I readily grant you that what follows sounds a bit obscure and in the weeds, but trust me: It’s really important.
When it comes to economic policy, “fix your roof when the sun shines” translates as follows: The time to prepare for the next downturn is when the economy is solidly firing on all cylinders. Right now, we’re enjoying low unemployment rates, real wage gains, and slightly faster gross domestic product growth. State budgets are not back to where they should be, but they are getting there. As a result, in part, of the deficit-financed tax cut, that’s not the case for the federal budget, which is going more deeply into the red. But I’ll get to that below.
Now, be assured that neither I nor any other economist can tell you when the recession will hit. But we know it’s out there somewhere, which is why we need to discuss space, i.e., fiscal space and monetary space. If you think of the next recession as a house fire, then these policy buckets are water buckets that need to be filled to the brim if we’re to effectively fight the blaze.
Monetary space is easier to explain, so let’s get that out of the way. It’s the distance between the interest rate the Federal Reserve controls and zero. The Fed’s primary tool against recession is to lower the interest rate, so if the rate they control is 2 percent when the recession hits, they have less monetary space, as in room to lower, than if the rate were 5 percent (three points less, to be precise). Hitting a recession with a Fed funds rate at 2 is like going into a fire with a bucket that’s barely half full.
Fiscal space is trickier, because it’s not bound by zero. It’s bound largely by politics.
When we hit a downturn, fiscal policy naturally expands. There are the “automatic stabilizers,” such as unemployment insurance or food stamps, which ramp up as more people need them. There’s also some support from the federal tax code, as decreasing incomes can push people into a lower bracket (the regressivity of the new tax plan dampens that stabilizer).
But especially in a deeper downturn, it will take more than the automatic stuff. Congress will need to enact discretionary stimulus as well, and therein lies the politics.
The economists Christine and David Romer recently released an important paper on these issues, showing that when countries have higher debt-to-GDP ratios, they do less to offset negative economic shocks. In that sense, a country with a debt ratio of 80 percent has less perceived fiscal space than one with a ratio of 40 percent. Empirically, the Romers find that countries with fiscal space (low debt ratios) apply anti-recessionary fiscal policy much more aggressively than countries without fiscal space. And it makes a big difference: “The fall in GDP with fiscal space is just 1.4 percent. The fall in GDP following a crisis without fiscal space reaches a maximum of 8.1 percent.”
Here’s what you need to know about this. It is close to certain that the United States will enter the next downturn without a lot of fiscal space, by this definition. The U.S. debt ratio is about 75 percent, but it could hit the mid-90s over the next decade. As noted, part of that rise is the unpaid-for tax cut; part is the structural gap between our revenue and spending (a structural budget gap is one that persists even when the economy is at full employment).
But here’s the other thing you need to know. Although fiscal space by this definition is not unlimited, there’s no good economic rationale that should lead policymakers to throw less fiscal water on the fire with high vs. low debt ratios. That’s why that word “perceived” above is so important. There is nothing in the hydraulics of countercyclical fiscal policy that makes it less effective at high, vs. low, debt levels. Whether it takes the debt ratio from 40 percent to 45 percent or from 75 percent to 80 percent, five percentage points of discretionary fiscal policy will be equally effective against the next recession.
To be clear, this is not an argument that the debt ratio doesn’t matter. There are economic risks of high debt levels. A spike in interest rates is a much more expensive problem at high vs. low debt levels. Throwing fiscal policy at a full employment economy can evaporate into higher prices vs. new, real economic activity if resources are fully utilized (which, according to inflation gauges, is not yet the case in our economy).
What, then, explains the Romers’ findings? In my interpretation, it’s not that fiscal policy is less effective at high debt levels. It’s that policymakers simply won’t do much of it when they’re staring down debt-to-GDP levels well above average. But at least in countries such as ours that can handily finance their debt and control their currency, this reluctance reflects political, not economic, constraints.
This fact does not make such constraints any less binding. In fact, given our current congressional majority, I suspect their ideological opposition to spending on vulnerable people would block them from helping those hurt by recession regardless of debt levels, which, for the record, they clearly don’t care about when it comes to tax cuts.
I’ll have more to say about these fiscal issues in future columns. There’s another perceived constraint worth knocking down in this space: the idea that fiscal policy doesn’t work fast enough, and thus monetary policy is the only viable defense. In fact, there are ways to get the fiscal water to the fire almost as fast as the monetary water.
But for now, let us recognize that the only reason we’ll have limited fiscal space in the next recession is because we’ve convinced ourselves that this is the case.