In much of the world, including the United States and Europe, a debate is taking place about whether the government’s first responsibility should be to reduce unemployment – which is at elevated levels – or to reduce government deficits and debt. Many of the arguments for deficit reduction are simplistic, based on ignorance, or ideologically-based. For example, there are inappropriate comparisons of government to household debt, a fixation on absolute numbers without any comparison to national income, or just right-wing opposition to government in general. Although these are the most commonly propagated views on television and through the media, it is worth taking a moment to examine the (ostensibly) more sophisticated and economics-based arguments and see whether they hold water.
Kenneth Rogoff is Professor of Economics at Harvard University and a former Chief Economist at the International Monetary Fund (IMF). This week he responded to some of the pro-stimulus arguments:
"Some portray Japan, with nearly a 200 per cent government debt to income ratio, as a poster child for extremely indebted countries with low interest rates. Japan’s ‘success’, of course, has a lot to do with its government’s ability to sell debt domestically. How the country will handle its finances as saving by retirees shrinks and as its labour force rapidly shrinks, remains to be seen."
Some background: Japan has a gross debt-to-GDP ratio of about 227 percent of GDP. This is more than three times the level of the United States. But more than 100 percentage points (of GDP) of this debt is owed to the Japanese central bank. This means that the interest payments on this debt go to the government of Japan, so there is no interest burden added by this part of the debt. In fact, Japan’s net interest payments are less than 2 percent of GDP, which is a modest amount.
It also means something else that most of the economists in this debate are not eager to talk about: it means that Japan has financed nearly half of its public debt by creating money. In other words, instead of the government borrowing money from investors, the central bank created money and lent it to the government. In the popular imagination, this creation of trillions of dollars (in yen) to finance government deficits has to cause serious inflation. However, the Japanese experience has been the opposite: over the last 20 years, Japan’s consumer price index has risen about 5 percent – that’s the 20-year total, not annual inflation.
Rogoff is correct to say that the domestic ownership of Japan’s debt is key to its success. But this is just an additional argument for the United States, or Europe, to finance deficit spending through money creation at this time. Such financing is by definition domestic ownership – i.e. ownership by the central bank. In the Eurozone, the European Central Bank (ECB) would have to agree to refund the interest payments on the debt to the borrowing countries, so as to duplicate what Japan (and the United States) has done with its own central bank.
Of course, Japan’s debt that is held by the public is also held mostly by domestic investors. So this part of Rogoff’s argument is really making the case for avoiding the chronic trade deficits that the United States has run for decades. It is the overvalued dollar, and the resulting trade deficits, that drive foreign borrowing in the United States.
As for the warnings about what might happen when savings and the labor force shrink, we have heard this rhetoric for decades from deficit hawks in the United States and Europe. Suffice it to say that there are many options open to rich countries should they ever face the problem of a "labor shortage." But unfortunately our problem for the foreseeable future is the opposite. It is a shortage of jobs, not labor.
Rogoff cites his own work, with Carmen Reinhart, in arguing that debt-to-GDP ratios of more than 100 percent are "above the threshold where growth might be affected." But their paper really doesn’t show much at all, especially for economies like the United States and the Eurozone that can borrow in their own currencies. Countries that end up with debt greater than 100 percent of GDP are likely to have other problems that got them there. As others have also noted, without controlling for these other factors – which this paper decidedly does not do – there is no way of establishing causality. In fact, the authors do not even control for changes in population growth, since they look only at GDP growth rather than per capita GDP.
Rogoff adds another self-defeating argument: "Importantly, governments that emphasize long-term fiscal sustainability are likely to have an easier time inducing their central banks to maintain highly supportive monetary conditions."
In other words, he is saying that central banks might react to expansionary fiscal policy in the present situation by tightening monetary policy. But this just means that the central bank should be subordinated to national economic policy, instead of the other way around. He is taking for granted that central banks must be "independent." But as experience has demonstrated – e.g. the U.S. Federal Reserve somehow missed the two biggest asset bubbles in world history – this doesn’t necessarily mean independent of Wall Street, it means independent of the public interest. So yes, a government that wants to use expansionary fiscal policy will need the cooperation of its central bank. And should have it.
Rogoff argues that "anemic growth with sustained high unemployment is par for the course in post-financial-crisis recoveries." Par for whose course? If past governments made stupid mistakes and/or didn’t care about condemning a generation of low-income young people to years of unemployment, does that mean we should do the same? At the end of the day, Rogoff provides no convincing economic argument why either the United States or Europe cannot, or should not, finance the necessary stimulus until unemployment approaches more normal levels.