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The U.S. Is Not Too Big To Fail

As several recent surveys make clear, concern about deficits and debt is rising sharply. An NBC/Wall Street Journal survey conducted in early May showed that the share of individuals rating “the deficit and government spending” as the top priority for the federal government to address has jumped since January from 13 to 20 percent—second only to job creation and economic growth. According to Gallup, “federal government debt” now ties with terrorism for the top spot in perceived threats to our future well-being. It is entirely possible that we are reaching an inflection point in public attitudes that will force the political system to change course.

Indeed, as Janet Hook shows in a well-reported piece in Monday’s Los Angeles Times, concerns about the deficit are already forcing congressional Democrats to scale back ambitious plans for continuing stimulus. Hook quotes Mark Mellman, a pollster who has long worked with Democrats, as saying that “there’s no question that people are almost as concerned about the deficit and government spending as about jobs. It is not just about the actual dollars—it is a metaphor for wasted money and lack of discipline and long-term economic decline.” A near-identical complex of concerns created an opening for a third-party presidential movement that garnered 19 percent of the vote in 1992 and strengthened the case for the policy of fiscal restraint Bill Clinton adopted in 1993.

All of this raises the question of whether public sentiment coincides with sound economics. A pretty good case can be made that it did in the 1990s, although it’s also possible to argue that the U.S. economy got a special boost during that decade from information technology and the winding-down of the Cold War. Today, many economists fear that we may be headed for a replay of Japan’s “lost decade” of slow growth, which in our case would condemn us to historically high levels of long-term unemployment.

That raises another question: What can the United States learn from the Japanese experience that should shape our own policy choices during this decade? This is more than an academic question, and the discussion cannot be confined to professional economists. After all, how to deal effectively with the twin challenges of economic growth and fiscal sustainability will be this decade’s dominant domestic policy debate.

It was in that context that I waded (some would say blundered) into a public colloquy with Paul Krugman and his legions of supporters. In the process, I discovered that Japan’s lost decade is surprisingly difficult to decode and that much of the data doesn’t mean what it appears to. Because Adam Posen of the Peterson Institute for International Economics seems to be the generally acknowledged guru of Japanese economics studies, I turned to a lecture he delivered at LSE last month. Posen argues that when the Japanese employed traditional Keynesian stimulus, it worked in the ways that conventional theory would predict and that the recovery faltered when the government unwisely pulled back from stimulative policies. (In that respect, Japanese policies in the late 1990s were akin to FDR’s turn toward restraint after 1936, which halted the recovery and renewed the decline.) Posen sums up as follows:

“Note, however, that this assessment is not a blank check for unlimited fiscal stimulus at every time, everywhere. Japan in the 1990s was where fiscal activism should have worked the best, being closed, with passive highly home-biased savers, and a large economy with essentially no foreign indebtedness. Having a low government share in GDP and a low tax base also means the distortions incurred by sustained fiscal expansions are of relatively low cost. Looking at today’s world, only the U.S. shares these attributes with Japan, and can thus afford to engage in ongoing fiscal stimulus in a protracted recession—and the lesser passivity of U.S. savers and increasing American foreign indebtedness suggest some limit will be reached.” [Italics mine]

In short, the United States can go down Japan’s road, but not as far. In that respect, the U.S. stands between Japan and the UK, whose economy is far less closed than Japan’s and whose public sector is much larger. (To judge from the important speech Prime Minister David Cameron gave on June 7, he agrees with Posen’s assessment and has decided to attack public spending frontally.)

To get a better handle on how far the U.S. can venture down the road of sustained fiscal stimulus, I turned next to an important survey, “Activist Fiscal Policy to Stabilize Economic Activity,” written by two macroeconomists, Berkeley’s Alan J. Auerbach and my Brookings colleague William Gale. In a key section of their paper, titled “Short-Term Stimulus with Long-Term Deficits,” they state that “there are many reasons to think fiscal policies would have different effects if they are adopted during a period of fiscal stress than they would otherwise. ... [F]iscal consolidations have less contractionary effects when adopted under fiscal stress, as measured by high debt and projected government spending relative to GDP.”

In plain English: the higher spending and public debt go, the stronger the economic case for fiscal restraint. At some point, serious deficit reduction ceases to be a green eye-shade exercise and becomes essential for sustainable economic growth. But when? After summarizing the grim prognosis for U.S. deficits and debt during this decade and beyond, Auerbach and Gale formulate the choice as follows:

“[P]olicy makers will need to decide when to cut off stimulus and start imposing fiscal discipline. Cutting off stimulus too soon could plunge the economy into a new downturn, as happened to the United States in 1937 and Japan in 1997. Letting stimulus run for too long could ignite investors’ fears and create a ‘hard landing’ scenario.”

In retrospect, Keynesians agree that U.S. and Japanese policymakers underprovided fiscal stimulus, given the length and severity of the crises they faced. If we were sure that we are now up against a comparable crisis, then the case for continued stimulus would be compelling. But the problem is that we aren’t sure, and we do know that as public spending and deficits continue to rise, the risks that come with excessive debt accumulation increase significantly.

I draw a few rules of thumb from this ensemble of theory, data, and prudential argument.

· First, the economic case for terminating key safety-net programs such as extended unemployment insurance is very weak, and the human case for continuing them is very strong. (Large, permanent programs affect the taxes and revenues that define our fiscal future—not modest cyclical programs that shrink as the economy improves.) It seems wrong-headed to allow valid concerns about deficits and debt to trump the good that we can do for our fellow citizens at modest cost during times of stress.
· Second, setting aside political constraints, it is not easy to decide whether we need another round of major economic stimulus to get the economy to the point of self-sustaining growth. It is facile to argue that all the risks lie on the side of inadequate stimulus. As we are learning from the European case, the global financial crisis has left investors very jittery—so much so that the budget woes of one small country (Greece) have been enough to trigger not only fears about excessive public debt in many other countries, but also a destabilizing flight from the Euro. This suggests that any additional stimulus should be linked explicitly to fiscal restraint down the road.
· What matters most is making a credible commitment—through binding legislation that changes both programs and budget procedures—to alter our long-term fiscal course before our debt enters the red zone (where federal debt closes in on GDP). I can only hope that the report of the president’s fiscal commission, due out in December, sets the stage for the national discussion we have evaded for far too long. This discussion will test our capacity to govern ourselves wisely, and the whole world will be watching. History makes one thing clear: In the long run, no country is too big to fail.