Borrowing, expectations, and potential output

Over at EconoSpeak they have attacked Kevin Hassett on his call that the US government should run a balanced budget (ht Economist’s View).

Now, although I don’t necessarily agree with Kevin Hassett’s prescriptions, I can understand his feeling that the “paradox of thrift” argument for more government spending seems a bit strange in the case where public and private debt are elevated.

Fundamentally, I believe that all the debate stems from different peoples view of “the natural rate of output”.

If we completely believe the CBO potential output projections (which I do not) then we are in a hole – and there is a DEFINTE and URGENT case for a fiscal stimulus. I am more than willing to concede that.

However, if potential is a lot lower (either because we have been running past, or because it has been “hammered” by recent supply side shocks), then the current pull back in spending by agents is rational and should be allowed to happen. If the government can help the transition (eg by pushing the real wage to adjust and/or by helping unemployed people “upskill”) then there could well be a case for that – but not for an indiscriminate fiscal stimulus.

Lets take today’s discussion of household wealth as an example. Households in the US based spending patterns on a estimated lifetime wealth level that included increases in real house prices. However, real house prices have plummeted. This is a real reduction in consumers lifetime spending power – and so should be match by a marked reduction in household spending.

If consumers now feel that they are borrowing to much we have to let them save – or else we will just be making them worse off. Is there a cost to this savings behaviour, YES.  But having the government tax (in the future) and spend people money for them in isn’t going to magically make things better.

The current crisis is the result of a huge change in expectations which can only occur in the case of both imperfect and asymmetric information among agents. With such a wide ranging market failure there are definitely ways that government can help – however, appealing to the “paradox of thrift” for arbitrary government spending is not one of them.

  • MattYoung

    Conclusion? Read more Matt Nolan, he has gotten this thing right.

  • “Conclusion? Read more Matt Nolan, he has gotten this thing right.”

    I wouldn’t call that the conclusion – if you had listened to the advice on my blog you probably would have lost some money over the past year 🙁

    However, I find the paradox of thrift story just a bit fishy – I think it misses the point of what is the “appropriate” counter-factual. Of course, I could easily be completely wrong again 😉

  • CPW

    I’m not convinced. You don’t really have any evidence that the output projections are wrong. Unemployment is rising sharply and inflation is falling. If you don’t think this is obviously a situation with insufficient aggregate demand, I suspect you don’t believe such a situation ever exists.

    The best econometric evidence seems to suggest that you get a more than 1 for 1 bang out of fiscal stimulus. What’s the worst-case scenario for implementing a fiscal stimulus now really? Inflation would be a boon in the current environment.

  • “I’m not convinced. You don’t really have any evidence that the output projections are wrong. Unemployment is rising sharply and inflation is falling.”

    I don’t expect you to be convinced – I’m just stating a point of view 😉

    Unemployment is rising sharply true, and that is a concern – as it suggests that the labour market isn’t clearing.

    On the inflation side this is cooling – but not to the degree you would expect with the GIANT output gap that is being suggested.

    Furthermore, of course I believe a situation exists where government should come in and just try to stimulate activity. If the output gap is that massive – then there is a ton of spare capacity that the government could use cheaply, and private industry is scared to use. But, is that the case?

    “What’s the worst-case scenario for implementing a fiscal stimulus now really?”

    The fact that it misallocates resources reducing social welfare – the goal of policy is to maximise social welfare overtime isn’t it, not GDP in the next quarter …

    Just because output is falling doesn’t mean the government needs to do something – that is not the default position. If output is falling we need to identify why, and whether government can actually help in the situation. Doing this requires a lot of faith in potential output forecasts – forecasts I don’t believe.