America is about to learn yet again that Republicans are hypocrites on the national debt. After furiously railing against the large debt increases added during the Obama years (due to a combination of recession-caused tax revenue declines and various stimulus spending), Republicans are going to turn on a dime and explode the deficit with gigantic tax cuts for the rich, just like they did when George W. Bush was president.
This has some liberals rediscovering their own deficit phobia. Paul Krugman writes that "deficits matter again." But liberals should not count on this. History and theory strongly suggests that huge new deficit spending won't create either inflation or a spiral in interest rates.
Let's first go through Krugman's argument, which is on its face fairly ordinary Keynesian reasoning. By this view, when there is a recession the government should spend more to counteract the collapse in aggregate demand. But when the recession is over, spending should pull back, because otherwise it will simply "crowd out" private economic activity as the government has to offer higher interest rates to bid away capital. "The boom, not the slump, is the right time for austerity at the Treasury," as Keynes wrote.
The problems with this in the current context are twofold. First, the evidence that the economy is indeed near capacity is weak at best. The unemployment rate is low, yes, but the share of prime working-age adults with a job is still lower than it was even at the bottom of the previous two recessions. Wages have ticked up a bit over the past few months, but this follows many decades of stagnant or declining wages for vast swathes of the population.
So, which indicators are right? It used to be liberal conventional wisdom that the way to know for sure that the economy can't benefit any more from stimulus is when sustained inflation pressure is seen. That's proof positive that the economy is starting to run into structural bottlenecks, causing a bidding war for goods and services — thus implying that further stimulus spending will merely raise prices. This argument is powerfully buttressed by an examination of relative risk: Overshoot stimulus and inflation (which has been under the Fed's 2 percent target for almost five straight years) might temporarily tick back up to where it was in Reagan's day; but undershoot and we might leave millions of people unemployed and trillions in output un-created. Obviously, the latter option is worse.
Second, there is a debate about structural economic anemia that has fallen by the wayside of late. A couple years ago all the bigshot liberal economists were fretting about "secular stagnation," the idea that the economy has become permanently short of aggregate demand for some reason. Part of the evidence for this was the extremely sluggish Obama recovery, but another part was the patent fact that George W. Bush's huge deficit-financed tax cuts and huge deficit-financed wars of aggression, coming at the same time as a massive housing bubble, did not seem to juice the economy anywhere close to overheating. As Larry Summers observed in a speech at the IMF Economic Forum:
If you go back and study the economy prior to the crisis, there's something a little bit odd. Many people believe that monetary policy was too easy. Everybody agrees that there was a vast amount of imprudent lending going on. Almost everybody agrees that wealth, as it was experienced by households, was in excess of its reality. Too easy money, too much borrowing, too much wealth. Was there a great boom? Capacity utilization wasn't under any great pressure. Unemployment wasn't under any remarkably low level. Inflation was entirely quiescent. So somehow even a great bubble wasn't enough to produce any excess in aggregate demand. [Larry Summers]
Indeed, Krugman himself wrote a nearly identical article to his latest one in 2003 arguing that the Bush deficits and war spending were risking an interest rate spiral. In reality, the opposite happened. President Johnson sparked inflation when he tried to have the Great Society and war in Vietnam at the same time, but President Bush had war and tax cuts, and a housing bubble, and the economy soaked it up without blinking. And today, we are far further from estimated full capacity than we were in 2003.
The most convincing explanation I have seen for this development is inequality. Rich people spend a lesser fraction of their income than poor people, so as more of the national income is captured by the very top, the more prone to aggregate demand weakness an economy becomes. As FDR's Fed Chair Marriner Eccles once observed, "Mass production has to be accompanied by mass consumption," thus implying a relatively equal distribution of income so people will have "buying power equal to the amount of goods and services offered by the nation's economic machinery." People can borrow to finance consumption, but only for awhile. That leave only investment to keep the economy pressurized — but with so many people constrained by their incomes, there are few new business opportunities in which to invest. Hence: permanent economic weakness. (Krugman has dismissed this argument on rather thin grounds.)
Today, inequality is substantially worse than it was in 2003, despite the modest transfers towards the bottom and tax increases on the rich passed during the Obama presidency. For the last eight years, the top 1 percent's share of income has bounced around near all-time highs established right before the Great Depression.
Unless a financial crisis strikes, there is every sign that President Trump and the Republican Congress will surpass that old record, by slashing social insurance to pay for massive tax cuts for the rich. That's a moral atrocity, and I would expect it to increase the chances of a financial crisis in the near term, as rich people look to sock away their windfall in an economy fundamentally short of investment opportunities — a recipe for an asset bubble of some kind.
But by further enriching the already obscenely wealthy, it will also further de-pressurize the economy. Therefore, I would not expect the Trump agenda to lead to inflation or a spiral in interest rates. It's not impossible, of course, but every recent experience points against it. Don't expect the bond vigilantes to save us from the oncoming Republican disaster.