start having political discussions, framed by our respective values, about how we would go about achieving the ends we want. But instead everyone argues over irrelevancies like the deficit and proposes policies that will do the opposite of what they intend.

  12. Anonymous  ::  7:14 pm on May 18th, 2010:

    A very interesting discussion.
    One point Mr. Burman makes that I think is worth discussion:
    “Galbraith’s argument implies that there is no limit to government’s borrowing capacity (and that the money never really has to be paid back)”
    Galbraith is very much right about this. The money really never has to be paid back. As Krugman and others have pointed out, as long as deficits as a percent of GDP are lower than overall GDP growth, then over time debt as percent of GDP becomes lower. But let's be clear, we could get a lower debt/GDP ratio without EVER running a surplus.
    I find it a bit odd to think that the US government has to pay off all it's debt. It's not like we're buying a house that's an asset we want to pass on. We're maintaining a functioning state. As long as you can service the debt, you're fine.
    Lots of other arguments in here, about inflation and bond markets and so on, are definitely intriguing to me, but the idea that we have to pay down our debt? Not really the case, and not really a problem.

  13. Anonymous  ::  8:24 pm on May 18th, 2010:

    Prof JKG can defend himself, and I'm no monetary theorist. But . . .
    The mainstream of the economics profession has a long history of exaggerating the impact of higher deficits. They have been wrong. For instance, by any reasonable interpretation of the dogma, interest rates should have blown up after Bush II reversed the long-term budget outlook from big surplus to big deficit. They didn't — not even close.
    There are quite a few well-credential economists on the right and left who have pooh-poohed the sort of hand-wringing provided by Len, otherwise an eminent public finance dude. So aside from his caricature of JKG, his post is demonstrably off-base to any Google-capable person on that as well.
    – Max Sawicky

  14. Anonymous  ::  8:47 pm on May 18th, 2010:

    Oh and by the way, to describe JKG as of “the far left” is political analysis worthy of Glenn Beck.

    — Max Sawicky

  15. Anonymous  ::  9:27 pm on May 19th, 2010:

    Taken to its illogical extreme, Galbraith’s argument implies that there is no limit to government’s borrowing capacity (and that the money never really has to be paid back). If that’s the case, why not dispense with the annoyance of taxes altogether?
    Taxes create demand for the currency (they must use dollars to pay US taxes). Otherwise people may ignore the fiat and use some other currency (most likely they would, in my opinion).
    Mike

  16. Anonymous  ::  6:04 pm on May 20th, 2010:

    That all depends on which tax increases you are talking about. Letting the Bush tax cuts expire should come before any spending cut in entitlements. Entitlements are unsustainable because having multiple children is unsustainable. Fix that and Medicare, Senior Medicaid and Social Security take care of themselves. In the short term, it is more important to finance the IOUs the Baby Boomers put into federal coffers through higher than necessary FICA taxes than to do long term sustainability. This must involve either borrowing from the rich or taxing them. It should not involve program cuts.
    This is why I say that not letting the cuts for the wealthy run out would make deficits matter, since China and Japan will start dumping bonds if we were to do something so gargantuanly stupid. Rich people don't shop at Wal-Mart, poor and middle class people do. China and Japan aren't worried about the liquidity of the rich – and neither should Obama.

  17. Anonymous  ::  6:07 pm on May 20th, 2010:

    Prof. Galbraith, please duplicate my regression analysis from above and let me know what you think. Note that if you wish to analyze more than one regime, a slope multiplier is needed for the numbers to work – meaning the IV needs to be multiplied by -1 for Democratic regimes for a generic model to work.

  18. Anonymous  ::  6:11 pm on May 20th, 2010:

    Actually, individual bond issues must be paid back, but in general the budget does not have to get to balance – unless you adequately tax the wealthy rather than borrowing their money. Right now, China buys US debt rather than America's rich because the rich made more money gambling on monetized mortgages – at least until they didn't. The rich also invest in Chinese factories. If the rich find no place else for their money, they will underbid the Chinese in buying debt.

  19. Anonymous  ::  8:56 pm on May 20th, 2010:

    since there is another Michael among the commenters, please sign you last initial or name.

  20. Anonymous  ::  1:24 am on May 26th, 2010:

    There is a school of finance, which is mostly wrong, which believes that all money is produced by fiat.
    No, you are wrong. That is exactly how money is produced. It is produced precisely the same way points are “produced” by the scoreboard when a team scores a goal. That is why it is called non-convertible currency. Fiat currency is accounting debits and credits all done electronically. If you don't understand this, you understand nothing whatever about modern money operations. You can read the Fed. Reserve manuals to be convinced of this–but most readers are too lazy. What they seek is entertainment–so they blog and reblog. Much of today's prattle is completely vacuous and could be relevant if we were living in pre-Bretton Woods times.

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