How Keynes would handle an abnormally slow recovery

In theory, Keynesian stabilization policy should "shave the peaks and fill the valleys." That is, when the economy falls into a recession the government should use deficit spending to lift the economy back towards the full employment level. It should then pay for the policy — increase revenues or reduce spending — during boom periods when the economy is overheated and needs to be slowed down. But what if, like now, there is no boom following the bust? How should we pay for the programs that were put into place during the recession in that case?

Should we care about deficit? The first question to ask is why we care about the deficit at all. The main problem with borrowing to finance government spending is that the increased demand for financing can cause the price of loans — the interest rate — to go up. This will slow down ("crowd out") private investment and reduce future economic growth. But when there is a large supply of funds sitting in banks and in corporate coffers — when there is an excess supply of funds even when the interest rate has fallen as much as it can — increased borrowing by the government does not cause interest rates to spike. Thus, when there is an abnormally slow recovery there is no rush to pay for the stimulus effort through austerity policies.

Wait for better times: Though the recovery from the recession has been very slow, things will eventually get better. As the economy improves and interest rates begin to increase, then we will need to start worrying about the debt's role in pushing interest rates up. At that time, we can begin to figure out how to use spending cuts and tax increases to offset any problems that can be traced to the national debt. Thus, we need patience, lots of it, during slow recoveries. Cutting spending too soon — as we have done — makes a slow recovery even slower.

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Taxes: If we cannot be patient, and if fears of the national debt persist despite the fact that interest rates show no sign of increasing — if politics rather than economics forces our hand and something must be done — then we ought to do our best to reduce the deficit without slowing the economy and employment at the same time. A good way to do this is to reduce the deficit through taxes on the wealthy rather than cutting back on stimulus measures. The increase in taxes will be mostly paid by reducing savings rather than consumption, and since there is already an excess of saving — that's why interest rates are so low — the effects on the economy should be small. Once the economy recovers and the stimulus measures can be safely reduced, the "balanced budget" tax increases can be reversed as well.

Infrastructure: As Brad DeLong and Larry Summers have argued, "In a depressed economy, with short-term nominal interest rates at their zero lower bound, ample cyclical unemployment, and excess capacity… even a small shadow cast on future potential output by the cyclical downturn … means, by simple arithmetic, that expansionary fiscal policy is likely to be self-financing." Infrastructure construction, for example, is very cheap to finance when interest rates are at rock bottom and labor and materials costs are low due to the recession. In this case, the increased income from higher employment, the fact that keeping people employed stops them from dropping out of the labor force — which reduces our long-run potential — along with the decades of increased growth that infrastructure spending gives us generates enough tax revenue to cover the costs of the infrastructure spending in large part or in full. In fact, according to their analysis, it could even help to lower the debt.

Debt Monetization: In normal times, high rates of inflation can be harmful and the Fed is right to avoid this outcome. But when the economy is in a severe recession and interest rates are as low as they can go — when we are stuck at the "zero lower bound" and inflation is running below the Fed's target — the situation is different. In this case, expected or actual inflation can help by reducing real interest rates, lowering nominal debt burdens for business and households, increasing stock market values, and promoting exports by lowering the exchange rate. Thus, in severe recessions paying for government spending by printing money, i.e. debt monetization, is an option that can avoid increased government debt.

Stimulus Measures are not the cause of our debt problem: Finally, the most important thing to realize is that the stimulus measures implemented during the recession are not the source of our worries about the debt. The long run debt problem is due to health care costs, not spending to fight recessions. The failure to recognize this due to willful obfuscation from politicians on the right with an ideological bias against stimulus spending and a desire to reduce the size of government ties our hands and hurts struggling households that cannot find jobs no matter how hard they try. We must understand the true nature of the debt problem, provide the needed stimulus — even now it's not too late to do more — and avoid the premature austerity policies that have been so harmful to the recovery.

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