International Finance

Going Forward: More Fiscal Stimulus or Debt Reduction?

As we come out of the debt ceiling debate in the US Congress and face the prospect of a word economy that seems destined to remain in the doldrums for some time to come, the debate over what to do next is heating up. Should we ignore the budget deficit and debt issues and go all in for anther massive government spending program to kick start the economy as economists like Paul Krugman suggest? Or should we follow the conservative track and put a credible debt reduction plan into place while revising the tax code and reducing future entitlement promises?

This discussion is sure to become even more heated due to the S&P downgrade of US Treasury notes and as the US Presidential race kicks into high gear by late this year. For many observers it is difficult to cut through the ideological rhetoric on both sides to decide what is the most appropriate course. Although many economists and political pundits declare that they know the answer, my suspicion is that no one really knows what is the best course to take, including myself.

But just because we must make decisions under great uncertainty doesn’t mean we can’t make decisions. Thus, rather than adding to the interminable ideological platitudes that appear online and on the nightly discussion shows, let me try to offer a more balanced evaluation by highlighting why both approaches have potential to succeed but both are also risky in different ways. I’ll suggest at the end that we might be best served to choose the less risky approach going forward.

I’ll begin with the liberal proposal that we should use Keynesian expansionary policy to put people back to work. The idea is to increase government spending, perhaps massively, especially on “shovel-ready” infrastructure and public works projects. One idea is to create a new Works Progress Administration as was created in the depression years by FDR. The WPA employed millions of unskilled US workers to construct roads and public facilities. According to Wiki, the budget in its first year was almost 7% of GDP. In today’s dollars, that would mean an expenditure of about $1 trillion per year.

The argument is that an expansion of government demand for goods and services, especially one this extensive, could substitute for the lack of private demand, and put millions of people back to work quickly. With the reduction in the unemployment rate and the rise of economic security, private sector demand might soon rebound. With confidence restored, the new WPA could then be wound slowly down as private sector job creation picks up the slack.

Proponents of this plan argue that a subsequent increase in the deficit and national debt is tolerable if the plan gets the economy growing rapidly. What is more, because interest rates are so low on US Treasuries, the cost of borrowing to finance this plan is almost miniscule.

Of course, such a plan is not without its problems and risks. One such problem is the deficit and debt problems we face. As a hypothetical, suppose the US had had a Federal balanced budget requirement for the last 50 years. Suppose further that several emergencies through the years had forced the government to run periodic deficits in some years that did not get completely paid off in boom periods. Suppose the national debt had built up to say 10% of GDP (about $1.5 trillion). If that were the US debt situation at the start of this recession few economists or political leaders would hesitate to implement a large public spending program.

The lesson we learned in WWII is that a huge government driven demand can quickly put people back to work and inspire a nation to produce again. However, it is worth highlighting that overcoming a recession by revving up a war machine in response to existential threats is not the preferred way to recover from an economic depression. Although unemployment fell to about 1% in 1944 we were also suffering about 2500 military deaths every week. Although we can certainly say we were out of the depression in the midst of WWII, we achieved that feat by enduring an even worse catastrophe.

It is also worth pointing out that the WPA was implemented in 1935 and yet unemployment remained at 19% in 1938, 3 years later, and 14.6% in 1940, 5 years later. On the surface, the massive jobs creation program had seemingly little effect. The spending that followed with the war machine was much more extensive. But one might ask then whether massive government spending to get the country out of a depression is only likely to be as effective when the country faces an existential threat as we did in WWII, but perhaps not when it is just a large public works project.

Nevertheless, the point I am trying to make is that the risk of a massive government stimulus program is relatively low when a country has not borrowed unconscionably in its past. Had the US been in that situation in 2008, there would be fewer objections to a Krugman-style stimulus. But because the US did have a reasonably high national debt to begin with, and because the recession raised the debt at an almost unprecedented pace, and because the seeds of the entire recession was excessive private debt fueling a real estate bubble, a further stimulus at this point in time must be considerably riskier. This is the concern of conservatives, which has inspired the whole debt debate. More on that in a minute …

A second big problem with another big fiscal stimulus at this point in time is the seeming failure of the first stimulus. Reasonable people could argue about whether the $800 billion stimulus bill passed in 2009 had no effect on unemployment or whether it prevented a much higher unemployment rate. If it did the latter, one could say it worked. Unfortunately though, it is impossible for anyone to know what we did not observe (e.g. a 15% unemployment rate without the stimulus) and so the former situation that it had almost no effect is more credible.

Also, if we recall the process by which the stimulus was enacted, it seemed never to adhere to the guidelines put forth by Obama’s own economic advisor Larry Summers that it be timely, targeted and temporary. Instead the stimulus funded State government shortfalls, was spread over several years, and seemed to fund a whole slough of pet projects that were lying in wait for the funding floodgates to open. Most observers on both sides agreed the stimulus was poorly designed. But one reason for that is that any stimulus will invariably be “designed” by the political process and not by some committee of wise experts. A similar outcome is likely if another stimulus were to be seriously considered.

Thus, although the idea of a stimulus is not crazy or without merit, it does carry important risks. We really cannot be sure that it would work effectively and if it didn’t, given that it would place an enormous burden on an already enormous government debt, it could put us into extreme economic jeopardy in just a few years.

That brings me to the other side of the debate. The tea party grew out of a grassroots concern for the growing size of our federal debt and the expansiveness of government. These are not ridiculous concerns or imagined problems. Through history there are plenty of examples of economic ruin caused by the excessiveness of government borrowing, and the often-concomitant increase in money supply to feed an ever-burgeoning government sector. In addition there are real concerns about the effectiveness of an economy in which a substantial percentage is driven by the non-market demands of the government sector. Many people, with good reason, believe that governments do not produce goods and allocate resources as effectively as private markets and thus are concerned about a government sector that keeps getting larger and larger with every passing year.

As with arguments about the effectiveness of Keynesian policy, reasonable people can also argue about the appropriate size of government and when the government influence over the economy is too large. Surely the presence of debt itself is not a problem for a household, a firm, or a government, when its overall size is a small share of either income or wealth. However, if an institution’s debt becomes excessive, the threat of bankruptcy and default or a long period of austerity becomes very real. One dilemma of course is that there is no simple delineation to decide when an institution’s debt becomes too large. Consequently, we have a difference of opinion among economic decision-makers.

Conservative Republicans, and Tea Party members especially, believe the debt has risen to very dangerous levels and that the country faces, either default, high inflation, or serious austerity if the present deficit course is not changed quickly and convincingly. Liberals and Democrats believe the debt, although too high, remains manageable and furthermore that the only chance to revive the stalled economy is by stimulating more government demand with continued short-term deficits. In other words they believe that additional deficits and debt are the only way to jumpstart the sagging economy.

So what’s the answer? As I suggested before, there no way for anyone to know for sure. What we hear on the airwaves and over the internet is just a lot of educated guesses. Further, as the debate heats up with rising stakes in the near future, stubborn intransigence will surely result in even more vitriolic rhetoric. Unfortunately, we are all in for a very unpleasant ride ahead.

Why can’t we discuss policy proposals and offer opinions and ideas without calling the opposing arguments, or the opponents themselves, stupid and inane?

So let me finish this discussion with what I would suggest is a more moderate evaluation of our current economic dilemma.

More fiscal stimulus ala Krugman, could expand demand, reduce unemployment and revive enough private confidence in the economy to reinvigorate rapid growth. The risk is that the positive effects are slow to appear, unemployment does not fall rapidly enough (remember the unemployment numbers after the WPA in 1935), and private confidence does not rebound. If this were the outcome, our national debt might be soon be approaching that of Japan’s at more than 200% of GDP. And with several decades building up international indebtedness (the US is a debtor nation internationally, while Japan is a creditor) the US economy could face several decades of austerity. (It is hard to know what the impact would be and how to describe it, but it would be pretty bad).

On the other hand, taking care of our fiscal deficit and trying to rein in our growing indebtedness, as the Tea party favors, could put our government on a firmer fiscal footing, restore our credit rating, restore confidence in the economy and prevent the calamity of future default and even greater austerity. If this restores business and consumer confidence, soon private sector demand may begin to revive economic growth. The risk is that quick reductions in the government deficit will lower payments to government contractors, federal workers, teachers and doctors, and thereby reduce demand for goods and services in the economy. This could cause an increase in unemployment and reduce consumer confidence even further. Getting to a healthier economy might require a worsening of the economy in the short-run, and what if that short-run is 3-5 years?

The downside of both of these approaches is pretty grim. It is why it is fair to say we are stuck between a rock and a hard place.

If I had to choose between these two approaches I would go with the approach to reduce the government deficit instead of the fiscal expansion path for several reasons. First, I think it is less risky. If the fiscal stimulus program doesn’t work then we’ll have even larger debt and economic problems in the future and it is hard to see how that won’t lead to possibly decades of economic hardship. If the balanced budget approach doesn’t work, we may suffer a little more in the short run, but at least we’ll have a smaller debt burden in the future. Overborrowing is a scourge for households, businesses and governments and it has got to be better in the long term to take every opportunity to reduce the extravagance.

Second, it is always politically expedient to raise deficits. Citizens always like more benefits and lower taxes because it seems like you’re getting something for nothing. Governments perpetuate this myth by first overborrowing and eventually by overinflating to resolve the overborrowing problem. Often, what is politically expedient, is simply the wrong thing to do economically.

Finally, I happen to believe that the private sector does a better job allocating resources to produce goods and services than government do. Government allocations are made for political reasons, and those are heavily influenced by special interests. Those special interests include big business, the military complex, labor unions, and other influential and powerful groups. Since every expansion of government debt involves raising the role and scope of government it is hard to imagine that another fiscal stimulus at this stage won’t have the same effects.

Thus for these reasons I would support politicians’ efforts to rein in the growing budget deficit even though it may contribute to the continuing stagnation of the economy. If legislators could simultaneously overhaul the tax system to take away most of the special provisions that have been given to curry favor with this or that interest group through the years, then maybe they could revive excitement in the private sector and jumpstart the economic engine even sooner. The chance of anything like this happening though is virtually zero because it is never politically expedient to rock so many special interest boats at the same time. But as I said before, if it’s NOT politically expedient, there’s a better chance that it’s the right thing to do economically.


Steve Suranovic received his B.S. in mathematics from the University of Illinois at Urbana/Champaign and his M.S. and Ph.D. in economics from Cornell University. He has been a faculty member at the George Washington University since 1988. He has served several terms as the current Director of the International Trade and Investment Policy M.A. program at the Elliott School of International Affairs.


  • Yes, the debt ceiling is finally over. But the debates and arguments are still going on regarding what should be done next. I think that the Keynesian expansionary policy may work. It is high time that people should get back to work. Public projects should be initiated by the government. This may help in overall growth in the economy eventually. This may somehow help to mitigate the national debt problems to some extent.

  • Dave here is the CBO's estimate last updated in June 2011 for the debt to GDP ratio at 70% (please don't make the CBO is biased argument afterward). It appears as if you were doing some data-mining to justify a certain ideological position.

    When Ken Rogoff speaks of Debt to GDP he is talking about public sector debt to GDP). This is something I couldn't find listed in on its own in your chart. Your chart appears to put the debt of every sector of the entire country in it. Ken Rogoff's argument does hold to be somewhat true but you must start with the facts (first that Debt to GDP is 70%). Rogoff has also recently said that targeted infrastructure spending is a very credible way to go as Steve has suggested. It could stimulate demand as well as cause inflation, which contrary to skeptics, is a good thing.
    The main reason for the lack of demand is the amount of private sector debt consumers have accumulated. The main argument is do we sit on our hands and do nothing (the Classical interpretation) and wait for consumers to deleverage on their own or do we want the government to do something to hasten it like government spending (the Keynesian and Monetary interpretation). The fed should be buying bonds to drive down interest rates and they should be injecting direct government stimulus as well. This will cause inflation and reduce the value of the debt on the backs of consumers as well as reduce unemployment (how much is debatable).

  • Some additional fuel for your fire. Here's some data on debt to GDP and income. As you can see from attached Morgan Stanley graph we're at historic levels of the former already.

    Second, Ken Rogoff and Carmen Reinhart's work has shown an inverse relationship between debt to GDP and growth. At 90% of GDP (roughly where we are right now) growth slows by about 1%.

    Third, there are some papers I've read out there somewhere that have found only a weak relationship between public sector employment and private sector employment. In other words the failure of fiscal stimulus to boost the economy in a self-sustaining way isn't entirely unexpected.

    Finally, the federal government isn't the only prospective source of increased demand. In a global economy we should be looking to countries that have as a matter of policy kept their consumer demand at low levels, e.g. China and India as I suggest here.

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