Committee for a Responsible Federal Budget

Translating Dr. Summers’ Econospeak: Are Budget Deficits Good or Bad?

Larry Summers gave a very interesting and thoughtful talk in Washington recently (May 24).

But it was delivered in High Oracular Econospeak, so many people may never get it.

And reasonable people can come away with very different interpretations of Dr. Summers’ High Oracular Econospeak.

For example, one prominent commentator takes away from Dr. Summers’ remarks that he dismisses our serious economic problems (massive unemployment, huge fiscal imbalances, and the EU sovereign debt crisis) because they reflect just an economic “fluctuation”.

Yet another interpretation is possible - after the ninth or tenth read of his speech. Namely, that Dr. Summers is worried (in fact very worried indeed) about the strength of the recovery; that he thinks additional stimulus is needed (he never used the “s” word, though); and that his worries have very immediate implications for the extenders package now under consideration in Congress. Consider the following, “in his words”:

“Moments like the present – when the economy faces a liquidity trap and when the Federal Reserve is constrained by a zero bound on interest rates, and when the financial system is functioning imperfectly because of credit problems in financial intermediaries and because of over leveraged borrowers – are moments when [fiscal policy will have the strongest impact ].”

[P.S. He did not even mention the likelihood that the fledgling U.S. recovery might be dampened by a Eurozone slowdown as they tighten fiscal policy and from slower growth in China from monetary tightening.]

“In areas where the government has a significant opportunity for impact, it would be pennywise and pound foolish not to take advantage of our capacity to encourage near-term job creation. This explains the logic of the Recovery Act’s success and the rationale for taking additional targeted actions to increase confidence in our economic recovery.”

“Consider the package under consideration in Congress to extend unemployment and health benefits to those out of work and support to states to avoid budget cuts as a case in point … It would be an act of fiscal shortsightedness to break from the longstanding practice of extending these provisions at a moment when sustained economic recovery is so crucial to our medium-term fiscal prospects … At the same time, the legislation properly emphasizes the importance of taking additional measures, including higher patches on Medicaid to avoid dramatic cuts in state budgets that would not only contract the economy but hurt the most vulnerable, additional subsidies through the TANF Emergency Fund for parents looking for work, a summer jobs initiative that will help tens of thousands work through the summer, and continued funding for the SBA lending initiatives that will help support tens of billions of dollars in credit for these small business …”

Yet, there is more to the story: our future deficit path cannot be sustained. Summers is fully aware that the United States faces huge fiscal imbalances that it cannot sustain, with all the tough, tough challenges for our well-being that this implies.

In his talk, he tries to reconcile his view that we need more fiscal stimulus now with his view that we must reduce the fiscal deficit so that the U.S. is on a budget path it can reasonably sustain. To consider the possible contradictions, he basically poses the question: Are budget deficits good or are budget deficits bad?

As he said (and we paraphrase), sometimes economists say budget deficits need to be reduced to promote economic growth and prevent financial Armageddon; but at other times economists say that budget deficits should be increased to prevent depression, increase public investment and promote growth.

The simple answer is that whether a deficit is “good” or “bad” importantly depends on where the economy is in the business cycle. The “good” deficit boosts growth and helps the economy out of its hole; the “bad” deficit hurts growth and an economy close to full resource use.

This is a question we have thought about, too, in our paper Good Deficit/Bad Deficit.

Our challenge is to figure out when the “good” deficit turns into the “bad” deficit. We are close to that point where reasonable people can disagree. And it may be impossible to say - other than in retrospect. An additional wrinkle is that the financial markets (and probably most taxpayers) the present and the future as a continuum. We are now looking at the good deficits doing their useful fiscal stimulus work but know that coming soon over the horizon are “bad” deficits once the economy regains its footing. Summers in fact said in his speech:

“I am convinced that it is impossible to sensibly address either challenge in isolation.”

So what is a deficit hawk to do? Summers sketches out a way forward:

“It has in recent years been essential for the federal deficit to increase as the economy has gone into recession and has been severely constrained by demand … [Yet] those who recognize the fiscal and growth benefits of strong expansionary policies must also recognize that it is simultaneously desirable to provide confidence that deficits will come down to sustainable levels as recovery is achieved. Such confidence both spurs recovery by reducing capital costs and reduces the risk of financial accidents.”

We welcome details of a Fiscal Recovery Plan for the near-term and the future – quite soon.