James Galbraith on Deficits: Dick Cheney of the Far Left

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.