Bigger Deficits for Bad Tax Cuts Is a Bad Deal

Piling on government debt during a recession makes sense, but not now.

Probably only half right.

Photographer: Andrew Harrer/Bloomberg

Tax debates make for strange bedfellows. During the long, slow recovery from the Great Recession, Americans became accustomed to a familiar economic debate -- Keynesians, usually aligned with the Democratic Party, would call for more government spending in order to stimulate the economy, while Republicans would call for cuts in outlays. Eventually, a compromise was reached, though dangerous theatrics were involved and nobody was overjoyed with the result. From 2011 to 2013, the large federal deficits that were a tool used to fight the recession were mostly eliminated:

Not a Lot of Profligacy Here

Federal deficit as a percent of gross domestic product

Source: Federal Reserve Bank of St. Louis

But now, with Republicans on the verge of adopting big tax cuts, the lines of debate have shifted. Some of the people calling for stimulus a few years ago are now worried about the tax plan’s effect on the deficit. Economist Larry Summers, for example, who has long called for fiscal stimulus to fight the slow growth that he calls “secular stagnation,” has excoriated the bill’s supporters for downplaying how much the tax cuts would add to the debt.

It’s typical for partisans to switch from deficit dove to hawk when the presidency changes hands. Republicans, in general, are famous for only worrying about deficits when the president is a Democrat. But Summers’ stance on the bill isn’t as self-contradictory as it might initially appear. Because the Republican bill would cut taxes mostly for the rich and could possibly even raise them for the middle class, it might not be a fiscal stimulus at all. Savvy economists realize that because poor and working-class people spend more of the money they get from the government -- while rich people tend to stick it in the bank -- a bill that shifts the tax burden from rich to poor could easily end up being fiscally contractionary. That could make secular stagnation even worse. Even if a tax cut for the rich provides a slight stimulus, if you think government debt puts a future burden on the citizenry, it’s probably just not worth it.

Summers’ position actually looks quite a bit like orthodox Keynesian policy -- borrow and spend when times are bad, cut government deficits when times are good. And since times are pretty good right now, an orthodox Keynesian might say this is the moment for a bit of austerity.

But some other people think that government deficits and debt aren’t a bad thing at all and that they contribute positively to the economy even in boom times. These are adherents of so-called modern monetary theory (MMT), a fringe concept that has gained some credence in the financial industry and the pundit class in the wake of the Great Recession.

For example, in a recent New York Times op-ed, Stephanie Kelton, a professor of economics and public policy at Stony Brook University, and a prominent MMT champion, urged people to think of government debt as a good thing.

Her reasoning, common in MMT circles, is that government deficits are also private-sector surpluses. That’s simple accounting -- since there are only the government and the private sectors in the world, when the government borrows it’s the private sector that lends. When banks or individuals buy government bonds, they become net lenders, meaning that they’re running a financial surplus with respect to the government. According to Kelton, who also served as an adviser to presidential candidate Bernie Sanders, that surplus constitutes a real economic benefit. She made the argument even more explicitly on Twitter:

The economic logic here doesn’t seem as watertight as the accounting. There’s no law that says a financial surplus equals a net economic benefit. If I lend my friend $100, I run a surplus and she runs a deficit, but that doesn’t necessarily mean I’m richer than before.

The real magic of MMT comes from the idea that the government doesn’t have to pay back its debts. Most economists assume that the government has to balance its budget in the long run -- that if it borrows today, it has to raise taxes tomorrow. Not so, say the MMTers -- the government can just keep rolling over its debts forever. If interest costs get too big, the central bank can lend a hand by lowering rates to zero. If people get scared of a default and stop buying government debt, the central bank can just print money to buy government bonds. That could conceivably cause hyperinflation, of course, but MMTers say not to worry -- the lack of inflation from quantitative easing and zero interest rate policy in Japan, the U.S. and elsewhere means that the danger of inflation spinning out of control is remote or nonexistent.

So although MMTers might -- as Kelton does -- oppose the GOP tax cut on the grounds that they favor the rich at the expense of everyone else, they have been vigorously attacking both Democrats and economists who see debt as a reason to worry about the bill. This has, strangely, put them at odds with Keynesians like Summers.

So who’s right? The MMTers seem to be ignoring the details of how deficits lead to fiscal stimulus. Accounting relationships alone can’t prove that deficits raise output -- if the tax cut shifts the burden to the middle class, there’s the possibility it will reduce aggregate demand despite increasing deficits. In addition, the premise that government debt is never dangerous rests on some questionable assumptions -- the low risk of sudden inflation, and the willingness of the central bank to support infinite borrowing.

Therefore, although Keynesians like Summers may look like they’re reversing their previous stance, their concerns must be taken seriously. MMT is an idea worth considering, but it’s also a dangerous experiment, and a regressive tax cut like the one now being considered isn’t the best occasion for pro-deficit crusading. In this case, I’d listen to Summers.

This column does not necessarily reflect the opinion of the editorial board or Bloomberg LP and its owners.

    To contact the author of this story:
    Noah Smith at

    To contact the editor responsible for this story:
    James Greiff at

    Before it's here, it's on the Bloomberg Terminal.