Transcript

Jessie Romero: Hi, I'm Jessie Romero, director of research publications at the Federal Reserve Bank of Richmond. Thanks for listening to "Speaking of the Economy," which you can subscribe to in Apple Podcasts.

This is our second of two conversations with Thomas Lubik, a senior advisor in the Research Department at the Richmond Fed. In this episode, we'll be talking about whether the government should reduce debt or provide stimulus and assistance when the economy faces a major shock, such as the COVID-19 pandemic. In the previous episode, which you can find on our website or in Apple Podcasts, we discussed when the government decides to have a budget deficit and what constraints exist on deficit spending.

Let's pick up the conversation where we left off.

Some pundits and policymakers would argue that a severe economic downturn is one instance when a government should temporarily boost spending over revenue in order to make up for lost private sector activity. Do past experiences support this view?

Thomas Lubik: I see the deficit as a shock absorber.

In downturns, expenditure rises and this happens almost automatically in the form of what we call automatic stabilizers, such as unemployment benefits. When times are bad during recessions, tax revenues decline, so the deficit then makes up the shortfall between revenue and spending. And, to continue this thought of equity between generations, the deficit allows future generations who will be richer than the current generation to participate in supporting the current generation.

The somewhat alternative view of government spending is that during downturns, the government should provide stimulus. Let me call this the "Keynesian view" of government support of the economy that had its heyday in the 1970s.

During the 1980s, this view of stimulus started shifting quite a bit. First of all, the main authority assigned to support the economy was seen less to be the fiscal authority, Congress, and more monetary policy. The Fed was supposed to do the heavy lifting in terms of economic stabilization, subject to its inflation goal. This was the heyday of the Volcker disinflation and the defeat of inflation in the early 1980s.

Also, macroeconomic thinking among researchers started to change during that time. This was mainly driven by the so-called real business cycle theory that saw recessions and expansions as typical phenomenon driven by shocks that did not necessarily require stimulus.

Then we encountered the financial crisis and the Great Recession and then also the COVID-19 shock. That arguably led to a rethinking of this. In terms of the example of the Great Recession, there was a shortfall of aggregate demand. This is when the fiscal authorities stepped in.

COVID was different because — and I'll say this with all deliberation, very measured — one could argue that the COVID recession was efficient in that production and consumption declined at the same rate. Yes, incomes were lost, quite dramatically so. But fiscal support should not be seen as stimulus, but rather as social insurance. It fell to society, based on a social contract, to support those worst afflicted by COVID.

To answer your question, to what extent the fiscal and the monetary authority should step in? It depends on the type of shock that hits the economy. This determines the appropriate monetary and fiscal policy response.

Romero: In that case, we were talking about boosting spending to support the economy during down times. But there is a contrary view. There are people who contend that when times are bad, a government should cut spending and increase taxes. Can so-called austerity measures have an expansionary effect on the economy?

Lubik: It's a very good question. To what extent the fiscal authority should step in depends on the specific economics situation and the shock. I described the fiscal support during COVID as social insurance, so austerity in this context would have been definitely the wrong policy choice.

Most of the expansionary austerity argument centers around very specific cases, namely small open economies that already have high debt levels incurred through economic policy institutional failures in the past and that now suffer from a serious downturn. In cases like this, in order for the small open economies to regain access to international financial markets and essentially to bring the economy back on a growth path, economic measures are put in place that improve deficit and debt levels — raising taxes, lowering government expenditure. This is often described as austerity.

This is likely contractionary at first, but in the medium to long term it could very well be that this will have very, very positive outcomes. So, austerity can sometimes be expansionary, but only in a medium or longer term context.

The prime example for this austerity situation and discussion was Greece during the European debt crisis. Greece had accumulated large budget deficits, large debt over previous generations and in the run-up to joining the European [and]Monetary Union. Then, the debt crisis happened, Greece went through a horrible recession, and there was the danger that Greece might drag down other European, small open economies during this time. It was felt that Greece had to be helped in regaining access to financial markets, international markets and the European markets by restructuring the economy -- so higher taxes, lower spending. Arguably, these austerity measures put Greece on a more sustainable path that will deliver benefits for future generations.

So I would say that austerity measures can have an expansionary effect on the economy, but only in very specific situations and in the long run. Austerity, really, it's a very narrow defined concept.

Romero: Thanks so much. Those are really great points — to think that not all shocks can be treated with the same kind of fiscal medicine.

Let's close by talking a little bit about spending, not in the context of a shock, per se. In recent years, there are some advocates who have pushed for putting massive amounts of government spending to do things like fight climate change and rebuild infrastructure. There's also been a push to address longstanding inequities in education and health care, many of which have been exacerbated by the COVID-19 pandemic.

I'm wondering, does economic research suggests that we should spend within our means to achieve these goals? Or would it be worth a temporary increase in either debt or taxation?

Lubik: Thanks for that question, Jesse, because that actually brings together a lot of the different strands of thinking that I was trying to pull together throughout our interview.

I want to disentangle the issue of debt and deficits from the issue [of] whether specific government spending is worthwhile in and of itself. I want to leave aside transfers — Social Security, Medicare, Medicaid. I just want to focus on government spending to fund climate change, rebuild infrastructure, [address] inequities in education and health. Let me just call this physical and human infrastructure.

In my mind, government spending is worthwhile if it satisfies a cost-benefit test or, in other words, if it has a positive net present value. Again, this brings in this notion of intergenerational equity. It is highly likely that we will make future generations richer if we educate them now, provide them with well-run institutions [and] good infrastructure, and fight climate change. If this government spending has a positive net present value, satisfies this cost-benefit test, then it's essentially self-financing by improving human and physical capital. It raises the productive capacity of the economy and it is self-financing because it raises future tax revenues.

All of the examples that you mentioned, well, I think this principle applies to them. I'm an economist, so there's an "on the other hand" argument here as well. There's a lot of devils in the details, particularly what are the appropriate discount rates?

How can we measure these future deficits, which brings me to another point that we actually haven't touched on yet and that is useful to consider in this context. That's the relationship between the interest rate on the debt that we have incurred and an economy's long-term growth rate. If what we call trend growth — [the] average growth rate of GDP over a longer time span — is higher than the average interest rate that we pay on debt, then in a way the economy can grow itself out of high debt levels because the higher growth rates of income and therefore tax revenues, all other things being equal, can more than cover the debt service cost.

One consideration is whether the proposed additional expenditures raise the long-term growth rate or not. This case can definitely be made for variable targeted infrastructure spending, research and development, climate change issues, but also for inequities in education and health care because they're all designed to raise human capital.

Well, there is this view — and you alluded to this — among commentators [and] policymakers. Just because interest rates are so low, the government can borrow with abandon since the carrying costs of higher debt are negligible. That may very well be true at the current low rate, although our net interest payments on current debt is already close to 10 percent of all spending. We cannot take it for granted that the current low level of interest rates will persist forever. If interest rates start rising then the debt service component of our deficits will also rise, which puts a limit on what we can do in terms of considering all the other spending components.

Yes, it is true that the fiscal space is certainly wider. But again, the logic of the intertemporal government budget constraint still applies. To answer your question, I would still argue that any additional spending should satisfy this cost-benefit test is it worthwhile in and of itself, taking into account its effects on future tax revenue, future productivity, and also the willingness of investors to hold this debt.

Romero: Thomas, thank you so much. You've certainly given me and our audience a lot to think about, and I really appreciate your time today.

Lubik: Thank you so much, Jessie.