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New Deficit Numbers in Perspective


In this week of financial market turmoil, there was a notable bit of good news: the US federal budget deficit shrank to 2.8 percent of GDP, its lowest level since 2007. The numbers mark a striking drop, from $1.4 trillion in 2009 to $483.4 billion in the fiscal year that concluded last month. The improvement was the result of a number of factors – economic growth, tax hikes, and spending restraint from the sequester foremost among them.

Herewith, three thoughts inspired by the welcome new numbers:

1. Austerity

A debate has raged about whether a misguided devotion to austerity is a major cause of global economic malaise. (I wrote about this a couple months ago in the context of France, where austerity is much-blamed but little-practiced). In the United States, at the time of the budget sequester, there were cries that we were casting ourselves back into the economic abyss by tightening at the wrong time.

In fact, looking across the world, the two countries that seemed to adhere most closely (and publicly) to a policy of austerity have also enjoyed some of the fastest growth. In the World Economic Outlook released this month, the IMF opined: “Among advanced economies, the United States and the United Kingdom in particular are leaving the crisis behind and achieving decent growth.” US growth was 2.2 percent in 2013 while the U.K. came in at 1.7 percent.

2. Keynesianism

The intellectual heft behind the austerity opponents comes from the work of Lord John Maynard Keynes. The idea was that a government could stabilize demand through its use of fiscal policy. It would run deficits in bad times and surpluses in good ones, thereby offsetting the spending of consumers and businesses and smoothing out economic cycles. This is not the place to debate the merits of a Keynesian approach (though it came under heavy attack over the years from some very prominent macroeconomists). Rather, the latest deficit numbers show how far we’ve strayed even from an orthodox Keynesian approach.

According to the National Bureau of Economic Research, which officially dates US business cycles, the most recent recession lasted from December 2007 to June 2009. That means we are in the 64th month of the post-recession expansion. The NBER reports that for the 11 business cycles since 1945, the average time period from trough to peak was 58.4 months.

Note that across this business cycle, the federal deficit hit its minimum of near one percent of GDP in 2007.  It peaked near 10 percent of GDP in 2009. It has been shrinking since, but after a long, tepid expansion, we have only gotten the deficit just below 3 percent of GDP. The implication is that we are not following an orthodox Keynesian prescription – we’re fluctuating between smaller and bigger deficits, not between deficit and surplus.

3. Debt and Context

Past deficits stay with us and future deficits will be driven by big structural factors beyond business cycles (a point Megan McArdle makes very well). The past deficits accumulate into the federal debt. If our deficits in bad times were offset by surpluses in good, the size of the debt would stay fairly constant. Instead it has grown. From just over 60 percent of GDP in 2007, it is now a notch below 100 percent of GDP.

This has a couple important implications. First, should the United States encounter a cyclical downturn, there is much less “fiscal space” to pursue deficit-driven demand. Second, it makes the United States vulnerable to a return to normalcy in financial markets. In FY 2008, on the eve of the financial crisis, the United States paid about $454 billion in interest on the federal debt. For the latest fiscal year, FY 2014, those payments were $431 billion. How could this be, with the debt escalating so rapidly, both in levels and as a share of GDP?

The key is the extraordinary low interest rate environment. In November 2007, the US government paid an average interest rate of 4.9 percent on its interest-bearing debt. In September 2014, that number was 2.4 percent.

It is impossible to say just when interest rates will return to historical norms. Speaking this week at The Chicago Council, Martin Wolf emphasized just how exceptional the present period of low rates is. Unless one believes that this extraordinary period will persist indefinitely, though, there will come a time when rates pop back up. When that happens, the cost of servicing the large US debt will pop up as well, even if we maintain more positive numbers like the one that came in this week.

Are EU Sanctions Working?

REUTERS/Alexei Nikolsky/RIA Novosti/Kremlin

REUTERS/Alexei Nikolsky/RIA Novosti/Kremlin

My friends at the European Center for International Political Economy (ECIPE) posed a serious question on Twitter this morning as part of their #ECIPEdebates: Are EU sanctions on Russia working? Constrained to 140 characters, I offered a flippant response: If goal is to annoy Russians and make symbolic gesture, then yes. Otherwise, no.

It may be worth addressing the question a little more carefully, particularly because it touches on the foreign policy topic of the week, following the President’s press conference remarks on Syria and ISIS– what is a strategy and do we have one?

In the aftermath of the Presidents’ gaffe, there were some interesting interpretations of just what a strategy might be from his supporters. From Vox:

Viewed in context with the rest of his remarks, Obama’s point might be that there is no good strategy available for fully defeating ISIS in both Iraq and Syria — which is both consistent with his approach to the crisis in those countries, in which he has primarily avoided risky escalation, and perhaps true.

An actual authority on strategy, Lawrence Freedman, tweeted:

Better to be tentative about strategy when there are no easy answers than claiming to have strategy when don’t.

— Lawrence Freedman (@LawDavF) August 28, 2014

This seems to reveal some semantic confusion. A strategy need not mean a committed invasion plan, nor is it defined as a measure which guarantees the full achievement of all goals. Instead, a strategy demands careful thought about the objective that an implementer is trying to achieve and then picks the approach that works best according to that objective. The approach itself might be quite intricate, prescribing different actions (or inaction) according to the way events play out. The choices would depend on an analysis of how an adversary is likely to react to each move. But there would be a plan. Note that by this definition, resolving to work on one’s putting game and hoping the problem goes away is a strategy, just not a very good one.

This is where Vox and Freedman go astray. They equate strategy with easy success. In fact, the optimal strategy may well mean choosing the least bad option. But a failure to engage in that process can make things even worse.

This was at the heart of the President’s debacle over Syria a year ago, when he was considering air strikes. It was never clear what the objective was. There were a number of plausible candidates:

  1. Remove Assad from power.
  2. Defend international restrictions on chemical weapons use.
  3. Protect the Syrian populace.
  4. Back up Presidential threats (red lines) to ensure credibility.

The core of the problem was that it was never clear which goal the White House was pursuing. Nor could one claim that a policy such as air strikes would be optimal, no matter what the ultimate objective. Different objectives called for different actions.

Back to Russia and the EU. We can ask the same sorts of questions. What are the United States and the EU trying to achieve? Here are some candidates:

  1. Compel Russian withdrawal from Crimea and the Eastern Ukraine.
  2. Ensure that international accords, such as the 1994 Budapest Memorandums on Security Assurance, are credible. [This was the one in which Russia, the United States and the UK promised to defend Ukraine’s territorial integrity if Ukraine gave up nuclear weapons].
  3. Make sure Russia goes no further, e.g. by threatening NATO Article V allies such as Estonia (where the President just visited).
  4. Signal displeasure.

Which of these is the objective of U.S. and EU strategy? The answer would help one assess the efficacy of the strategy. None of the measures so far have pushed Russia out of Crimea nor blocked interference in Ukraine. They have imposed serious economic costs on Russia, so one might argue that it is just a matter of time, but for the moment Russia seems determined to bear these costs.

The sanctions might serve as a warning shot, a means of saying: You may go that far, but no further. But the disarray over the imposition of sanctions cannot be sending that signal very clearly. To really draw a line will require actions of the sort called for by my colleague, Chicago Council President Ivo Daalder, including new defense capabilities within NATO and advanced weaponry to Ukraine.

So far, the U.S. and EU sanctions have just signaled displeasure.


Phantom French Austerity

Hollande and VallsThe New York Times is reporting a brewing political crisis in France. The Prime Minister is planning to dissolve the government in a battle over budgetary belt-tightening. Per the story:

“The political crisis reflected a widening backlash against austerity not only in France but in Europe more broadly, as well as deepening tensions between France and Germany, which continues to advocate budget cuts as necessary to restore confidence in the eurozone.”

The authors contrast France’s woeful recent record of poor growth (none in the first half of 2014) with that of Spain. After suffering a much sharper downturn, “Spain, whose government last year pledged to ease up on austerity, is only starting to see the return of some growth.”

The story presents a simple tale: governments that follow the misguided path of austerity (presumably cutting spending) suffer from weak growth, while those who spend more freely can turn the corner. This is a Keynesian line of thinking, but the authors present the causal links as received truth, rather than as contested theory.

Relatively few people like quibbling about macroeconomic theories, so let us delve further than the authors did and look at data. From the World Bank dataset, here are government final consumption expenditures as a percentage of GDP:
France_GraphThese numbers do not seem to support the Times story at all. The fiscal pain, it’s plain, has mainly been in Spain. Before jumping to that conclusion, though, a bit of caution is in order. The virtue of looking at spending as a percentage of GDP is that it lets us compare different-sized countries more easily (France’s economy is bigger than Spain’s). It can make comparisons across time tricky, though, when GDP is fluctuating. This is not too much of a problem for France, where from 2008 to 2013 GDP grew by a total of 1.1 percent, with only modest swings. Spain, on the other hand, saw its GDP plunge 17 percent from a peak in 2009 to a trough in 2013, before experiencing a 2.7% rebound in 2014.

But these adjustments only sharpen the contrast between the Times tale and the data. Spain has cut expenditures to well below peak crisis levels – which were lower than French levels to begin with – and is now starting to see growth. French austerity is very difficult to discern – spending is above pre-crisis levels and staying relatively constant.

To be fair, in the case of both France and Spain, the story emphasizes pledges and plans, rather than the effects of past budget measures. Perhaps consumers and businesses in France and Spain are acting on the basis of their expectations about the future rather than responding to the immediate effects of current spending.

This is a possibility that received a lot of attention in macroeconomics (the so-called “rational expectations revolution”), but the upshot was that a great deal of Keynesian thinking got tossed out the window. As a small taste of why, consider what the average Parisian should make of the French government’s austerity talk. Should that person believe that budgets will be trimmed, just because President Hollande says so? Or should that person look at the country’s recent track record? Or should that person undertake a more sophisticated calculation of how France will need to respond to political and economic pressures in the years to come? One could make a case for each of these approaches, though the gullibility approach of accepting public pronouncements seems the least supportable. More sophisticated approaches may lead our Parisian to ask whether he will ultimately have to pay back a trumpeted fiscal stimulus, thereby undercutting the enthusiasm the stimulus was supposed to inspire.

Even though the a Keynesian approach may be called into question by recent experience, the episode still provides evidence of John Maynard Keynes’ acuity. After all, it was he who warned us: “Practical men, who believe themselves to be quite exempt from any intellectual influence, are usually the slaves of some defunct economist.”