DeLong Says Not Time to Cut U.S. Budget With Free Lunch

Photographer: Andrew Harrer/Bloomberg

Former U.S. Treasury Secretary Lawrence Summers argues that with borrowing costs near record lows, the multiplier right now is at its most powerful. Close

Former U.S. Treasury Secretary Lawrence Summers argues that with borrowing costs near... Read More

Close
Open
Photographer: Andrew Harrer/Bloomberg

Former U.S. Treasury Secretary Lawrence Summers argues that with borrowing costs near record lows, the multiplier right now is at its most powerful.

Just as lawmakers force as much as $85 billion of budget cuts on the federal government, economists Bradford DeLong and Lawrence Summers have a message for Washington: Now is the perfect time to spend more, not less.

Their advice is based on new research suggesting that, because of today’s rare economic circumstances, increased spending could be unusually potent in reviving growth. A study by former Treasury Secretary Summers and DeLong, a University of California at Berkeley economist, concluded stimulus now could generate so much growth that it would pay for itself.

The risk in the current focus on deficit reduction, say exponents of more stimulus, is not only that Congress squanders the chance to borrow at record-low costs to bolster the economy and make lasting investments for the future. There is also the danger that the same forces that magnify the strength of stimulus also make austerity particularly harmful, with as much as $1.2 trillion in federal spending cuts on the line, according to Martin Eichenbaum, an economics professor at Northwestern University in Evanston, Illinois.

“Look around at the infrastructure we have, the schools we have, all the things we desperately need to do,” said Eichenbaum. He has found that the economy is as much as three times more sensitive to changes in government spending when central banks are keeping interest rates near zero, as the Federal Reserve is doing now. “Why aren’t we fixing that now when it’s going to be a win-win? There are so many obvious things to do and this is a good time to do them.”

Fiscal Multiplier

Key to the debate is rethinking a number called the fiscal multiplier, a gauge of how much growth can be generated for each dollar spent by the government. DeLong and Summers argue that, with short-term interest rates near zero, the multiplier right now is at its most powerful.

“We need more government spending right now, not less,” DeLong, 52, an economics professor at the University of California at Berkeley, wrote on his blog in January, reprising his research with Summers as the automatic budget cuts known as sequestration loomed.

They argue that expenditures that are going to be needed anyway, such as renovating New York’s Kennedy Airport, might as well be done now when the government can borrow cheaply. While more spending would expand the deficit in the short run, the investments could bolster the economy’s capacity to grow and bring lower deficits in the long run, Summers and DeLong say.

The economists’ message has so far had no influence on the debate in Washington, where lawmakers clash in standoff after standoff over how to reduce, not expand, the federal budget.

Spending cuts of as much as $85 billion for this fiscal year started on March 1 after Congress and Obama failed to agree on a deal to postpone the reductions or come up with a like amount of deficit reduction.

Significant Headwind

Last month, lawmakers dismissed Fed Chairman Ben S. Bernanke’s warning to Congress that such short-term budget contractions “could create a significant headwind for the economic recovery.”

Congress would have “zero” credibility if lawmakers tried to “somehow postpone” the budget cuts and promise to implement them later, Republican Senator Patrick Toomey of Pennsylvania told Bernanke during the Fed chairman’s Feb. 26 testimony before the Senate Banking Committee. “Our economy would respond in a very adverse way, because it would see that we have absolutely no willingness, no political ability to begin even the slightest imposition of fiscal discipline.”

Investors haven’t signaled a call for stimulus either. The Standard & Poor’s 500 Index (SPX) has climbed 8.9 percent this year. The U.S. Dollar Index (DXY), which tracks the currency against six of America’s biggest trading partners, is near a seven-month high.

DeLong’s Blog

That hasn’t deterred DeLong, who has used his economics blog as well as his daily 100 tweets and retweets to deride those he calls “austerians.”

The budget cuts represent “Congress hitting the economy on the head with a brick,” DeLong said in an interview with Pimm Fox on Bloomberg Television’s “Taking Stock” on Feb. 28. “We had a recovery -- not a great recovery -- going. Now we’re putting it at risk.”

Summers, who advocated fiscal discipline as an official in the Clinton administration, has produced a series of newspaper opinion articles denouncing the current U.S. “obsession” with deficit-cutting. He has taken his message for government investment to members of Congress and, in January, to business leaders and policy makers at the World Economic Forum in Davos, Switzerland.

Supply-Side Counterpart

DeLong and Summers represent a school of economic thought that might be viewed as the liberal counterpart to conservative supply-side theories about tax cuts generating enough growth to pay for themselves.

Until recently, few studies suggested the government got much bang for its taxpayer’s buck.

In a normal economy, the boost to growth would lead to faster inflation, prompting the central bank to raise interest rates. That would at least partially offset the benefits of stimulus, the theory went.

“The net effect didn’t seem that big,” said Eichenbaum. “The consensus of the profession was very much that fiscal policy was not the way to go.”

Yet the deepest recession since the Great Depression left the U.S. in unfamiliar territory, with a frustratingly slow recovery and a Fed unable to lower its benchmark interest rate any further. Turning to ideas economist John Maynard Keynes published in the 1930s, economists went back to their computer models and historical data. Their question: what happens when the Fed refrains from tightening in response to a boosted economy?

Research Explosion

A burst of studies followed, from Berkeley to Northwestern to the Fed. The papers found that in depressed economies, each $1 increase in government spending can generate as much as $2 or $3 in additional economic growth. That compares with little boost in normal times.

A minority of economists including Nobel laureate Paul Krugman had been arguing for years of this possibility. Krugman repeatedly argued that the economy needed a bigger jolt as Obama, advised by Summers, was putting together a spending proposal in early 2009, and has continued to be one of the most vocal critics of fiscal cuts today.

Fed economists Christopher Erceg and Jesper Linde found that when a central bank is stuck with interest rates at zero for much beyond two years, increased government spending leads to so much growth that public debt actually falls.

Summers and DeLong, who have been co-authoring papers since the 1980s and worked together at the Treasury Department under President Bill Clinton, got together to further expand on the possibility of a fiscal free lunch.

Economic Lift

As long as the Treasury’s inflation-adjusted borrowing costs don’t exceed historic levels, the economic lift from the stimulus could lead to higher tax revenue and cover the costs of servicing that debt, they showed in a paper presented at the Brookings Institution in March 2012.

The real yield for 10-year Treasuries after inflation was at negative 0.5 percent on March 12.

“If fiscal expansion is self-financing, there are no costs, only benefits,” the two wrote in their paper. Fiscal policy “has a major role to play in a severe downturn in the aftermath of a financial crisis that carries interest rates down to the zero nominal lower bound,” the point where central bankers run out of room to lower their policy rate any further.

Bernanke warned Congress last month that his monetary stimulus can’t “carry the entire burden” of supporting the expansion. He referred to Congressional Budget Office estimates that fiscal tightening this year will probably reduce gross domestic product by 1.5 percentage point. Such a drag on the economy would result in “less actual deficit reduction in the short run,” Bernanke said.

Still Controversial

To be sure, economists are far from consensus that the conditions are right today -- or will ever be right -- for more spending. Reflecting the still-controversial nature of the debate, the CBO estimates the fiscal multiplier in today’s zero- interest-rate environment may be as little as 0.5 or as much as 2.5.

Valerie Ramey, a professor at the University of California at San Diego who reviewed DeLong’s and Summers’s work, found that contrary to their assumptions, the U.S. economy isn’t any more sensitive to government spending during periods of high unemployment and low interest rates.

Others worry about boosting spending when government debt is three-quarters the size of the economy, up from 36 percent in 2007.

Delayed Austerity

“The best path forward is a comprehensive fiscal deal combining upfront stimulus with delayed but credible austerity,” Peter Orszag, formerly Obama’s head of the Office of Management and Budget, wrote in a Bloomberg View article published Feb. 6. “Unemployment remains stubbornly high and our fiscal outlook is problematic” and “two-month budget deals address neither” of those concerns, he said.

And even those who see bigger multipliers at zero interest rates acknowledge the practical difficulties of designing the spending programs. For maximum impact, the stimulus must be deployed before the economy improves enough for the central bank to consider raising interest rates, according to research by Michael Woodford, an economist at Columbia University in New York, and Fed economists Erceg and Linde.

That urgency has spurred Summers and DeLong as they continue to evangelize their work. At the beginning of the year, Summers had one message for the World Economic Forum.

“This is a moment for broad renewal that corrects all the deficits we have,” including poor infrastructure, rising health care costs and educational inequalities, he said. If today “is not the moment to do something about it, I don’t know when the moment will be.”

To contact the reporter on this story: Aki Ito in San Francisco at aito16@bloomberg.net

To contact the editor responsible for this story: Chris Wellisz at cwellisz@bloomberg.net

Press spacebar to pause and continue. Press esc to stop.

Bloomberg reserves the right to remove comments but is under no obligation to do so, or to explain individual moderation decisions.

Please enable JavaScript to view the comments powered by Disqus.